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Corporate finance dealing with financial decisions business enterprises
make and the tools and analysis used to make these decisions. The primary
goal of corporate finance is to maximize corporate value while managing the
firm's financial risks. Although it is in principle different from managerial
finance which studies the financial decisions of all firms, rather than
corporations alone, the main concepts in the study of corporate finance are
applicable to the financial problems of all kinds of firms.
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which projects receive investment, whether to finance that investment with
equity or debt, and when or whether to pay dividends to shareholders. On the
other hand, the short term decisions can be grouped ". This subject deals with
the short-term balance of current assets and current liabilities; the focus here is
on managing cash, inventories, and short-term borrowing and lending (such as
the terms on credit extended to customers).
The terms corporate finance and corporate financier are also associated
with investment banking. The typical role of an investment bank is to evaluate
the company's financial needs and raise the appropriate type of capital that best
fits those needs.
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Suppose you decide to start a firm to make tennis balls. To do this, you
hire managers to buy raw materials, and you assemble a workforce that will
produce and sell finished tennis balls. In the language of finance, you make an
investment in assets such as inventory, machinery, land, and labor. The amount
of cash you invest in assets must be matched by an equal amount of cash raised
by financing. When you begin to sell tennis balls, your firm will generate cash.
This is the basis of value creation. The purpose of the firm is to create value for
you, the owner. The value is reflected in the framework of the simple balance
sheet model of the firm. Following Factor have to be consider before making
the Corporate Finance.
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In many cases, for example R&D projects, a project may open or close) paths
of action to the company, but this reality will not typically be captured in a
strict NPV approach. Management will therefore (sometimes) employ tools
which place an explicit value on these options. So, whereas in a DCF valuation
the most likely or average or scenario specific cash flows are discounted, here
the ³flexible and staged nature´ of the investment is modeled, and hence "all"
potential payoffs are considered. The difference between the two valuations is
the "value of flexibility" inherent in the project. The two most common tools
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are Decision Tree Analysis (DTA) and Real options analysis (ROA); they may
often be used interchangeably:
ó ROA is usually used when the value of a project is contingent on the value
of some other asset or underlying variable. (For example, the viability of a
mining project is contingent on the price of gold; if the price is too low,
management will abandon the mining rights, if sufficiently high,
management will develop the ore body. Again, a DCF valuation would
capture only one of these outcomes.) Here: (1) using financial option theory
as a framework, the decision to be taken is identified as corresponding to
either a call option or a put option; (2) an appropriate valuation technique is
then employed - usually a variant on the Binomial options model or a
bespoke simulation model, while Black Sholes type formulae are used less
often; see Contingent claim valuation. (3) The "true" value of the project is
then the NPV of the "most likely" scenario plus the option value. (Real
options in corporate finance were first discussed by Stewart Myers in 1977;
viewing corporate strategy as a series of options was originally per Timothy
Luehrman, in the late 1990s.)
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financing mix can impact the valuation. Management must therefore identify
the "optimal mix" of financing²the capital structures those results in
maximum value. (See Balance sheet, WACC, Fisher separation theorem;
but, see also the Modigliani-Miller theorem.).
One of the main theories of how firms make their financing decisions
is the Pecking Order Theory, which suggests that firms avoid external
financing while they have internal financing available and avoid new equity
financing while they can engage in new debt financing at reasonably low
interest rates. Another major theory is the Trade-Off Theory in which firms
are assumed to trade-off the tax benefits of debt with the bankruptcy costs of
debt when making their decisions. An emerging area in finance theory is
right-financing whereby investment banks and corporations can enhance
investment return and company value over time by determining the right
investment objectives, policy framework, institutional structure, source of
financing (debt or equity) and expenditure framework within a given
economy and under given market conditions. One last theory about this
decision is the Market timing hypothesis which states that firms look for the
cheaper type of financing regardless of their current levels of internal
resources, debt and equity.
