We really can’t forecast all that well and yet we pretend that we can but we really can’t.

Alan Greenspan, quoted on The Daily Show, 2013¹

In a nutshell

Corporate finance is part of strategic thinking because collectively managers must assess, implement and evaluate a given course of future action in terms of its ability to create or destroy value. The most common metrics used to measure this are financial. In Part 2 we looked at finance in terms of reporting past performance, but this is not the same thing as valuing the business. A business is worth what it can be expected to do in the future. Corporate finance is about systematically choosing a course of action that will create value in the future.

In this chapter you will:

• understand how businesses measure value in the future
• look at risk and how it may be managed
• see how governance structures are set up and work
• understand the principles behind and importance of valuation in financial planning

Ensuring the future of the organisation

You don’t have to be the manager making the big, strategic decisions for corporate finance to be important. The fact is that you are already involved, because those decisions need implementing and you must align what you do to an overall direction. Look back now at the McKinsey 7-S framework. Imagine how each of those elements needs to be aligned for the organisation to maintain balance. In a similar way, knowing more about why your organisation has the capital structure and investments it does makes it easier for you to understand the purpose of your job. Later in your career it could be you deciding which plans to implement, so an understanding of the language and theory of corporate finance will be crucial then.

First we need to restate as plainly as possible what value looks like in finance terms. An organisation with no cash (or access to cash) has no future. It follows that an organisation must be concerned with how it will continue to generate enough cash in the future to fulfil the task of value creation. To do this, senior management has to make three kinds of decision:

1. Investment: deciding which projects or assets will produce free cash flows (i.e. investable or distributable returns after adjustment for earnings before taxation) in years to come.
2. Financial: deciding where is the best place to source the funding for investment. Is it better to seek new investment from equity or debt, for example?
3. Dividend: deciding whether and how cash surpluses (after other obligations have been paid) should be redistributed among shareholders, or reinvested.

Sounds straightforward. As you might expect, though, there are some caveats:

• In many free-market economies, shareholder wealth is the most important measure of value and generating returns to shareholders is more important than profit. But not all companies, countries or cultures place shareholder value so clearly above the interests of other stakeholders. Interest is growing in alternative models, such as production cooperatives, mutual societies, collaborative economies (consumers swapping goods directly with each other) and Islamic finance.
• Numbers feel real, but the quantification of value creation masks exactly how much human judgement and intuition are used in financial planning, which is a lot.
• Despite systems of safeguards intended to prevent unethical behaviour, company managers may fail to avoid temptation and put their own interests first. Corporate scandals and greed have been in the news all too often.

Nevertheless, wealth creation remains at the heart of value measurement as it is taught at business school. Wherever you work, fiduciary duty affects what you do. So, let’s look at corporate finance decisions through five lenses: governance, valuation, risk management, value and financing. I will focus on what these concepts mean for you as a manager in your day-to-day work rather than what they might mean to an investor (the literature in that area is vast).

Governance

We saw in Chapter 1 that representing the interests of the owners or founders is a basic management task. Shareholders are supposed to trust that managers will make decisions without the need for constant monitoring, and managers are supposed not to put their own reward ahead of the interests of the shareholders. This responsibility is called fiduciary duty and is a legal relationship between the principal (owner) and agent (manager).

That relationship, called governance, is what is called for in agency theory. In an ideal world – in theory – managers will act only to maximise the interests of owners or shareholders and not to further their own to the detriment of shareholders. Agency theory states that this needs to be governed to make sure that managers don’t put their own wealth first. Governance makes sure that activity carried out by managers is not in conflict with owner interests. It tries to mitigate this risk by incentivising senior managers, often with performance-based inducements such as bonuses or shares, to fulfil their fiduciary duty and create value.

It will help to understand the differences between management and governance:

• Responsibilities of management:

  –	Make day-to-day decisions to execute a strategy.
  –	To ‘do things right’.
  –	Align their actions with the boundaries set by the governing body.

• Responsibilities of governance:

  –	Oversight of the whole organisation and its structures, functions and traditions.
  –	To ‘do the right things’.
  –	Make sure that objectives are met in an effective and transparent way.
  –	Hold accountability to stakeholders and the wider community.

Boards are appointed by shareholders to undertake this setting of direction and upholding of values and to monitor and check the work of management. They are not involved in the day-to-day running of the business.

