Corporate Finance

This paper provides an illustration of the field of corporate finance as it relates to business. It looks at some of the decision-making processes involved in maintaining the delicate balance between profitability and cost. The reader gleans an in-depth understanding of the situations and issues that can mean the difference between a path toward success and the road to bankruptcy.

Keywords Bond; Corporate Finance; Credit Supply Uncertainty; Dividend; Optimal Investment

Finance > Corporate Finance

Overview

At the turn of the 20th century, industrialist John D. Rockefeller found himself the target of the ire of his competitors and the scrutinizing eye of the media. In order to circumvent laws that prevented businesses from owning property out of state, Rockefeller decided to incorporate his oil business and create for it a holding company (or trust) known as Standard Oil. His move paid off — Standard Oil would in short time dominate the entire industry; from production to refining to shipping and barrel-making.

For his decimated competitors, who lay prostrate at the feet of Standard Oil, Rockefeller had gone too far by single-handedly destroying his competition. Journalist Ida Tarbell joined the fight against Standard, writing articles designed to inflame simmering public opinion against Rockefeller's business practices. The public backlash was powerful, as was the nation's political response. Rockefeller countered that the price of oil was decreasing due to Standard's presence in the industry, but his claims fell on deaf ears. Anti-trust suits were lodged against Standard Oil, and by 1911, the corporation was broken down into dozens of smaller companies.

However, Rockefeller got the last laugh. Ironically, the dissolution of his company meant that his holdings in each of these "splinter" groups would increase in value. With Rockefeller's presence in every one of these offshoot oil providers, his personal wealth increased exponentially. Already retired from business, Rockefeller could now breathe much easier — as America's first billionaire (Anecdotage.com, 2008).

In the latter 20th century, as well as the early years of the 21st century, corporations are arguably the most powerful entities in commerce. They are as myriad in size and configuration as the business environment in which they operate. From the smallest, non-profit association to the largest multinational entity, corporations are the preferred vehicle for those who seek to maximize profit-generation while minimizing costs and liability.

It is this latter point that suggests a difficult balancing act. Although risk is always a factor to consider in the development of a business, it is considered sage advice for those who invest in a business to protect his or her investment at all costs. By ensuring that profits are flowing consistently, systems and operations are streamlined and obstacles to long-term growth are addressed or circumvented, companies engaged in the practice of corporate finance are galvanizing the foundations on which the organization is built.

This paper provides an illustration of the field of corporate finance as it relates to business. It looks at some of the decision-making processes involved in maintaining the delicate balance between profitability and cost. The reader gleans an in-depth understanding of the situations and issues that can mean the difference between a path toward success and the road to bankruptcy.

The Crux of Corporate Management

Business owners and entrepreneurs must tread a delicate path. In their quest for commercial success, they must be wary of the pratfalls and obstacles that await them in business. Managers and owners must make a series of critical decisions that weigh the costs and investments as well as real and potential profits to be generated through the business process. This decision-making process is known as "corporate finance."

A relatively new practice (the notion was introduced in the 1950s), the traditional model of corporate finance encompasses three major concerns by which the entrepreneur or business manager makes financial decisions. These three arenas are:

• Optimal investment;
• Financing;
• Dividends.

Of course, how each of these three elements impacts the others has long been the source of debate — without a thorough understanding of this interaction (as well as the equilibrium that must be established in light of this triumvirate of areas), the traditional view of corporate finance must be updated (Jensen & Smith, 1984).

An interesting and as-yet underanalyzed aspect of corporate finance is the rationale of corporate managers in their pursuit of effective long-term financial policy. Weighing the best options at the disposal of chief financial officers and CEOs is a difficult and yet extremely important undertaking. Many experts, although not averse to attempting to understand the mindset of these managers (like corporate finance as a whole, the field of "behavioral finance" is still in its fledgling stages), look to the actual activities themselves as the basis for corporate financial behavior. For example, the benefits of a corporate acquisition, which may disproportionately favor the target rather than the corporation itself (such a move may therefore prove suboptimal for the CFO as an extension of corporate financial policy) (Subrahmanyam, 2008).