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investors. These free cash flows comprise cash remaining after all business
expenses have been met.
This is the general case, however there are exceptions. For example,
investors in a "Growth stock", expect that the company will, almost by
definition, retain earnings so as to fund growth internally. In other cases, even
though an opportunity is currently NPV negative, management may consider
³investment flexibility´ / potential payoffs and decide to retain cash flows; see
above and Real options.
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focuses on risks that can be managed ("hedged") using traded financial
instruments (typically changes in commodity prices, interest rates, foreign
exchange rates and stock prices). Financial risk management will also play an
important role in cash management.
Financial risk; Default (finance); Credit risk; Interest rate risk; Liquidity
risk; Market risk; Operational risk; Volatility risk; Settlement risk; Value at
Risk;.
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ó Corporate Finance.
ó "Debt and equity funding.
ó Start up and Growth capital.
ó Pre-IPO finance.
ó Real Estate Sales and Acquisition.
ó Company Sales and Acquisitions.
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ó Closely working with Government and business promotion organizations in
India and the respective partner countries.
ó Also hosts high-level Government dignitaries and help build close working
relationships between Governments and business organizations.
ó It also exchanges business delegations, joint task forces and identifies
bilateral business co-operation potential and makes suitable policy
recommendations to Governments.
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Indian Businesses are slowly shifting their base from agriculture major
industrialization. Numerous types of Businesses in India coming up. As India
is developing the Iron & Steel Businesses in India, IT Businesses in India,
Indian Businesses in Travel &I "tourism, Indian Businesses in Business
Process Outsourcing, Food Business market in India, Soft Drinks Businesses in
India and various other types of businesses are coming to the forefront and
taking the center stage.
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business to excessive high borrowings, but without unnecessarily diluting the
share capital. This will ensure that the financial risk of the company is kept at
an optimal level.
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There are over 100 different venture capital funds in the UK and some
have geographical or industry preferences. There are also certain large
industrial companies which have funds available to invest in growing
businesses and this 'corporate venturing' is an additional source of equity
finance.
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Finance can be raised against debts due from customers via invoice
discounting or invoice factoring, thus improving cash flow. Debtors are used as
the prime security for the lender and the borrower may obtain up to about 80
per cent of approved debts. In addition, a number of these sources of finance
will now lend against stock and other assets and may be more suitable then
bank lending. Invoice discounting is normally confidential (the customer is not
aware that their payments are essentially insured) whereas factoring extends
the simple discounting principle by also dealing with the administration of the
sales ledger and debtor collection.
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Hire purchase agreements and leasing provide finance for the acquisition
of specific assets such as cars, equipment and machinery involving a deposit
and repayments over, typically, three to ten years. Technically, ownership of
the asset remains with the lessor whereas title to the goods is eventually
transferred to the hirer in a hire purchase agreement.
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Medium term loans (up to seven years) and long term loans (including
commercial mortgages) are provided for specific purposes such as acquiring an
asset, business or shares. The loan is normally secured on the asset or assets
and the interest rate may be variable or fixed. The Small Firms Loan Guarantee
Scheme can provide up to £250,000 of borrowing supported by a government
guarantee where all other sources of finance have been exhausted.
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An overdraft is an agreed sum by which a customer can overdraw their
current account. It is normally secured on current assets, repayable on demand
and used for short term working capital fluctuations. The interest cost is
normally variable and linked to bank base rate. Completing the Finance-raising
Raising finance is often a complex process. Business management need to
assess several alternatives and then negotiate terms which are acceptable to the
finance provider. The main negotiating points are often as follows:
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to fund their activities. Finance can broadly be broken down into two fields.
The first is asset pricing, which is concerned with the decisions of investors.