What is interesting in this case is that, amid enormous media interest, successive offers from Pfizer were rejected by the AstraZeneca board. While the popular press focused on the emotive politics of a threat to jobs post-merger and loss of British identity in the sector (despite AstraZeneca’s global reach and Swedish co-ownership), financial media coverage looked into the governance aspects of the proposed move. The background was analysed from several angles, including strategic marketing (match of respective brand portfolios, access to R&D for new product pipeline), corporate finance (cash flows drying up due to the ‘cliff’s edge’ of expiring patents) and governance (avoiding tax, dividends payments for shareholders, share price).

What made the difference here? It’s unlikely to be a question of politics. As many insiders were reported as saying, ‘price trumps politics’, and any deal – now or in the future – will hang on the vested interests of the shareholders of both companies. Pfizer’s long-term strategy may have been to bring together two large companies in order to de-merge them later on and take advantage of the new drug pipeline acquired from AstraZeneca. The story will no doubt continue to evolve.

Valuation

It is a board’s responsibility to create value as a return on money invested by shareholders. Therefore they need to understand not just the performance of the business but also how much it is worth – its valuation. They will be the ones who make decisions about buying or selling parts of the business (or acquiring others), so it’s vital for them to know what the return is, or will be, as generated by a particular investment. Governance addresses risk (and therefore financial risk) as well as valuation. Management and governance need to coordinate for a business to work well.

Senior management is expected to act to maximise shareholder value and minimise risks found in long-term financial planning. Shareholder value is measured using discounted cash flows (DCF), which allows the organisation to address two questions:

1. Will a given future strategy create value for owners/shareholders?
2. Which future strategy is better than continuing the current one?

Because of inflation the value of money will decrease over time unless invested. Fiduciary duty means that management must look for, and then be able to justify and evaluate, the best future plan to create wealth. You may have many possible courses of action available to you, so you need a way to compare like with like. The most common way to do this is by an NPV calculation, which is the total present worth of a series of future cash flows that has been discounted at a specified rate.

In finance terms, value is created when companies invest at returns that exceed the opportunity cost of capital (OCC) and this is the minimum expectation for any project in its terminal value at the end of the planning period. OCC is a key concept in corporate finance because the money working in one place is missing the ‘opportunity’ of working somewhere else and it establishes the measure of performance of an investment in a commercial organisation. The time during which economic return exceeds the hurdle rate (for example, the OCC) is known as the competitive advantage period (CAP). Beyond CAP, the advantage diminishes as returns are eroded to a point where no additional value is being produced. Context means that what is ‘long-term’ in one industry may be ‘short-term’ in another, and different parts of different businesses assess things in different ways. Critically, in all cases the past is no guarantee of the future. A planning period will end with a hypothetical point at which you expect your competition to catch up, so to continue to generate value there must then be further investment, and the cycle goes on.

While these principles are known to all players, there is enormous scope for qualitative judgement (and misjudgement) and no amount of number crunching will replace business acumen and experience. Here is where corporate finance meets the many internal and external forms of analysis featured in earlier chapters.

Calculating a discount rate

The valuation of debt covers borrowings, although here, as with equity, there is complexity and volatility (think about the jungle of traded derivative instruments or the background to the US subprime mortgage collapse in 2007), but since prices for most sources of debt are determined by open-market supply and demand, a market rate is available to determine OCC. The initial basis for that rate is the interest earned on government bonds because they deliver a (virtually) risk-free return.

Any uncertainty about the future represents risk, so adjustments for this will also be built into the calculation of a discount rate. There are three broad categories of metrics:

• Free cash flow: ‘free’ because it can be distributed to shareholders, cash is discounted over a known period at the appropriate cost of capital. The time in which any returns are in excess of this capital cost is known as the competitive advantage period.
• Economic profit: measured by, for example, EVA (Chapter 5) or market value added (MVA).
• Cash flow ROI: a modified internal rate of return (IRR) calculation using cash flows to assess whether investments exceed or fall below the cost of capital.

