Part A: Financing
Overview of corporate finance
Key takeaways
- Corporate finance covers three interlinked decision areas: the capital structure decision (how to finance the firm), the capital investment decision (what to invest in), and the working capital and payout decisions.
- The finance manager has five functions: investment, financing, working capital management, dividend decisions and risk management. Each later chapter is a deep dive into one of them.
- The operative goal is shareholder wealth maximisation, maximising the market value of equity, rather than profit maximisation, because only wealth properly accounts for the timing and risk of cash flows.
- The shareholder-manager agency conflict recurs across the paper: managers may resist an optimal capital structure, overinvest in low-return projects, hoard excess cash or resist a value-creating acquisition.
- Linking pay to share price or economic value added performance is the standard resolution, aligning what management is rewarded for with what creates shareholder wealth.
Corporate finance is the branch of finance concerned specifically with how a company itself raises, allocates and manages capital, the same core decisions introduced generally in CIFA Introduction to Finance and Investment, examined here in far greater depth.
Scope of corporate finance
Corporate finance covers three interlinked decision areas that structure this whole paper: the capital structure decision (how to finance the firm), the capital investment decision (what to invest in), and the working capital and payout decisions (how to manage day-to-day liquidity and how much to return to shareholders), with mergers, restructuring and risk management as major applied extensions of all three.
The financial decision-making process
As in CIFA Introduction to Finance and Investment, sound financial decisions follow a consistent process: define the objective, identify and evaluate alternatives, gather data, apply the appropriate analytical tool (WACC and capital budgeting techniques, covered in the chapters on the cost of capital and capital investment), decide, and monitor the outcome.
Functions of a finance manager
- Investment (capital budgeting) decisions: the chapter on capital investment decisions
- Financing (capital structure) decisions: the chapters on capital structure and the cost of capital
- Working capital management: the chapter on working capital
- Dividend (payout) decisions: the chapter on dividend policy
- Risk management: the chapter on corporate risk management
Goals of the firm
As established in CIFA Introduction to Finance and Investment, the operative goal in modern corporate finance is shareholder wealth maximisation, maximising the market value of equity, rather than simple profit maximisation, since only the former properly accounts for the timing and risk of the cash flows every decision in this paper affects.
Agency conflicts and their resolution
The shareholder-manager agency conflict, developed generally in CIFA Professional Ethics and Governance (under theories of corporate governance) and specifically for finance in CIFA Introduction to Finance and Investment, resurfaces directly across this guide: managers may resist an optimal capital structure that increases takeover risk, overinvest in low-return projects that expand their own empire, hoard excess cash rather than return it to shareholders, or resist a value-creating acquisition that threatens their own position, each taken up in its own chapter.
Managerial performance and pay
Exam tip
Treat this chapter as the paper's map: every later chapter is really a deep dive into one of the five finance-manager functions listed above, useful for orienting an unfamiliar question quickly.
Self-check
(a) State the three interlinked decision areas that make up the scope of corporate finance. (3 marks)
(b) State the five functions of a finance manager. (5 marks)
(c) A manager resists a value-creating acquisition because it threatens their own position. Name the concept this illustrates, and state one resolution. (3 marks)
(d) State two return-based measures used to assess managerial performance. (2 marks)
Show worked answer
(a) The capital structure decision, the capital investment decision, and the working capital and payout decisions.
(b) Investment (capital budgeting) decisions; financing (capital structure) decisions; working capital management; dividend (payout) decisions; risk management.
(c) The shareholder-manager agency conflict. Resolution: linking pay to share price or economic value added performance, so management is rewarded for what actually creates shareholder wealth.
(d) Any two of: ROA; ROE; ROIC; residual income or EVA; total shareholder return.