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Corporate finance

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Corporate finance
Looking north from the Empire State Building, New York City, 2005
Working capital
Cash conversion cycle
Return on capital
Economic Value Added
Just-in-time
Economic order quantity
Discounts and allowances
Factoring
Sections
Managerial finance
Financial accounting
Management accounting
Mergers and acquisitions
Balance sheet analysis
Business plan
Corporate action
Societal components
Financial market
Financial market participants
Corporate finance
Personal finance
Public finance
Banks and banking
Financial regulation
Clawback
v t e
Corporate finance is the area of finance dealing with the sources of funding and the capital structure
of corporations and the actions that managers take to increase the value of the firm to the
shareholders, as well as the tools and analysis used to allocate financial resources. A goal of
corporate finance is to maximize shareholder value.[1] Although it is in principle different from
managerial finance which studies the financial management 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.
Investment analysis (or capital budgeting) is concerned with the setting of criteria about which
value-adding projects should receive investment funding, and whether to finance that investment
with equity or debt capital. Working capital management is the management of the company's
monetary funds that deal with the short-term operating 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).[citation needed]
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. Thus, the terms corporate finance and
corporate financier may be associated with transactions in which capital is raised in order to
create, develop, grow or acquire businesses.
Financial management overlaps with the financial function of the Accounting profession. However,
financial accounting is the reporting of historical financial information, while financial management
is concerned with the allocation of capital resources to increase a firm's value to the shareholders.

Outline of corporate finance[edit]

Investment analysis and capital budgeting[edit]
Main article: Capital budgeting
Investment analysis (or capital budgeting) is the planning of value-adding, long-term corporate
financial projects relating to investments funded through and affecting the firm's capital structure.
Management must allocate the firm's limited resources between competing opportunities (projects),
which is one of the main focuses of capital budgeting.[2] Capital budgeting is also concerned with
the setting of criteria about which projects should receive investment funding to increase the value
of the firm, and whether to finance that investment with equity or debt capital. Investments should
be made on the basis of value-added to the future of the corporation. Projects that increase a firm's
value may include a wide variety of different types of investments, including but not limited to,
expansion policies, or mergers and acquisitions. When no growth or expansion is possible by a
corporation and excess cash surplus exists and is not needed, then management is expected to pay
out some or all of those surplus earnings in the form of cash dividends or to repurchase the
company's stock through a share buyback program.
Choosing between investment projects may be based upon several inter-related criteria. (1)
Corporate management seeks to maximize the value of the firm by investing in projects which yield a
positive net present value when valued using an appropriate discount rate in consideration of risk.
(2) These projects must also be financed appropriately. (3) If no growth is possible by the company
and excess cash surplus is not needed to the firm, then financial theory suggests that management
should return some or all of the excess cash to shareholders (i.e., distribution via dividends).
Maximizing shareholder value[edit]
One of the primary goals of financial management is to maximize shareholder value. Maximizing
shareholder value requires managers to be able to balance capital funding between investments in
projects that increase the firm's long term profitability and sustainability, along with paying excess
cash in the form of dividends to shareholders. Managers of growth companies (i.e. firms that earn
high rates of return on invested capital) will use most of the firm's capital resources and surplus cash
on investments and projects so the company can continue to expand its business operations into the
future. When companies reach maturity levels within their industry (i.e. companies that earn
approximately average or lower returns on invested capital), managers of these companies will use
surplus cash to payout dividends to shareholders. In practice, maximizing shareholder value is not
always possible and usually difficult to accomplish, because managers must do an analysis to
determine the appropriate allocation of the firm's capital resources and cash surplus between
projects and payouts of dividends to shareholders, as well as paying back creditor related debt.
Return on investment[edit]
Return on investment is the concept of an investment in some resource or asset yielding an upward
growth trend or appreciation in value to the investor. In purely economic terms, ROI is used to
measure the profits gained in comparison to the capital invested. ROI is a broad method for
investment valuation, and may be employed using different valuation approaches. One method is to
compare the investment value and its opportunity cost to other forms of investments available (this
method is generally known in finance as the cost of capital). Alternative methods may include a cost-
benefit analysis of the future recurring growth or sustainability of the profits from the investment.
When profit trends cannot be accurately forecasted, investors are advised to benchmark their
investments in corporate stock against comparable businesses (such as to evaluate industry
standard best practices and to do an industry analysis) to help them estimate the earnings multiplier
or the return on capital likely to be received in the future.