The decision-making process of corporate financial managers such as chief financial officers may be better understood by paying attention to the three basic concerns facing a corporation's fiscal strategy. Before one can analyze the relationship between these three critical elements of corporate finance, it is important to provide a clear definition of each individual issue. This paper next turns to each of these arenas, beginning with one of the most salient (and preferable) courses of action: Optimal investment strategy.

Optimal Investment

By its very nature, investment is a risk. Of course, some investments are more risky than others, and some potentially reap greater returns and therefore appear worth the risks. In any business setting, investments are critical even if the potential exists for negative returns in the short-run. It is therefore incumbent upon corporate financial officers and CEOs to weigh the myriad of investment options that exist and pursue the strategy that best meets corporate goals.

Effective corporate financial policy is dependent on infusions of funds into key endeavors. From an internal point of view, some of these areas include research and development, staff development and training, mergers and acquisitions and marketing activities. For some companies, the endeavor may not be to continue development of key products or expand operations — it may be to ensure that a new company grows to the status it needs to in order to succeed, or it may even be to revitalize a corporation that is struggling to regain its former stature in the face of a troubled market or previous internal mismanagement. Regardless of the rationale behind the pursuit of optimal investment, the goal of the investment strategy is not always to simply meet established performance goals and benchmarks. In fact, in most cases, investment is offered in order to exceed expectations.

Investment strategy often comes in two varieties. The first is based largely on reactive, so-called "naïve" strategies in which the trader acts on his or her experience and interpretations of the market or target area. The second, and more preferable according to empirical study, stems from careful, scientific analysis of not only the target area, but the conduciveness of the environment in which the investment will transpire (Salter, 2006).

Regardless of the approach to investment policymaking, it is clear that, of the three components of corporate finance, investment is considered by business leaders to be pivotal. In a recent survey of 140 chief financial officers from five different countries, an overwhelming majority cited investment as their top priorities (Cohen & Yagil, 2007).

Of course, a corporation's investment in its own endeavors (whether research and development, marketing initiatives, sales territory expansions or even mergers and acquisitions) is central to business growth. While this fact remains strong on the minds of corporate leaders, and is likely the first matter that comes to fore in the development of corporate financial policy, investment is not the sole factor worthy of attention. In fact, as suggested earlier, to focus on but one of the three primary factors in corporate finance is to discount the other two and therefore create a disruption to the equilibrium that should exist. It is to these two elements that I now turn attention.

Financing

In 2002, French telecommunications giant France Telecom (FT) was on life support. It was in debt by over 68 billion Euros and was in desperate need of government intervention. Investor confidence in FT was waning, and there seemed to be little hope for the company to reemerge from its debt load. FT seemed to be on its last legs.

In the last month of 2002, however, the company's chief financial officer, Michel Combes, spearheaded an aggressive effort to refinance the debt load. Using funds from the French government, and employing a comprehensive effort to streamline internal operations as well, FT embarked on a 180-degree turnaround. To catalyze the transformation, the company took out nearly several billion Euros in bonds in early 2003 to help refinance the balance of its debt. The market's positive status helped Combes' endeavor, enabling the company to make the necessary changes to pay down debt, revitalize operations and entice investors to return to the fold (Neville, 2004).

Borrowing to bolster a company's long-term financial health is not always as successful as France Telecom's example illustrates. In fact, the second element of corporate financial decision-making involves arguably a greater risk than the investment side. This statement holds water due to the very nature of financing. In this arena, a company borrows against its estimated worth or future anticipated revenues. In other words, a company utilizing financing is beholden not just to reaching its speculative fiscal performance — it is relying on the conduciveness of the markets from which the external financing comes.

