Corporate Finance: Maximizing Shareholder Value

Corporate finance is the subfield of finance that deals with corporate funding, capital structuring, accounting, and investment decisions; it also includes the tools and analysis utilized to distribute financial resources. Ultimately, corporate finance’s goal is to maximize shareholder value whilst balancing risk and profitability. Three predominant activities govern corporate finance: capital investments, capital financing, and capital return.

Capital Investments – Capital investing covers the placement and distribution of the firm’s capital assets towards investments and the process in which the utmost possible risk adjusted returns are derived from said investments. Mainly, this consists of decisions regarding the pursuit of investment opportunity. Extensive financial analysis is used to reach such decisions.

Capital Financing – Capital financing covers the decisions regarding the optimal funding of capital investments through the firm’s equity and debt. Management ought to balance the firm’s capital structure — the specific mix of debt and equity the firm uses for investments — in the most efficient manner to maximize returns.

Capital Return – Capital return covers the decision making process regarding the time and method in which capital is returned to investors. Usually, managers need to determine whether to route excess earnings for future investments or to distribute them back to shareholders via dividends or share buybacks.

The aforementioned activities concern the firm’s capital structure. Specifically, a firm’s capital structure is the combination of debt and equity used by the firm to finance its operations and growth — in essence, capital structure is the foundation of a firm’s finances. Furthermore, given the fundamental accounting equation, Assets = Liabilities + Equity, the capital structure will always be equal to a firm’s assets. Thus a firm’s capital structure is fundamentally the structure and organization of the firm’s finances.

As such, a firm with a high debt and low equity is more aggressive and risky financially; these firms have a high leverage ratio, whereas a firm with a low debt and high equity is more conservative; these firms have a low leverage ratio. The ratio between debt and equity is called D/E. Analysts usually refer to this when referencing a firm’s capital structure.

Financing the firm

Source of capital to fund ongoing or future operations within a firm is a substantial part of corporate finance. There are three main sources of capital: debt capital, equity capital, and preferred stock.

Debt Capital – Debt capital is a form of capital which relies on borrowed funds, whether bank loans, notes payable, or bonds issued to the public. Most managers prefer debt capital because it does not dilute ownership; however it is considered more risky than other forms of capital.

Equity Capital – Equity capital is a form of capital raised by selling shares of the firm. Shareholders or investors in the firm expect an appreciation of the firm’s stock value, or for excess cash surplus to be paid out in the form of dividends to make their investment a profitable and worthwhile purchase. Equity capital may also come with certain voting rights of the shareholders.

Preferred Stock – Preferred stock is generally considered a hybrid form of security, combining elements of both debt and equity capital. Preferred stock is senior, or higher ranking, to common stock, but subordinate to forms of debt capital such as bonds in terms of claim. For example, preferred stockholders have a higher claim on distributions such as dividends and assets in the event of liquidation than common stockholders. Preferred stock is also less volatile compared to common stock, and as a result it is safer at the cost of potential yields; preferred stock is additionally callable. However, preferred stockholders usually have limited or no voting rights in corporate governance compared to their common stockholder counterparts.

Upon financing the firm, the firm must allocate its capital accordingly in the most efficient and profitable manner toward investments. To determine the most effective investments, the firm must exercise investment and project valuation, also called capital budgeting.

Capital Budgeting and Dividend Policy

The core notion behind capital budgeting is to use rigorous techniques and analysis to determine the most profitable investments that add value to a firm. The capital budgeting process can include almost anything given the various amount of investments a firm can undergo, but in general firms use a set of metrics to track the performance of a potential project or investment. Additionally, there are different methods to capital budgeting — given them, firms may find it useful to prepare a capital budget through analysis that incorporates a variety of capital budgeting methods and metrics. Business valuation, mergers & acquisitions, discounted cash flow valuation, and fundamental analysis are also all important topics in the capital budgeting world which aid in investment and project valuation.

Part of a firm’s capital budget is its dividend policy — dividend policy concerns the financial policies regarding the payment of cash via dividends, such as if to pay dividends, when to pay dividends, and how to pay dividends. If a firm has unappropriated profit then it is usually expected to pay dividends or to repurchase the firm’s stock through a share buyback program, unless the firm’s shareholders consider it a growth company; then excess earnings are reinvested into the firm’s operations for future profit. A share buyback program may be accepted when the value of the firm’s stock is greater than the returns to be realized from the reinvestment of undistributed profits — whether to be paid via dividends or reinvested into the firm’s operations. Ultimately however, that which maximizes long term shareholder value usually directs dividend policy: good policy is mandatory to maximize shareholder value, whether dividends are paid or not, because dividend policy helps drive investors to invest in the firm — either to profit from paid dividends or to profit from an appreciation in a growth firm’s stock.

Investment Banking and Financial Risk Management

Investment banking and corporate finance are often correlated terms. Whereas corporate finance concerns the finances of a corporation, investment banking is moreso an advisory service for such corporate finances. For instance, investment banking may regard the merger and acquisition of a corporation, or alternatively the task of raising financial capital for a corporation. In essence investment banking and corporate finances are two interlinked worlds.

Investment banking and corporate finance also overlap in financial risk management: the field within finance that covers the measurement and management of market risk, credit risk, liquidity risk, and operational risk. Specifically, corporate finance uses financial risk management to maximize the potential profit of an investment without realizing unwanted risk.

The Shareholder Wealth Maximization Doctrine

Although the goal of corporate finance is to maximize shareholder value, both sections of academia and the corporate world have begun to reject the Shareholder Wealth Maximization Doctrine — which states that a corporation’s sole duty is to maximize shareholder wealth at all costs within the confines of the law. Proponents of the Shareholder Wealth Maximization Doctrine argue that it maximizes wealth in society by encouraging the creation of the utmost amount of wealth possible, whereas opponents of the doctrine argue it leads to wealth inequality, immoral acts, and short term prioritization over long term growth.