Capital structure[edit]

Capitalization structure[edit]


Domestic credit to private sector in 2005.
Main article: Capital structure
Further information: Security (finance)
Achieving the goals of corporate finance requires that any corporate investment be financed
appropriately.[3] The sources of financing are, generically, capital self-generated by the firm and
capital from external funders, obtained by issuing new debt and equity (and hybrid- or convertible
securities). As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will
be affected, the financing mix will impact the valuation of the firm. There are two interrelated
considerations here:
Management must identify the "optimal mix" of financing the capital structure that results in
maximum firm value.[4] (See Balance sheet, WACC.) Financing a project through debt results in a
liability or obligation that must be serviced, thus entailing cash flow implications independent of the
project's degree of success. Equity financing is less risky with respect to cash flow commitments, but
results in a dilution of share ownership, control and earnings. The cost of equity (see CAPM and APT)
is also typically higher than the cost of debt - which is, additionally, a deductible expense and so
equity financing may result in an increased hurdle rate which may offset any reduction in cash flow
risk.[5]
Management must attempt to match the long-term financing mix to the assets being financed as
closely as possible, in terms of both timing and cash flows. Managing any potential asset liability
mismatch or duration gap entails matching the assets and liabilities respectively according to
maturity pattern ("Cashflow matching") or duration ("immunization"); managing this relationship in
the short-term is a major function of working capital management, as discussed below. Other
techniques, such as securitization, or hedging using interest rate- or credit derivatives, are also
common. See Asset liability management; Treasury management; Credit risk; Interest rate risk.
Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are
assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when choosing how
to allocate the company's resources. However economists have developed a set of alternative
theories about how managers allocate a corporation's finances. One of the main alternative theories
of how firms manage their capital funds is the Pecking Order Theory (Stewart Myers), 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. Also, Capital
structure substitution theory hypothesizes that management manipulates the capital structure such
that earnings per share (EPS) are maximized. 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 of the more recent innovations in this area from a theoretical point of
view is the Market timing hypothesis. This hypothesis, inspired in the behavioral finance literature,
states that firms look for the cheaper type of financing regardless of their current levels of internal
resources, debt and equity.
Sources of capital[edit]
Further information: Security (finance)
Debt capital[edit]
Further information: Bankruptcy and Financial distress
Corporations may rely on borrowed funds (debt capital or credit) as sources of investment to sustain
ongoing business operations or to fund future growth. Debt comes in several forms, such as through
bank loans, notes payable, or bonds issued to the public. Bonds require the corporations to make
regular interest payments (interest expenses) on the borrowed capital until the debt reaches its
maturity date, therein the firm must pay back the obligation in full. Debt payments can also be made
in the form of sinking fund provisions, whereby the corporation pays annual installments of the
borrowed debt above regular interest charges. Corporations that issue callable bonds are entitled to
pay back the obligation in full whenever the company feels it is in their best interest to pay off the
debt payments. If interest expenses cannot be made by the corporation through cash payments, the
firm may also use collateral assets as a form of repaying their debt obligations (or through the
process of liquidation).
Equity capital[edit]
Corporations can alternatively sell shares of the company to investors to raise capital. Investors, or
shareholders, expect that there will be an upward trend in value of the company (or appreciate in
value) over time to make their investment a profitable purchase. Shareholder value is increased
when corporations invest equity capital and other funds into projects (or investments) that earn a
positive rate of return for the owners. Investors prefer to buy shares of stock into companies that
will consistently earn a positive rate of return on capital in the future, thus increasing the market
value of the stock of that corporation. Shareholder value may also be increased when corporations
payout excess cash surplus (funds from retained earnings that are not needed for business) in the
form of dividends.
Preferred stock[edit]
Preferred stock is an equity security which may have any combination of features not possessed by
common stock including properties of both an equity and a debt instruments, and is generally
considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to common stock, but
subordinate to bonds in terms of claim (or rights to their share of the assets of the company).[6]
Preferred stock usually carries no voting rights,[7] but may carry a dividend and may have priority
over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock
are stated in a "Certificate of Designation".
Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for
preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest
payments from bonds and they are junior to all creditors.[8]
Preferred stock is a special class of shares which may have any combination of features not
possessed by common stock. The following features are usually associated with preferred stock:[9]
Preference in dividends
Preference in assets, in the event of liquidation
Convertibility to common stock.
Callability, at the option of the corporation
Nonvoting
Investment and project valuation[edit]