In one study, attention was paid to institutional investors' rates of credit supply uncertainty (CSU). The authors use CSU as a sort of "investment horizon," in that the degree to which credit supply is plentiful or lacking has an impact on the size, length and terms of any bond issuance or refinancing authorization. High CSU, according to the study's revelations, leads to lower leverage and a lower probability of issuing bonds in the next quarter or financial period. However, high CSU also tends to prod borrowers toward banking institutions instead of bonding firms. There is, therefore, an unexpected benefit for borrowers that results from supply uncertainty and the segmented credit market, which gives corporate financial decision-makers a wide range of choices from which to borrow (Massa, Yasuda & Lei, 2007).

Bonding and other forms of borrowing are indeed important arenas for finance managers to include in their efforts to maximize available revenues for long-term growth. As suggested in the above example of France Telecom, however, the role of investors in the success of a corporation cannot be understated. This paper next looks at an invaluable tool designed to draw and retain that critical group.

Dividends

Publicly traded corporations understand the value of the investor. Without investor-based revenues and, more importantly, investor confidence, a corporation whose stock is traded on the open market may suffer. It is for this reason that a great many corporations offer dividend payments to their shareholders.

Put simply, dividends are incentives. Shareholders of stable companies (that is, corporations that are already fully developed) are often offered a portion of those companies' profits, as the business does not see the need to reinvest this surplus. With little need to use extra profits for infrastructure improvements, flagship product development or other arenas, these established corporations may see great potential returns by offering quarterly dividends to shareholders.

The rationale behind dividend packages is obvious — if shareholders are given a larger return on their investments (especially since, in light of the company's stability and modest growth, they will likely not see much profit in selling their blue chip stocks), they could use it to purchase more shares or otherwise use the dividend income to bolster their standings.

As one might expect, dividends represent a sizable percentage of corporate finance practice. In 1999, US multinational corporations listed in Standard and Poors' Compustat database reported after-tax earnings of $516 billion, but paid nearly $200 billion back to common shareholders. Those same companies reported generating $182 billion overseas, but returned to US-based shareholders $97 billion in dividend packages (Desai, Foley & Hines, 2007).

In a recent study, it was revealed that dividends do more to increase consumption among shareholders than other forms of financial returns on investment (such as capital gains). In fact, while sales of stocks may prove useful for forward-thinking investors, it appears that dividend income is more likely to be used and reinvested by shareholders than capital gains (Baker, Nagel & Wurgler, 2007). With the perception in mind of stockholders that dividends are considerably more desirable and consistent than are capital gains, it comes as no surprise that corporations are often all too happy to offer such programs in order to retain shareholders. In fact, corporate managers are likely to determine dividend payout levels before they make decisions on investment strategies. Only when corporate earnings are lagging do financial officers cool on the size of dividend distributions, but they still tend to divest in assets and defer on projects that would potentially generate positive returns before they forgo freezing dividends (Bray, 2006).

As an incentive, dividends are an invaluable tool for retaining shareholders and investors. It is perhaps due to the sheer clarity of the benefits of dividend programs that, ironically, financial officers pay more attention to optimal investments than dividends (a point raised earlier in this essay), as investment policies are more complex in nature and demand a greater degree of scrutiny in order to realize the potential returns. The benefits of dividends in terms of retaining the faith of investors are far easier to gauge.

Corporate Finance & its Aggregate Components

Corporate finance entails, as demonstrated in this paper, the use of investment, financing and dividends as means to bolster profits and retain long-term growth. However, each of these individual components is not an island unto itself. They are part of an aggregate set of procedures. As such, an interesting point to discuss is how this collective group interacts as Chief Financial Officers work them into a larger overall business plan.

As was the case with France Telecom, office machine giant Xerox was, until recently, suffering major stagnation. Financial mismanagement had given rise to a case with the Securities and Exchange Commission. Additionally, in a market that had become saturated with competitors, a lack of 21st century vision left the once iconic manufacturer of printers, copiers and other office machines in search of a path back to its previous stature. In addition to revising its accounting practices to reach a settlement with the SEC, as well as streamlining operations, Xerox invested its funds into a new joint venture with GE Capital and the development of a fast, high-priced commercial printer (Deutsch, 2002).

