Concept of Value in Corporate Finance

Introduction

The corporate finance practices and their expediency as far as growing the shareholder value is concerned has been subject to debate for the last twenty years and they are among the very few elements troubling corporate monetary practice in which the academics-practitioners gap is substantially wide enough for attracting concern. The academic common grounds are that a dividend does not matter a lot while from the practitioner perspective a dividend matters very much (Allen 2004).

From an academic view the markets do not affect the shareholder value, and should not be responsible for fluctuating the commodity price of companies based on whether the company integrates to equitable shareholder value practices or no shareholder value. The specialists affiliated to investment and/or corporate financial institutions conversely, insist that organizations’ dividend practices matter very much evidenced through cases of organizations whose value crumpled after endorsing constant dividends; or whose share value increased after declaring a recommencement of constant shareholder values (Ang & Chen 2002).

The shareholder value although does not actually influence the dividends, however may appear to the shareholders as risk aspect of the commodity prices. There are scholarly researches for underpinning this assertion in which it has been described as why, based on financial premise, no relationship between price and shareholder value should be imagined (Baker & Wurgler 2004).

The investment literature usually depicts risk management as a way to identify and manage an organization’s exposure to economic threat in which economic risks are described as being the variations in market value and cash flow due to uncontrollable shifts in stock values, exchange rate and interest rate variations (Damodaran 1997). Corporate finance structures, in the financial terms, are frequently indicated to be a set of regulations, models, and policies through which an investor assures himself/herself of achieving a substantial return on investment and ensures that top management does not mismanage his/her capital (Kaen 2003).

So, the link between corporate finance and risk levels can be identified by understanding how managing risk can create value for the shareholders and makes certain that a manager manages the organization in favour of owners when shareholders and management are different identities – what Allen (2004) depicted as the contemporary conglomerates and what are known commonly as the public corporations with distributed ownerships.

This essay will attempt to critically analyze the idea of value in corporate finance. In particular, the paper will attempt to respond to the following issues: pricing of risk, relation between risk and different cash flow calculation methods, and ways of identifying future threats. It in addition presents background information regarding these issues.

Theoretical perspective

Contemporary monetary theory comprises some highly significant concepts that have shifted academic and professional thoughts regarding both risk management and corporate value. One significant concept is that an investor need increased anticipated returns in assuming greater rates of risk. Another critical concept is that an investor can eradicate an extreme deal comprising the risk linked to possessing an organization through holding, rather, an extensively-diversified collection of commodities – the idea regarding differentiation.

The outcome of the later concept is that an investor requires risk premiums only for those risks which he/she cannot eradicate by way of diversification – usually known as market or regular risks. Another concept is that a manager may grow the corporate value of an organization only if he/she can initiate something unique an investor is not capable of doing. Relating to risk pricing, this unique concept implies changing the risk portfolios or augmenting the present values associated with cash flow by means inaccessible to an individual investor (Watson & Head 2010).

For instance, consider a United States based chemical firm trading in an international market. The cash flow of this chemical industry is exposed to foreign money and stock prices risk. In case the industry involves debts in its financial model, the cash flow is in addition affected by interest level risks. However, does (or should) this risk affect well-diversified investors interested only on expected returns and risks? In the faultless market sector of previous economic premise the answer to the query is no since the risk could be avoided by increasing portfolio or by developing risk controlling strategy adopted by the investors (Broughton 2010).

Why? Fine, what may seem to be “awful draw” regarding stock price for the chemical industry is “excellent draw” for a company that supply the chemical raw materials. For the shareholder value the ordinary commodity of both industries, this “draw” offsets one another. The same applies to exchange level risks if the investors hold a globally diversified stock. However, if the investors were interested in hedging their anticipated cash flow from the chemical industry, they could get the exchange rate and stock risk portfolio on their own. Thus, in both cases, the management of this plant cannot reduce the organization’s assets (which are the investors’ desired level of returns) through merely levelling the cash flow by shielding the organization from these risks (Watson & Head 2010).

