Corporate finance is about maximizing the value of a firm or business. Alternatively, it is about maximizing the returns to the owners of that business subject to acceptable risk levels. Returns come in two forms: capital appreciation, or the growth in value of a business over time, and dividends (for C corporations) or economic distributions (in excess of pass-through tax liabilities) for pass-through tax entities like S corporations and limited liability companies.
All a firm’s activities can, in some sense, be considered part of corporate finance. These activities, including sales, marketing, production, manufacturing, service, distribution, accounting, human relations, strategy and more, lead to the earnings (say EBITDA, net income, or net cash flow), which are then allocated according to a three-part corporate finance decision tree. Managing your finances and a regular flow of working capital mississauga is crucial.
At the outset, let me say that my colleague, Travis Harms, has written a wonderful series called Corporate Finance in 30 Minutes. He has a paper on each of the corporate finance decisions and I highly recommend the series to readers.
The three parts of the corporate finance decision tree for public and private businesses are:
- The investment (or reinvestment) decision. The investment decision is referred to as the capital budgeting decision in usual corporate finance terms. I prefer the terms investment (or reinvestment) to focus on the fact that business owners and boards must make decisions regarding the reinvestment of the cash flows generated by their businesses.
- The financing decision. This decision is referred to as the capital structure decision in usual corporate finance terms. Decisions are made regarding the level of debt and equity that businesses will use to finance themselves. These decisions determine the cost of capital, or the hurdle rate, for a business.
- The dividend (or distribution) decision. To the extent that there is residual cash flow, or, that there are not sufficient capital projects to invest in at or exceeding a company’s hurdle rate, then the decision may be made to return cash flow to its owners in the form of dividends.
By addressing each of these three decisions, corporate managers and boards determine what will be done with all available cash flows of a business, whether from the operation of the business itself or from financing sources such as debt or the sale of stock. The effectiveness with which they make these decisions determines, in large measure, the success of value creation for private firms.
Decision #1: The Reinvestment Decision
The capital of a business each period must be allocated productively to maximize value. Available investment dollars, whether from the reinvestment of earnings or the acquisition of debt (or sale of stock), must be allocated.
The reinvestment decision is also called the capital budgeting decision because companies must allocate their capital. I call it the reinvestment decision because for most companies in most periods, the majority of investable assets are generated from the business’s operations and are available for reinvestment.
In the figure below, we show components of the reinvestment decision in the context of a company’s conceptual cash flow statement, beginning with its net (after tax) income. In the case of tax pass-through entities, this is income after the payment of all corporate taxes and the distribution of pass-through tax liabilities to owners.
To the net income of a business (Line #1), we add depreciation and amortization, the non-cash charge (Line #2), and account for the net investment in working capital (Line #3).
The basic decision guide for capital allocation is called the “hurdle rate” or the required return. Projects that have expected returns in excess of the hurdle rate are considered to create value. Projects that have expected returns less than the hurdle rate are unfavorable and, if implemented, will diminish value and returns. The hurdle rate is each company’s weighted average cost of capital or WACC.
I like to think of two kinds operating investments. The first is replacement of existing capital assets which have reached or exceeded their useful lives (Line #4). The second is new projects (Line #5). Sometimes it is difficult to distinguish between these two kinds of investments. Nevertheless, both should be subjected to analysis to determine if they meet the hurdle rate test. We are, of course, assuming that the new projects meet the basic test of common sense and fit into the strategy of a business. For purposes of this discussion, we have included any sale of operating assets in the reinvestment decision.
We lump a third type of investment in the “operating” category, that of investments in low-yielding cash or marketable securities and other assets unrelated to the nature of the business (i.e., nonoperating assets) (Lines #8 and #9). We do this because many private companies do, indeed, invest in excess nonoperating assets. They will not meet the hurdle rate test, nor will they meet the test of common sense, or fit the business model.
Nonoperating assets suck up cash flow and, because of their normally low yields, dampen returns. Often, the reason for accumulating cash is “for a rainy day” or for the unexpected acquisition. In my experience, such assets tend to burn holes in the pockets of managers who sit and look at the assets on their balance sheets. So there is an additional risk that the nonoperating assets will be spent on investments that do not meet a company’s hurdle rate.
The sum of Lines #7 and #10 combined provide the net investment in all assets (operating and nonnoperating) at Line #11. At the end of the year, a company will have invested less than, equal to, or more than its available net operating cash flow for the period. At this point, analytically at least, we move to Decision #2, the financing decision.
Decision #2: The Financing Decision
The financing decision is important because all investments must be financed. Financing decisions determine the capital structure of a business, or the relative use of debt and equity in the capital structure.
If the cash flow does not come from operations (Line #11), it must come from borrowings or the sale of stock. The financing decision is summarized in the following figure.
We bring Line #11 over as the beginning point for the financing decision. A company will want to borrow funds, which are lower cost than equity, until the point where its cost of capital is minimized. For a more detailed discussion, see Travis Harms’ Capital Structure in 30 Minutes. Corporate value is maximized when the cost of capital is optimized.
