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Theory and Practice of Corporate Finance

Theory and Practice of Corporate Finance

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Theory and Practice of Corporate Finance

Sound and clearly corporate finance decisions are necessary for ensuring that the

decisions made by the management maximize the welfare of the shareholders. While various

factors may influence the financial decisions made by the management, capital budget, cost of

capital, the risk associated with various investments, and specific risks in a project or the firm

play a leading role in influencing this decision. This paper will analyze the various factors that

are pertinent in corporate finance with respect to capital budget, the cost of capital, specific risk

factors in various sources of capital, project versus firm risk.

Capital Budget

In capital budgeting, the use of NPV and IRR is higher in large firms than small firms.

NPV and IRR are also commonly used in firms that have high leverage level, CEOs who have

MBAs, and those that pay dividends. Sensitivity analysis is also common in firms with high

leverage levels than those with little leverage levels. On the contrary, the payback period is

preferred in small firms, among CEOs who do not possess an MBA and those that do not pay

dividends. The main motivation for use of payback period in small firms is due to their exposure

to more volatile projects (Graham and Harvey 1-10). Since NPV provides a more elaborate

measure of future value than payback period, this information is important in enabling investors

to evaluate the accuracy of financial information from various firms (Jurek 2189-2211). In

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general, financial information from firms that use NPV is more credible than those that use

payback period.

Cost of Capital

Capital asset pricing model (CAPM) is the most popular method of estimating the cost of

capital, it is followed by the average stock return, and lastly the multi beta CAPM. Very few

firms use the dividend discount model to evaluate the cost of equity. Large firms and CEOs with

MBA are more likely to use CAPM. Smaller firms, on the other hand, mainly use the cost of

equity capital. Firms that have smaller management ownership and those with low leverage

levels also prefer to use CAPM (Graham and Harvey 1-10). The analysis of the cost of capital is

important in enabling investors to identify the factors used to analyze the underlying cost of

finance for investments. This information is essential in enabling investors to estimate the

probable profits they will make from their investments (Wong 95-104).

Risk Factor

The various risk factors in an organization are fundamental, momentum, and

macroeconomic factors. Most firms incorporate the risks of changes in the risk factors in their

cash flow. Specifically, firms incorporate factors that are related to inflation, foreign exchange

rate, interest rate, and GDP growth risk factors. On the contrary, few companies make changes

on their cash flows and discount rates due to book-to-market distress or momentum risks. In

large firms, foreign exchange risk, commodity price risk, business cycle risk, and interest rate

risk are the most important risk factors. In particular, foreign exchange risk is their most

important nonmarket risk factor, which is followed by risk caused by business cycles. In small

businesses, interest rate risk and labor risk are the main important risk factor. The most important

risk factors for businesses with a lot of foreign trade and growth firms the foreign exchange risk

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Surname 1 Name Tutor Course Date Theory and Practice of Corporate Finance Sound and clearly corporate finance decisions are necessary for ensuring that the decisions made by the management maximize the welfare of the shareholders. While various factors may influence the financial decisions made by the management, capital budget, cost of capital, the risk associated with various investments, and specific risks in a project or the firm play a leading role in influencing this decision. This paper will analyze the various factors that are pertinent in corporate finance with respect to capital budget, the cost of capital, specific risk factors in various sources of capital, project versus firm risk. Capital Budget In capital budgeting, the use of NPV and IRR is higher in large firms than small firms. NPV and IRR are also commonly used in firms that have high leverage level, CEOs who have MBAs, and those that pay dividends. Sensitivity analysis is also common in firms with high leverage levels than those with little leverage levels. On the contrary, the payback period is preferred in small firms, among CEOs who do not possess an MBA and those that do not pay dividends. The main motivatio ...
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