Risk management

Higher risk suggests higher return, which in most for-profit companies is an attractive proposition. It also has a downside, of course, if the venture fails to produce returns. The future value of risk is therefore reflected in calculations of the cost of capital. Financial economists distinguish between two types of risk:

1. Unsystemic, which is inherently present in a particular industry, sector, company or even in a narrow set of stocks.
2. Systemic (aggregate), which is the instability inherent in the market as a whole. Volatility is a systemic risk: the amount by which returns on an asset may vary over time. The more it varies and the more difficult this variation is to predict, the lower the value of the asset in the present time. The measurement of an asset’s systemic volatility is a comparison of asset return to market return and this is known as the beta (i.e. how much it moved, or didn’t move, with the market in the past). Interest rates, economic cycles and day-trading are all sources of systemic risk on stock markets.

As nervous entrepreneurs pitching unrealistic valuations on the popular TV show Dragons’ Den often find to their cost, the value of a company is tied to future cash flows. Every business is different, but management must take into account all the risk factors appropriate to its sector, size and life-cycle maturity, as well as the whole host of internal and external concerns that we looked at in earlier chapters.

Investment decisions: SVA

Shareholder value analysis (SVA) is what corporate finance has substituted for traditional business measurements in many parts of the world. Shareholders’ capital is supposed to earn a higher return than by investing in other assets with the same amount of risk. If a company sees equity returns higher than equity costs, value is created. When that value is known, the organisation can act on this to improve its performance, as well as work out how successful past projects have been. Shareholder value can be determined by discounting the expected cash flows to the present at the weighted average cost of capital. So far we have looked at finance only from the perspective of for-profit enterprises, which aim at generating free cash flows for their owners or shareholders.

The investment side of corporate finance covers stocks, shares and financial markets for managing investments and risk and would take more than a section in this book to cover. Since our focus is on the types of decisions middle and senior management need to make internally, knowing how a particular investment or project is attractive in value terms is more important.

The attractiveness of a proposed course of future strategic action is determined by its discounted cash flows. This brings us back to the capital structure of an organisation and to the weighted average cost of capital (WACC), which is a calculation of opportunity costs averaged across the capital structure of the organisation, reflecting the risks associated with debt and equity. WACC is a calculation of the percentage and cost of debt plus the percentage and cost of equity. The function of a corporate WACC is as a discount rate. In other words, the level of return on capital needed for an investment must be better than employing that debt or equity elsewhere. This approach is part of value-based management (VBM).

VBM, though, is under severe scrutiny following the near collapse of the economic system in many of the world’s mature economies. When all that matters is that every decision is evaluated in terms of the effect on shareholder wealth, the dynamic between the owners and the managers acting on their behalf is thrown into sharp contrast.

It is worth noting here that things are a little different in the case of not-for-profits (e.g. community groups, charitable trusts, non-governmental organisations (NGOs), social enterprises), where the aim is not to accrue wealth but to serve the aims of members by maximising the marginal effect of operations on the capital donated. Value here means human well-being. Can this still be measured by cash flows? Not exactly, but the idea of the time value of money is still useful to evaluate competing options for long- or short-term welfare benefits.

In many countries, the funding of the health care sector (especially if it is a public service funded by the state) is a significant – and complex – subset of valuation because it is not always obvious how to put a monetary value on health benefits. Should only the costs of interventions be compared, or rather costs versus benefits?

SMEs cannot generate the kind of data for the capital assets pricing model (CAPM) or for beta calculations, so the quickest solution is to replace many of the variable elements of SVA with market-driven substitutes (for example, by identifying and using the betas of traded companies with similar debt/equity ratios and similar economic influences). Value in SMEs is a broader concept than in traded companies, so the market value is often seen as being the price the owners would get if they were to sell the company. That may be arrived at by:

1. valuing the firm’s assets, which usually indicates the business is not viable and needs to be broken up
2. comparing what similar companies are worth (rather like valuing your house by looking at house prices around you)
3. expected future income. This last one is the most common, but may take into account all sorts of other factors, such as competitive position, industry life cycle, type of customer base, scalability of the business and so on.

Financial planning

Financial planning combines strategic decision making with the capital structure of the whole organisation into the future. Chapter 5 established where this process begins – with awareness of the current situation using financial statements and ratios. There is a lot of wriggle room for interpretation in statistics and ratios, so when it comes to planning rather than formulaic answers, you want this information to provide good, common-sense questions about the long term. When you get down to it, planning for the long term (i.e. beyond the coming 12 months) involves the following:

• Preparing for contingencies: ‘what ifs’ are the difference between simple forecasting and scenario planning (Chapter 7).
• Weighing up all the angles: a strategic direction may not always be set with only one thing in mind. A move in a new direction may have non-financial imperatives, such as laying the groundwork now in something that enables other, future steps.
• Bringing it all together: properly done and clearly communicated, long-term plans can unify by providing a perspective for all parts of an organisation and by linking the consequences of managerial decisions at all levels.