The pillars to contemporary economic premise are, perhaps, the shareholder value side issue raised by Fama (1970); diversification premise (Statman 1999); the risk pricing framework (Arnold 2008) and perfect market premise (Samuelson 1965, Watson & Head 2010). Coupled with, these premises, frameworks and systems produced definite but not all the time overtly tangible propositions regarding how a manager manages the organization and what a manager can and cannot do, particularly as far as risk shielding is concerned.

Markowitz (1959) put forward the ancient saying that one should not put all eggs in a single basket. He formalized this through illustrating that an investor could lower risk by developing a collection of securities whose anticipated return was less compared to efficiently constructively correlated returns, with the stress being levelled about optimizing stock return for a specified rate of risk. This effort resulted to the risk pricing framework that required an investor, in efficient share market, to demand risk premiums based on market risks only.

The framework’s assertive management effect was that a manager should not be worried regarding whether the anticipated returns based on a suggested investment would match the requirements of well-diversified investors worried by whether the anticipated returns were sufficient for the impact the organization would have on the regular risks of their stock (Watson & Head 2010).

The inputs perfect market premise brought into shareholder value were that an investor did react radically with regard to focus on anticipated returns and the corresponding risks when pricing shareholder value and integrating details rapidly into portfolio values (Damodaran 1997). Arbitrage chance was rare and far within; and, when it showed up, it was immediately eradicated. The next section describes how to price risks.

Pricing risk

Assuming there is a similar planet to earth where the people are risk neutral (e.g. planet PN). Planet PN is identical to earth in terms of exchange rates and risks. Given that there are similar commodities trading on planet PN and earth with the same likelihood margin. Those assets will trade relatively low on earth compared to planet PN since people on earth are risk averse.

Basically, shareholder risk preference is not relevant when pricing risk. That assertion seems as if the forward prices would be similar in the two scenarios, but they are not similar. Shareholder risk preference matter very much when determining the final prices of any risk. It does not matter to the comparative prices of the risk (McDonald 2006). Comparative prices refer to the prices of the risk compared to the prices of the respective shareholder value. It also implies the statistical relation between the risks and their respective shareholder values. The implication is that the respective shareholder values are assumed as provided, having been calculated using the risk preference of shareholders. Given the price of risk is computed based on the cost-of-risk method or any other suitable method (Neftci 2004).

These simple techniques to use risk neutrality have made it simpler in solving various difficult risk pricing hitches, but they have been underrated and/or overstated in many events. Utilizing risk neutrality does not imply that a shareholder is risk neutral. Furthermore, utilizing risk neutrality in deriving pricing models do not imply that total risk price does not vary with risk preference. Comparative risk price does not vary with risk preference.

These differences are exceptionally quoted but referring to them aid in clearing up the uncertainty created when an economic expert implies that he is utilizing risk neutrality in deriving pricing models. He is not actually utilizing risk neutrality. He is purely assuming risk-neutrality (Hull 2006). The next section illustrates whether various cash flows bring about different levels of risk.

Cash flows and risk level

Corporate monetary coordination can be described to be the process followed to ensure that a fiscal resource is acquired and utilized both efficiently and profitably, in realization of the goal of the company. Over the years, the aim for organizations has been to optimize their individual sales or profit margins. However, following the economic slowdown, the core purpose of organizations has been shifted from optimizing their individual profit margin so as to survive in the sector to maximizing their shareholder value. Optimizing shareholder value implies ensuring constant flow of payments to a shareholder with time and at regular intervals (Arnold 2008).

Since there are various return and risk of the project that an organization invests in. Therefore, organizations should organize carefully on their economic and investment choices. An organization can have various methods of spending fiscal resources like paying dividends, capital allocation during decision-making and using as working capital. Capital allocation refers to the process and/or procedure of evaluating an investment opportunity in the fixed asset which is made for producing gains for over twelve months (McDonald 2006).

And since this is an extended period procedure involving high cost, there are numerous undesired events that would be occurring at the time of making decisions, the organization requires evaluating all the possible alternatives so as to select the most appropriate method to spend the financial resources and for achieving its goal. Otherwise, a hurried planning can cause substantial effects on the organization’s future activities.