In its efforts to right the ship, Xerox also took out a series of bonds to help enable its turnaround. The combination of investment and financing seem to have paid off. The company is now reporting profits, and its bond rating has been upgraded in light of the company's improved financial health. Finally, with the corporation finally turning a profit, Xerox is reaching out in appreciation to its shareholders — in late 2007, the company announced that is about to resume its quarterly dividend payments (Bulkeley, 2007).

Examples such as France Telecom and Xerox provide interesting illustrations of how the three major elements of corporate finance work in conjunction in order to enhance the strength of a business. As discussed earlier in this paper, it is clear that, in the future study of corporate finance, greater attention should be paid to the dynamics by which these concepts, which are often viewed separately, work in concert.

Conclusion

Corporate business is a fickle endeavor in the 21st century commercial world. Success in this field depends not only on smart, innovative management practices — it depends on external factors as well. Corporations that take this fact to heart tend to find long-term success.

Chief financial officers know that such success is contingent upon sharp corporate finance strategies. These strategies encompass three major areas: optimal investment, financing and dividends.

The former of these three arenas entails, as its name suggests, making the right choices on investments. Some corporate managers rely on "gut decisions" to drive their investment pursuits. It is the manager who initiates a careful analysis of the environment in which investments will be made to ensure that driving corporate dollars into one or more program will both bring returns and ensure the company's long-term growth. It comes as no surprise, therefore, that CFOs overwhelmingly embrace investment as the more critical of the three major elements of corporate finance.

Of course, one cannot view investment as the sole issue on the minds of financial officers. Especially for those companies attempting an upgrade or revitalization, corporate financial planners must look outside of their environs for assistance. Such policies are often integral to a company's revival, as the case of France Telecom clearly demonstrates. Furthermore, a corporation's turnaround can also improve its standing in the eyes of lending and credit institutions, which means an improvement in status for companies and in turn, an influx of additional investors. While corporate finance experts believe this second area is not as high a priority as optimal investment, it is clear that financing can help make the difference between a successful company and one that has fallen flat.

Third among the chief issues for which a corporate financial officer must account is that of rewarding investors for their loyalty and contributions to the corporation. As investors believe that a flat quarterly payment is more stable than capital gains and other forms of shareholder appreciation payouts, dividends are the preferred vehicle. This practice keeps investors loyal to the company and, at the same time, continues to increase consumer consumption.

The study of corporate finance is a relatively new discipline, with roots back only as far as the 1950s (when corporations became more prevalent in the modern economy). Although the three basic components of this critical practice are worthy of in-depth study, corporate finance as an academic topic is somewhat limited in its information in one vital area. While each individual component is critical to corporate finance, success is achieved based upon how each of these three practices work in concert with (or in conflict with) one another. This paper has presented two cases of major corporations that had previously experienced downturns and, utilizing all three elements of corporate finance, experienced revivals that appear to be long-term. There are likely more examples to be found as the discipline of corporate finance continues its evolution.

Terms & Concepts

Bond: Lending vehicle whereby an entity (corporation or government) borrows funds from an investor for a defined time period at a specific interest rate.

Corporate Finance: Term applied to the decision-making process undertaken by financial officers in developing business strategy.

Credit Supply Uncertainty: Degree to which credit supply is plentiful or lacking; has an impact on the size, length and terms of any bond issuance or refinancing authorization.

Dividend: Corporate policy whereby profits of a stable company are divided among shareholders rather than reinvested.

Optimal Investment: Investment strategy that most accurately meets revenue-generating and corporate goals.

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Suggested Reading

The age of anxiety. (2007). CFO, 23(10), 77. Retrieved January 20, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=27149332&site=bsi-live

Baeyens, K. & Manigart, S. (2003). Dynamic financing strategies. Journal of Private Equity, 7(1), 50-58. Retrieved January 20, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=11583800&site=bsi-live

Lintner, J. (1963). The cost of capital and optimal financing of corporate growth. Journal of Finance, 18(2), 292-311. Retrieved January 20, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=6643481&site=bsi-live