The second is corporate finance, which is concerned with the decisions of
firms. This paper will focus on the latter field and how game theory can be
used to explain certain behaviors that are regularly witnessed. Traditional
financial thinking relies on assumptions of certainty, complete knowledge and
market efficiency and in this context, financial decisions should be relatively
straightforward. In the real world though, many times what is observed
deviates greatly from what would be expected using traditional financial
thinking. This paper will show how different game theory models can be used
to more accurately explain observed financial decisions dealing with capital
structure, corporate acquisitions and initial public offerings (IPOs).
Game theory has made great strides in explaining many of the observed
phenomena falling under corporate finance. One example is the capital
structure decided upon by a firm¶s management. Capital structure deals with
the firm¶s decision to raise funds through debt versus equity and what ratio of
debt to equity should the firm maintain. Modigliani and Miller in 1958 showed
that in perfect capital markets (i.e. no frictions and symmetric information) and
no taxes a firm could not change its total value by altering its debt/equity ratio;
thus capital structure is irrelevant. However in the real world, capital structure
is carefully thought about by every company, and it is in fact not irrelevant
because taxes do exist and capital markets are not perfect. In the United States,
interest paid by a company is a tax-deductible expense. This tax shield creates
an incentive to take on debt. Modigliani and Miller corrected their original
model to include corporate income taxes showing that a firm could increase its
equity, or shareholder value, by taking on debt and taking advantage of tax
shields. Their model then showed all firms stood to gain the most if they were
100% debt financed; however this is not observed in reality. In fact, some
companies and industries thrive with no debt at all. Different game theory
models have been used to explain the actions of managers in determining their
company¶s capital structure, the most influential deals with the signaling
effects attributed to debt vs. equity financing. In 1984 Myers and Majluf
developed a model based on asymmetric information that insists managers are
better informed of the prospects of the firm than the capital markets.
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selling its stock at a premium. Investors are not dull and will predict that
managers are more likely to issue stock when they think it is overvalued while
optimistic managers may cancel or defer issues. Therefore, when an equity
issue is announced, investors will mark down the price of the stock
accordingly. Thus equity issues are considered a bad signal; even companies
with overvalued stock would prefer another option to raise money to avoid the
mark down in stock price. Firms prefer to use less information sensitive
sources of funds.
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An average payoff would not benefit the stockholders much when the
company is near default because most of the payoff will be paid out to the debt
holders. A financially sound company would not have this agency problem
because equity holders stand to lose more from risky projects when the
company is not in risk of going bankrupt, and thus want to avoid them along
with bondholders. The second conflict arises when equity holders cannot fully
control the actions of managers. This occurs when managers have an incentive
to pursue their own interests rather than those of the equity holders. Executive
compensation in the form of option contracts can create incentives for
managers to make risky decisions in an attempt to gain the highest payoff from
the call options. Higher risk increases the value of an option, but risk can also
cause a stock price to take a nosedive. A manager with options is not hurt
nearly as much as a worker with his/her retirement savings in a company
whose stock plummets because of risky bets. Option contracts were meant to
better align the interests of managers with stockholders, but it is obvious that
this is not so easily achieved. Game theory can also be used to explain what is
observed in the course of many corporate acquisitions. If markets are efficient
then one would expect a company to pay fair value when acquiring another
company; however in many instances the acquirer pays a large premium to buy
the other company. In 1986 Shleifer and Vishny provide one explanation of
this phenomenon, the free rider problem. One of the concepts behind efficient
markets is the market for corporate control. The market for corporate control
says that in order for resources to be used efficiently, companies need to be run
by the most able and competent managers. One way to achieve this is through
corporate acquisitions.
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is to under-price the stock on average. This means that on average the
uniformed will buy a stock that started out undervalued and thus they are still
able to buy the stock at or below its true value. Since all investors know that an
IPO will likely be under priced they all try to buy the stock as quick as possible
creating a demand for the stock that results in substantial price gain in the
initial days of trading.