In any event, corporate management determines the extent of leverage that will be utilized for a company. That leverage decision, together with the investments made in the investment decision, determine the extent of necessary debt acquisition (Line #12) or debt retirement (Line #13) in a given period. It may also be necessary or appropriate for the company to sell additional stock (Line #14). The net of both decisions, reinvestment and financing, determines the cash flow available to equity owners (Line #16).
In corporate finance terms, the capital structure decision relates to the relative use of debt and equity at their respective market values, and not their book values. For debt, in most instances, the stated book values can be assumed to be at or near market values.
Equity is a different story. Many businesses generate market values substantially in excess of their book values. Therefore, to make appropriate capital structure (i.e., financing) decisions, corporate owners and boards must have current information about the market values of the equity in their businesses. This information will not be available in the absence of a regular appraisal process for a business.
Decision #3: The Dividend (or Distribution) Decision
In the conceptual analysis thus far, we have looked at the reinvestment and financing decisions. These two decisions are interrelated. Reinvestment decisions (capital budgeting) are made based on the hurdle rate, for example, which is established through the financing decision (capital structure).
The net results of the reinvestment and financing decisions determine the amount of cash flow available for allocation to owners through the third corporate finance decision, i.e., the dividend decision. We see the dividend decision in the following figure.
Conceptually, the dividend decision is straightforward. We begin with Line #16 from the financing decision, or cash flow available to equity owners. Returns to owners come in two forms. The first is dividends to shareholders (or economic distributions to pass-through entity owners) as seen on Line #17.
Dividends are current returns to owners in the form of cash. These current returns are then available to owners for reinvestment or for consumption. They form an important aspect of shareholder returns.
In the alternative, companies can allocate cash flow available to equity owners through selective share repurchases. Share repurchases provide liquidity to specified owners and enhanced returns through capital appreciation for the remaining owners. For example, share repurchases reduce the number of shares outstanding and increase future earnings per share and dividends per share (assuming similar earnings) for remaining owners.
Note that in the reinvestment decision discussion above, we talked about reinvestment in nonoperating assets as part of operating cash flow. This is intentional, because some private companies make the decision to invest in cash and low-yielding nonoperating assets. They may do so at the expense of additional investments or dividends to shareholders.
The accumulation of nonoperating assets has the effect of lowering current returns (because dividends are not paid) and dampening shareholder returns (because they do not yield a company’s hurdle rate for successful investments). My advice has long been to get those low-yielding assets off the balance sheet.
We can make one more important point about the dividend decision. Every company has a dividend policy. I wrote about this in an earlier post. The questions are, what is that policy and how effective is it in terms of maximizing owner returns?
#4: Valuation Results and Shareholder Returns
Whether private business owners and boards think consciously about the three corporate finance decisions above, every company makes capital budgeting decisions (reinvestment), capital structure decisions (financing), and dividend decisions. The end result of these decisions lies in the change in value of a business over time and the current returns paid to its owners over time.
We said earlier that shareholder returns are comprised of current returns (dividends) and capital appreciation, or the growth in value of a business from period to period. Symbolically, we see shareholder returns in the following equation:
For public companies, the change in value calculation is easy. A public company’s stock has a price at the beginning of a year (V0) and at the end of that year (V1). The change in value over a year is simply (V1 – V0). Add the current owners’ returns to that and divide by the beginning value (V0) to calculate shareholder returns for the year.
It is not so easy for a private company. There is no public pricing of its shares. However, conceptually, returns are shown in the following figure:
We add the current return to owners (Line #19) and capital appreciation (Line #20) to obtain the total return to equity owners (Line #21). That sounds easy; however, unless there is a beginning appraisal for the private company (V0) and an ending appraisal (V1), there is no means of calculating the actual shareholder returns as in the equation above.
For private companies that obtain annual appraisals, the return calculation is possible. We make these calculations for all of our recurring (annual) clients, so that their owners and boards can stay focused on shareholder returns and can compare their company’s performance with appropriate benchmark returns.
This introduction to private company corporate finance begins with three important decisions: (1) the reinvestment or capital budgeting decision, (2) the financing or capital structure decision, (3) and the dividend decision. In this post, we have followed these decision in the context of the cash flow statement of a private company.
These three decisions account for all of the cash flows of a business for any period. If investment opportunities are abundant, all operating cash flow will be invested in these projects and additional financing may be employed to make further investments. If investment opportunities are abundant, there may be no residual for current dividends to owners. However, owners should be satisfied if the investments bear fruit and create value and growth for the business. Capital gains opportunities through value growth offset the benefit of current dividends.
If investment opportunities are not abundant, and there is residual cash flow after those commitments that meet the company’s hurdle rate, then the owners and board may decide to make distributions to the owners during such periods. It should be clear from the discussion above that investment in excess cash, other than for a specific short-term objective, is not an optimal investment for most private companies.
Valuation is important for business owners for many reasons. One of these reasons is for the operation of buy-sell agreements. If you are thinking about your buy-sell agreement (and you should be), then take a look at Buy-Sell Agreements for Baby Boomer Business Owners, my Kindle book on the topic.
I’ve priced it at $2.99 so you won’t have to think about the expense. So click on the image of the book. You will be taken to Amazon. Then buy the book. Don’t be mislead by the price. It is a full length book. If you like it, as most readers have, please take a few minutes and review the book on Amazon!