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Value and Compounding

The Firm: Structural Set-Up

            In corporate finance, we will use firm generically to refer to any business, large or small, manufacturing or service, private or public. Thus, a corner grocery store and Microsoft are both firms. The firm�s investments are generically termed assets. Although assets are often categorized by accountants into fixed assets, which are long-lived, and current assets, which are short-term, we prefer a different categorization. The assets that the firm has already invested in are called assets in place, whereas those assets that the firm is expected to invest in the future are called growth assets. Though it may seem strange that a firm can get value from investments it has not made yet, high-growth firms get the bulk of their value from these yet-to-be-made investments. To finance these assets, the firm can raise money from two sources. It can raise funds from investors or financial institutions by promising investors a fixed claim (interest payments) on the cash flows generated by the assets, with a limited or no role in the day-to-day running of the business. We categorize this type of financing to be debt. Alternatively, it can offer a residual claim on the cash flows (i.e., investors can get what is left over after the interest payments have been made) and a much greater role in the operation of the business. We call this equity. Note that these definitions are general enough to cover both private firms, where debt may take the form of bank loans and equity is the owner�s own money, as well as publicly traded companies, where the firm may issue bonds (to raise debt) and common stock (to raise equity).

            Thus, at this stage, we can lay out the financial balance sheet of a firm as follows:


Note the contrast between this balance sheet and a conventional accounting balance sheet.

An accounting balance sheet is primarily a listing of assets in place, though there are some circumstances where growth assets may find their place in it; in an acquisition, what gets recorded as goodwill is a conglomeration of growth assets in the target firm, synergies and overpayment.

First Principles   

Every discipline has first principles that govern and guide everything that gets done within it. All of corporate finance is built on three principles, which we will call, rather unimaginatively, the investment principle, the financing principle, and the dividend principle. The investment principle determines where businesses invest their resources, the financing principle governs the mix of funding used to fund these investments, and the dividend principle answers the question of how much earnings should be reinvested back into the business and how much returned to the owners of the business. These core corporate finance principles can be stated as follows:

�      The Investment Principle: Invest in assets and projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and should reflect the financing mix used—owners� funds (equity) or borrowed money (debt). Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.