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Corporate managers are the agents of shareholders, a relationship
fraught with conflicting interests. Agency theory, the analysis of such conflicts,
is now a major part of the economics literature. The payout of cash to
shareholders creates major conflicts that have received little attention. Payouts
to shareholders reduce the resources under managers¶ control, thereby reducing
managers¶ power, and making it more likely they will incur the monitoring of
the capital markets which occurs when the firm must obtain new capital.
Financing projects internally avoids this monitoring and the possibility the
funds will be unavailable or available only at high explicit prices.
Free cash flow is cash flow in excess of that required to fund all projects
that have positive net present values when discounted at the relevant cost of
capital. Conflicts of interest between shareholders and managers over payout
policies are especially severe when the organization generates substantial free
cash flow. The problem is how to motivate managers to disgorge the cash
rather than investing it at below the cost of capital or wasting it on organization
inefficiencies.
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activities as broadcasting and tobacco are similar to those in oil, and 5) why
bidders and some targets tend to perform abnormally well prior to takeover.
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The agency costs of debt have been widely discussed, but the benefits of
debt in motivating managers and their organizations to be efficient have been
ignored. I call these effects the ³control hypothesis´ for debt creation.
Managers with substantial free cash flow can increase dividends or repurchase
stock and thereby pay out current cash that would otherwise be invested in
low-return projects or wasted. This leaves managers with control over the use
of future free cash flows, but they can promise to pay out future cash flows by
announcing a ³permanent´ increase in the dividend. Such promises are weak
because dividends can be reduced in the future. The fact that capital markets
punish dividend cuts with large stock price reductions is consistent with the
agency costs of free cash flow.
Thus debt reduces the agency costs of free cash flow by reducing the
cash flow available for spending at the discretion of managers. These control
effects of debt are a potential determinant of capital structure. Issuing large
amounts of debt to buy back stock also sets up the required organizational
incentives to motivate managers and to help them overcome normal
organizational resistance to retrenchment which the payout of free cash flow
often requires. The threat caused by failure to make debt service payments
serves as an effective motivating force to make such organizations more
efficient.
Stock repurchases for debt or cash also has tax advantages. (Interest
payments are tax deductible to the corporation, and that part of the repurchase
proceeds equal to the seller¶s tax basis in the stock is not taxed at all.)
Increased leverage also has costs. As leverage increases, the usual agency costs
of debt rise, including bankruptcy costs. The optimal debt-equity ratio is the
point at which firm value is maximized, the point where the marginal costs of
debt just offset the marginal benefits.
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The control hypothesis does not imply that debt issues will always have
positive control effects. For example, these effects will not be as important for
rapidly growing organizations with large and highly profitable investment
projects but no free cash flow. Such organizations will have to go regularly to
the financial markets to obtain capital.
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28505163 / 1392107
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(Current Asset ± Stock ± Prepaid Exp) / (Current liability ±
Bank Overdraft)
27237873 / 1392107
= 19.56
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[(Closing Stock) / (Working Capital)] *100
The standard ratio is 200 % here the ratio is only 2.33%. this
shows that the company will face certain problems in near future.
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(Cost of Goods sold + Operating Exp) / Net Sales *100
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[37331 / 238756 ]
= 0.15 times
[12 / 0.15]
= 80 months
[5,42,407 / 1876199069]
= 0.29
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Market Price per share / Earning per share
[10 / 0.29]
= 34.48
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2. Sales increased each year from 2000 to 2002. The difference between the
year 2000 and 2001 was a 5.35% increase (5,450-5,173/5,173 = .0535).
The difference between the year 2001 and 2002 was a 45.85% increase
(7,949-5,450/5,450 = .4585).
3. The largest expense for General Mills for the years 2000, 2001, and 2002
was the same; over 50% of the revenue each year went towards the cost
of sales. Sales in 2002 were the largest, about 7% more than the two
previous years. 2000: (2,698/5,173) = .522 = 52.2% 2001: (2,841/5,450
= .521 = 52.1% 2002: (4,767/7,949) = .599 = 59.9%
4. Net Income: 2000: $614 million 2001: $665 million 2002: $458 million
When comparing the net income figures for the past three years, it is seen
that between 2000 and 2001, the net income increased by $51 million,
but between 2001 and 2002, the net income decreased by $207 million.