We’ve seen that the main sources of funding for future growth and investment are equity and debt.

Equity is money invested in the business by shareholders, usually in the form of shares. Additional money may be raised by the sale of new shares and usually this is in the expectation that funds will go towards non-current assets. Equity attracts returns in the future through payments of dividends from excess residual funds, but equity holders carry more risk (they are not first in line for repayment) so will expect a higher rate of return, which they will also discount to present value to make sure it is invested well. Shareholders are closer to the running of a business than financial institutions, so this can bring additional pressure to bear on senior management to aim for short-term gains.

Debt, meanwhile, is money lent to the business by investors or financial institutions without the expectation of a say in the aims or purpose of the business. Debt offers a fixed claim to interest payments and may offer a slightly lower cost of capital than equity because the lender knows that they have preferred status for repayment. Finding the right balance of long-term funding is not easy. Many companies try to match long-term assets to long-term borrowings or equity, but prefer to maintain liquidity in working capital financed from inventories or short-term securities.

Capital budgeting is the annual listing of major investment projects and these are expenditures that will, presumably, bring some future benefit if properly implemented. All such decisions must consider:

• the current and future composition of the organisation’s capital structure
• whether the size and balance of current asset structure is right for the expected returns, and how that structure should change in the future
• the size of funding needed to finance future asset structure.

The ratios mentioned in Chapter 5 can be useful in addressing some of these issues because they are all in relationship with the capital structure. What you as a general manager are looking for is:

1. a way of explaining present and past performance, and
2. assessment of risk and return in future activity.

This leads to the further question of the best sources of capital, because as we have seen above, equity and debt carry different costs and can have implications for valuation. All of these options will produce changes to the capital structure, which is why it is important to find out from your finance staff what is appropriate for your organisation. Organisations may change their capital structure in more radical ways. Here are just a few:

• Merger or acquisition: Legally, a merger is the creation of a third entity from the coming together of two others and an acquisition is the new ownership of one organisation by another. However, the distinction is often blurred, as what occurs in law can be very different to what is experienced by all those concerned.
• Leveraged buyout (LBO): A (private) takeover funded mostly with debt from institutional investors, usually as a prelude to the rapid sale or radical reorganisation of assets. Collateral comes from the expected cash flows or existing assets of the target.
• Spin-off: This is when a potentially profitable part of a going concern is sold off as a separate business with, initially, identical ownership structure (and perhaps management team as well) in both old and new.
• Carve-off/divestment: A privatisation would be an example of this in the public sector, but in the private sector it can usually indicate the removal by sale of unwanted assets. Reasons for doing this may vary, but often include a wish to return to a particular core competence or activity, indication of under-performance of a part of a portfolio, fundraising, or as a requirement imposed by regulatory bodies.
• Bankruptcy: A legal status that indicates the inability (of a person) to pay one’s creditors. However, when applied to the ‘corporate person’ bankruptcy may indicate a more subtle and controlled (protected) relationship with creditors whereby commercial activity may continue. This form of arrangement may vary from one country to another.

Putting it together: governance in an age of market failure

Corporate governance is what ties together the various strands in this chapter. Governance and agency theory refer to the structures in place in an organisation to represent and protect the interests of owners and shareholders. If the agent possesses asymmetrical information of a kind that may damage or destroy shareholder value, it could lead to dilemmas, such as:

• moral hazard: behaviour that takes advantage of asymmetric information after a transaction
• conflict of interest: behaviour of an individual due to multiple interests, at least one of which is in direct opposition to the interests of the principal (owner).

In some countries governance of larger, publicly traded companies is legislated for and codified. Structures that organisations put in place to mitigate the risks of governance failures include managerial incentive schemes, takeovers, board of directors, pressure from institutional investor, product market competition and organisational structure, all of which can be thought of as constraints that affect the process through which risk and returns are distributed.

Further reading

Note

1 www.businessinsider.com/alan-greenspan-on-the-daily-show-2013-10