Further information: Business valuation, stock valuation, and fundamental analysis
In general,[10] each project's value will be estimated using a discounted cash flow (DCF) valuation,
and the opportunity with the highest value, as measured by the resultant net present value (NPV)
will be selected (applied to Corporate Finance by Joel Dean in 1951). This requires estimating the
size and timing of all of the incremental cash flows resulting from the project. Such future cash flows
are then discounted to determine their present value (see Time value of money). These present
values are then summed, and this sum net of the initial investment outlay is the NPV. See Financial
modeling.
The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate often
termed, the project "hurdle rate"[11] is critical to choosing good projects and investments for the
firm. The hurdle rate is the minimum acceptable return on an investment i.e., the project
appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically
measured by volatility of cash flows, and must take into account the project-relevant financing
mix.[12] Managers use models such as the CAPM or the APT to estimate a discount rate appropriate
for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing
mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that
applies to the entire firm. Such an approach may not be appropriate where the risk of a particular
project differs markedly from that of the firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary) selection criteria in
corporate finance. These are visible from the DCF and include discounted payback period, IRR,
Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements) to NPV
include Residual Income Valuation, MVA / EVA (Joel Stern, Stern Stewart & Co) and APV (Stewart
Myers). See list of valuation topics.
Valuing flexibility[edit]
Main articles: Real options analysis and decision tree
In many cases, for example R&D projects, a project may open (or close) various paths of action to
the company, but this reality will not (typically) be captured in a strict NPV approach.[13] Some
analysts account for this uncertainty by adjusting the discount rate (e.g. by increasing the cost of
capital) or the cash flows (using certainty equivalents, or applying (subjective) "haircuts" to the
forecast numbers).[14][15] Even when employed, however, these latter methods do not normally
properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt
the risk adjustment.[16] 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 flexible and staged nature of the investment is
modelled, and hence "all" potential payoffs are considered. See further under Real options
valuation. The difference between the two valuations is the "value of flexibility" inherent in the
project.
The two most common tools are Decision Tree Analysis (DTA)[17][18] and Real options valuation
(ROV);[19] they may often be used interchangeably:
DTA values flexibility by incorporating possible events (or states) and consequent management
decisions. (For example, a company would build a factory given that demand for its product
exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given
further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by
contrast, there is no "branching" each scenario must be modelled separately.) In the decision tree,
each management decision in response to an "event" generates a "branch" or "path" which the
company could follow; the probabilities of each event are determined or specified by management.
Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to
management; (2) given this knowledge of the events that could follow, and assuming rational
decision making, management chooses the branches (i.e. actions) corresponding to the highest value
path probability weighted; (3) this path is then taken as representative of project value. See Decision
theory#Choice under uncertainty.
ROV 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 Scholes 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.) See also Option pricing
approaches under Business valuation.
Quantifying uncertainty[edit]
Further information: Sensitivity analysis, Scenario planning, and Monte Carlo methods in finance
Given the uncertainty inherent in project forecasting and valuation,[18][20] analysts will wish to
assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a
typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant,
ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and is calculated as
a "slope": NPV / factor. For example, the analyst will determine NPV at various growth rates in
annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then
determine the sensitivity using this formula. Often, several variables may be of interest, and their
various combinations produce a "value-surface",[21] (or even a "value-space",) where NPV is then a
function of several variables. See also Stress testing.
Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario
comprises a particular outcome for economy-wide, "global" factors (demand for the product,
exchange rates, commodity prices, etc...) as well as for company-specific factors (unit costs, etc...).
As an example, the analyst may specify various revenue growth scenarios (e.g. 0% for "Worst Case",
10% for "Likely Case" and 20% for "Best Case"), where all key inputs are adjusted so as to be
consistent with the growth assumptions, and calculate the NPV for each. Note that for scenario
based analysis, the various combinations of inputs must be internally consistent (see discussion at
Financial modeling), whereas for the sensitivity approach these need not be so. An application of this
methodology is to determine an "unbiased" NPV, where management determines a (subjective)
probability for each scenario the NPV for the project is then the probability-weighted average of
the various scenarios; see First Chicago Method. (See also rNPV, where cash flows, as opposed to
scenarios, are probability-weighted.)
A further advancement which "overcomes the limitations of sensitivity and scenario analyses by
examining the effects of all possible combinations of variables and their realizations." [22] is to
construct stochastic[23] or probabilistic financial models as opposed to the traditional static and
deterministic models as above.[20] For this purpose, the most common method is to use Monte
Carlo simulation to analyze the projects NPV. This method was introduced to finance by David B.
Hertz in 1964, although it has only recently become common: today analysts are even able to run
simulations in spreadsheet based DCF models, typically using a risk-analysis add-in, such as @Risk or
Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are
simulated, mathematically reflecting their "random characteristics". In contrast to the scenario
approach above, the simulation produces several thousand random but possible outcomes, or trials,
"covering all conceivable real world contingencies in proportion to their likelihood;" [24] see Monte
Carlo Simulation versus What If Scenarios. The output is then a histogram of project NPV, and the
average NPV of the potential investment as well as its volatility and other sensitivities is then
observed. This histogram provides information not visible from the static DCF: for example, it allows
for an estimate of the probability that a project has a net present value greater than zero (or any
other value).
Continuing the above example: instead of assigning three discrete values to revenue growth, and to
the other relevant variables, the analyst would assign an appropriate probability distribution to each
variable (commonly triangular or beta), and, where possible, specify the observed or supposed
correlation between the variables. These distributions would then be "sampled" repeatedly
incorporating this correlation so as to generate several thousand random but possible scenarios,
with corresponding valuations, which are then used to generate the NPV histogram. The resultant
statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the
project's "randomness" than the variance observed under the scenario based approach. These are
often used as estimates of the underlying "spot price" and volatility for the real option valuation as
above; see Real options valuation: Valuation inputs. A more robust Monte Carlo model would
include the possible occurrence of risk events (e.g., a credit crunch) that drive variations in one or
more of the DCF model inputs.
Dividend policy[edit]