There are numerous cash flow models through which organizations can plan their money efficiently. Firstly, the framework that first appeared in the economic arena is pay-back system. The payback duration for an investment refers to the period taken prior to the total stream of projected cash flow corresponds to the first investment (Watson & Head 2010). Pay-back framework is easy to understand and in addition can be utilized when identifying that project which yield extra cash flow within a short period. However, such a model ignores the time-value of fiscal resources and the cash-flow past the breakeven level (i.e. high level of risk).

Secondly, there is the discounted pay-back framework. This model calculates the net-present-value (NPV) of individual cash flows and then assesses the time taken to payback utilizing a discounted system. The model has similar benefits as payback technique in that it is easy to understand but it has extra benefit since it has integrated time-value of fiscal resources and does not factor in the negative approximated NPV (Arnold 2008). However, such a model may in addition ignore the positive NPV and hence unfair to a long-period project (i.e. relatively low level of risk).

The other model is the NPV which is a discounted cumulative amount of the projected cash flows. The discounting level considers the period and uncertainty of the expected cash-flow that is accessible based on investment (Watson & Head 2010). It is computed through the NPV of cash in minus total cost and gives the actual margin of shareholder value. The organizations are reluctant in accepting the investment bearing a NPV more than zero and willingly ignore any project with NPV below zero.

Finally, the internal-rate-of-return (IRR) refers to the discount level that produces NPV equal to zero. The threshold inclusion criterion of IRR is allow it if the internal-rate-of-return is above the expected return, otherwise ignore the investment. The IRR cash flow model is broadly utilized due to its nature. However, the model fails in differentiating between funding and investing and can be cumbersome when dealing with mutually inclusive investments. Both NPV and IRR cash flow models have low level of risk. At this juncture, it is with no doubt that different cash flows present varying rates of risk. The next section indicates how to predict future trends.

Based on rational projections concept, what is relevant in financials, and particularly in decision-making in corporate finance, is frequently not defined by what really happens, but by the future trends of return and level of risk. If an organization is expecting to give dividends four times per year (three-month period) in immediate future, as the period of announcing draws near, the market determines what dividends are to be expected, depending on the shareholder approximates of the organization’s total income, investment opportunity, and funding plan, which are in turn determined by dividend future plans, the current plans of other industry players and expected change in tax.

In conclusion, the wider view regarding risk, different cash flow techniques and predicting of future financial patterns should be the one to provide direction on the variation in corporate finance and associated risk. While controlling should deter financial misinterpretations, it should in addition determine the financial value and future patterns that can be predicted through a simpler concept of value in corporate finance.

References

Allen, F & Michael, R 2004, Payout policy: Handbook of economics, Education Australia, North Holland.

Ang, A & Chen, J 2002, ‘Asymmetric correlations in equity portfolios’, Journal of Financial Economics, vol. 63, pp. 443-494.

Arnold, G 2008, Corporate financial management, 4th edn, Pearson Prentice Hall, Harlow.

Baker, M & Wurgler, J 2004, ‘A Catering theory of dividends’, Journal of Finance, vol. 59, pp. 1125-1165.

Broughton, P 2010, ‘Keep it simple to understand value’, Financial Times, 16 November, p. 14.

Damodaran, A 1997, Corporate finance: Theory and practice, John Wiley & Sons, Inc., New York.

Fama, E 1970, ‘Efficient capital markets: A review of theory and empirical work’, Journal of Finance, vol. 25, pp. 383-417.

Hull, C 2006, Options, Futures, and Other Derivatives, 6th edn, Prentice Hall, Upper Saddle River, NJ.

Markowitz, H 1959, Portfolio selection, Yale University Press, New Haven.

McDonald, R 2006, Derivative markets, 2nd edn, Addison Wesley, Boston.

Neftci, S 2004, Principles of financial engineering, Elsevier Academic Press, San Diego.

Samuelson, P 1965, ‘Proof that properly anticipated prices fluctuate randomly’, Industrial Management Review, vol. 6, pp. 41-49.

Statman, M 1999, Behavioral finance: past battles and future engagements’, Journal of Financial Economics, vol. 55 no. 6, pp. 18-27.

Watson, D & Head, A 2010, Corporate finance: Principles and practice, 5th edn, Prentice Hall, FT.

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