6. Even though General Mills paid dividends in 2000, 2001 and 2002, the
corresponding total dividend payments did not appear as an expense on
the income statement because dividends are not an expense; they are a
financing activity that is reported on the statement of stockholder's
equity. They are payments that are made to only the owners of the
company.
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7. A company has assets so that they have a location and equipment to
operate/create a business. Assets are resources that are controlled by a
business. Without assets, one cannot produce and/or run a company. The
purpose of assets are to keep track of expenses, what a company owns,
like equipment, inventory, cash etc., and creates value for the company.
8. The total amount of assets at the end of 2002 was $16,540 million.
9. When comparing the assets from the beginning of 2002 to the end, we
found that the percentage increase in assets was 224.89% (16,540-
5,091/5,091 = 2.2489 = 224.89%). Goodwill is the type of asset that is
responsible for the increase.
10.The two groups that have contributed assets to General Mills and claims
on the assets are shareholders and lenders. Shareholders have about
$5,733 million in claims and the lenders have a claim of $5,591 million.
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11.The General Mill's total stockholders increased significantly from May
27, 2001 to May 26, 2002 because they sold more stock.
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13.There are three categories of cash flows shown on the company's cash
flow statement. They are the following:
1.Operating activities 2. Investing activities 3. Financial
activities.
14.When comparing the net income figure to the amount of net cash
provided by operating activities for each of the three years, one observes
that the net income went up in the first two years and than decreased
between the second and the third year. The net cash from operating
activities increased each year, but its greatest growth was between the
second and the third year. So, when the net income was the lowest, the
net cash from operating activities was the greatest.
15.Net cash provided by Net cash used by operating activities investment
activities 2000: $722 million (564 million) 2001: $737 million (460
million) 2002: $913 million (3,271 million) It is clear to see that in the
year 2000 and 2001, operating activities was large enough to cover the
investing cash outflow, but in 2002, the investing cash outflow exceeded
far past the amount of net cash provided by operating activities. Loans
were used to make up the difference.
16.When comparing the dividend payments to the income amounts for the
current year, we found that the dividend payout ratio for 2002 was 78.2%
(358/458 = .7816 = 78.2) E. General Mills Report of Management
Responsibilities and Reports of Independent Public Accountants:
17.The management of General Mills, Inc. is responsible for the accounting
numbers in the annual report.
18.For safeguards, General Mills used internal controls to ensure the
accuracy of the reported numbers, including: an audit program, a
separation of duties and responsibilities, and instated policies that
demand ethical behavior from employees.
19.The independent accountant does not say that the reported amounts are
correct, but does state that they are reported fairly. "We believe these
consolidated financial statements do not misstate or omit any material
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facts... In our opinion, the consolidated financial statements referred to
above present fairly, in all material respects..." The CPA assures that the
statements are in accordance with the GAAP.
20.General Mills hired a CPA (Certified Public Accountant) to audit the
financial statements to ensure accuracy and to verify that the numbers on
the statements (disclosures made by the management in its reports) are
consistent with the company's actual financial position, cash flow, and
results from its operating activities.
21.General Mills hired KPMG LLP as their accountant to audit their
financial statements. The report of the independent accountants that
performed this was signed on June 24, 2002.
22.General Mills major operating activities during 2002 were net sales,
selling, general, and administrative, and cost of goods. The major
difference between accrual and the cash flow of these activities is that
accrual includes cash and credit, where these major operating activities
only include cash. Accrual accounts for all, while the cash flow doesn't
account for credit sales until the money is collected.