Main article: Dividend policy
Dividend policy is concerned with financial policies regarding the payment of a cash dividend in the
present or paying an increased dividend at a later stage. Whether to issue dividends,[25] and what
amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and
influenced by the company's long-term earning power. When cash surplus exists and is not needed
by the firm, then management is expected to pay out some or all of those surplus earnings in the
form of cash dividends or to repurchase the company's stock through a share buyback program.
If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and
excess cash surplus is not needed, then finance theory suggests management should return
some or all of the excess cash to shareholders as dividends. This is the general case, however there
are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost
by definition, retain most of the excess cash surplus so as to fund future projects internally to help
increase the value of the firm.
Management must also choose the form of the dividend distribution, generally as cash dividends or
via a share buyback. Various factors may be taken into consideration: where shareholders must pay
tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases
increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from
stock rather than in cash; see Corporate action. Financial theory suggests that the dividend policy
should be set based upon the type of company and what management determines is the best use of
those dividend resources for the firm to its shareholders. As a general rule, shareholders of growth
companies would prefer managers to have a share buyback program, whereas shareholders of value
or secondary stocks would prefer the management of these companies to payout surplus earnings in
the form of cash dividends.
Working capital management[edit]

Main article: Working capital
How to manage the corporation's working capital position to sustain ongoing business operations is
referred to as working capital management.[26] These involve managing the relationship between a
firm's short-term assets and its short-term liabilities. In general this is as follows: As above, the goal
of Corporate Finance is the maximization of firm value. In the context of long term, capital
budgeting, firm value is enhanced through appropriately selecting and funding NPV positive
investments. These investments, in turn, have implications in terms of cash flow and cost of capital.
The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able
to operate, and that it has sufficient cash flow to service long term debt, and to satisfy both
maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced
when, and if, the return on capital exceeds the cost of capital; See Economic value added (EVA).
Managing short term finance and long term finance is one task of a modern CFO.
Working capital[edit]
Working capital is the amount of funds which are necessary to an organization to continue its
ongoing business operations, until the firm is reimbursed through payments for the goods or
services it has delivered to its customers.[27] Working capital is measured through the difference
between resources in cash or readily convertible into cash (Current Assets), and cash requirements
(Current Liabilities). As a result, capital resource allocations relating to working capital are always
current, i.e. short term. In addition to time horizon, working capital management differs from capital
budgeting in terms of discounting and profitability considerations; they are also "reversible" to some
extent. (Considerations as to Risk appetite and return targets remain identical, although some
constraints such as those imposed by loan covenants may be more relevant here).
The (short term) goals of working capital are therefore not approached on the same basis as (long
term) profitability, and working capital management applies different criteria in allocating resources:
the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which
cash flow is probably the most important).
The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This
represents the time difference between cash payment for raw materials and cash collection for
sales. The cash conversion cycle indicates the firm's ability to convert its resources into cash.
Because this number effectively corresponds to the time that the firm's cash is tied up in operations
and unavailable for other activities, management generally aims at a low net count. (Another
measure is gross operating cycle which is the same as net operating cycle except that it does not
take into account the creditors deferral period.)
In this context, the most useful measure of profitability is Return on capital (ROC). The result is
shown as a percentage, determined by dividing relevant income for the 12 months by capital
employed; Return on equity (ROE) shows this result for the firm's shareholders. As above, firm value
is enhanced when, and if, the return on capital exceeds the cost of capital.