23.General Mills return on total assets for 2001 was 13.1% (665/5,091=
.1306) and in 2002, the return on total assets was 2.8% (458/16,540 =
.0276). The return on total assets deteriorated from 2001 by 10.3%
(.1306-.0276 = .103)
24.If you owned 10,000 of the company's common stock in 2002, your
claim on the company's earnings would be $13,800 (10,000 x 1.38 (EPS-
basic) = 13,800). If you were to own 10,000 of the company's common
stock in 2001, your claim would be greater than your claim if you would
to purchase them in 2002 by $9,600, making your claim in 2001 $23,400.
(10,000 x 2.34 (EPS-basic) = 23,400).
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25.The major source of cash for General Mills in 2002 was the issuance of
long-term debt. With the cash they received, they were able to purchase
Pillsbury (acquired in a stock and cash transaction).
26.Major financing activities performed in 2002 were the change in long-
term debt. They increased their amount of debt while paying off some of
their notes payable. They also purchased some treasury stocks. In the
year 2002, their net cash increased incredibly, by about $3,500 million,
which was one of the biggest increases recorded over the previous years
for net cash.
27.A major investing activity that occurred in 2002 was when General Mills
purchased Pillsbury.
28.At the end of 2002, the company's most important assets were:
inventories, goodwill, receivables, and land, buildings, and equipment.
Other resources that might be important that aren't reported on the
balance sheet are the skills and level of intelligence of the management
and the employees, as well as the value of the brand name 29. If asked to
assess the company's financial performance of General Mills in 2002, I
would have to say that they were very successful. Their financial
activities show that they are a growing and prosperous company; their
operating and financing activities are increasing and the investing cash
flows decreasing, keeping the inflow larger than the outflow. Their
successfulness opens many new opportunities for them in the future.
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Arguably, the role of a corporation's management is to increase the value
of the firm to its shareholders while observing applicable laws and
responsibilities. Corporate finance deals with the strategic financial issues
associated with achieving this goal, such as how the corporation should raise
and manage its capital, what investments the firm should make, what portion
of profits should be returned to shareholders in the form of dividends, and
whether it makes sense to merge with or acquire another firm.
Another way to value the firm is to consider the future flow of cash.
Since cash today is worth more than the same amount of cash tomorrow, a
valuation model based on cash flow can discount the value of cash received in
future years, thus providing a more accurate picture of the true impact of
financial decisions.
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The distinction between cash and equity shareholders' equity is the sum
of common stock at par value, additional paid-in capital, and retained earnings.
Some people have been known to picture retained earnings as money sitting in
a shoe box or bank account. But shareholders' equity is on the opposite side of
the balance sheet from cash. In fact, retained earnings represent shareholders'
claims on the assets of the firm, and do not represent cash that can be used if
the cash balance gets too low. In this regard, one can say that retained earnings
represent cash that already has been spent.
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Financial decisions, the analysis and tools that are required to reach
these conclusions is what corporation finance is all about. The objective of this
is to improve the value of the company while simultaneously reducing any
financial risks. In addition it oversees that the company gets maximum returns
on whatever ventures they have invested in. Corporate finance can be
categorized into short and long term decisions.
Short term decisions like capital management deal with current liabilities
and asset balance. This is basically management of cash, inventories and
lending on a short term basis. The long term category deals with investments
of capital in relation to projects and the techniques required to fund them.
Corporate finance is also associated with investment banking. The investment
banker is in charge of evaluating the different projects that are brought to the
bank and making appropriate investment decisions.
For the company to be able to achieve their objectives, they need to have
a proper financial structure in place. It has to be able to accommodate the
various financial options that are available. These sources could be a
combination of equity and also debt. When a business or project is funded
through equity, there is a lower risk in terms of the cash flow. The one done
through debt is more of a liability to the company which needs to be assessed.
This automatically affects the cash flow even if the project turns out to be a
success.
The company must try to equate the invest merge with the asset being
financed as much as possible. When a company is adequately financed, it has
enough in its reserves for any contingencies.
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