Management of working capital[edit]
Guided by the above criteria, management will use a combination of policies and techniques for the
management of working capital.[28] These policies aim at managing the current assets (generally
cash and cash equivalents, inventories and debtors) and the short term financing, such that cash
flows and returns are acceptable.
Cash management. Identify the cash balance which allows for the business to meet day to day
expenses, but reduces cash holding costs.
Inventory management. Identify the level of inventory which allows for uninterrupted production
but reduces the investment in raw materials and minimizes reordering costs and hence increases
cash flow. Note that "inventory" is usually the realm of operations management: given the potential
impact on cash flow, and on the balance sheet in general, finance typically "gets involved in an
oversight or policing way".[29]:714 See Supply chain management; Just In Time (JIT); Economic order
quantity (EOQ); Dynamic lot size model; Economic production quantity (EPQ); Economic Lot
Scheduling Problem; Inventory control problem; Safety stock.
Debtors management. There are two inter-related roles here: Identify the appropriate credit policy,
i.e. credit terms which will attract customers, such that any impact on cash flows and the cash
conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see
Discounts and allowances. Implement appropriate Credit scoring policies and techniques such that
the risk of default on any new business is acceptable given these criteria.
Short term financing. Identify the appropriate source of financing, given the cash conversion cycle:
the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to
utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".
Relationship with other areas in finance[edit]

Investment banking[edit]
Use of the term corporate finance varies considerably across the world. In the United States it is
used, as above, to describe activities, analytical methods and techniques that deal with many
aspects of a companys finances and capital. In the United Kingdom and Commonwealth countries,
the terms corporate finance and corporate financier tend to be associated with investment
banking i.e. with transactions in which capital is raised for the corporation.[30] These may include
Raising seed, start-up, development or expansion capital
Mergers, demergers, acquisitions or the sale of private companies
Mergers, demergers and takeovers of public companies, including public-to-private deals
Management buy-out, buy-in or similar of companies, divisions or subsidiaries typically backed by
private equity
Equity issues by companies, including the flotation of companies on a recognised stock exchange in
order to raise capital for development and/or to restructure ownership
Raising capital via the issue of other forms of equity, debt and related securities for the refinancing
and restructuring of businesses
Financing joint ventures, project finance, infrastructure finance, public-private partnerships and
privatisations
Secondary equity issues, whether by means of private placing or further issues on a stock market,
especially where linked to one of the transactions listed above.
Raising debt and restructuring debt, especially when linked to the types of transactions listed above
Financial risk management[edit]
Main article: Financial risk management
See also: Credit risk; Default (finance); Financial risk; Interest rate risk; Liquidity risk; Operational risk;
Settlement risk; Value at Risk; Volatility risk; Insurance.
Risk management [23][31] is the process of measuring risk and then developing and implementing
strategies to manage ("hedge") that risk. Financial risk management, typically, is focused on the
impact on corporate value due to adverse changes in commodity prices, interest rates, foreign
exchange rates and stock prices (market risk). It will also play an important role in short term cash-
and treasury management; see above. It is common for large corporations to have risk management
teams; often these overlap with the internal audit function. While it is impractical for small firms to
have a formal risk management function, many still apply risk management informally. See also
Enterprise risk management.
The discipline typically focuses on risks that can be hedged using traded financial instruments,
typically derivatives; see Cash flow hedge, Foreign exchange hedge, Financial engineering. Because
company specific, "over the counter" (OTC) contracts tend to be costly to create and monitor,
derivatives that trade on well-established financial markets or exchanges are often preferred. These
standard derivative instruments include options, futures contracts, forward contracts, and swaps;
the "second generation" exotic derivatives usually trade OTC. Note that hedging-related transactions
will attract their own accounting treatment: see Hedge accounting, Mark-to-market accounting,
FASB 133, IAS 39.
This area is related to corporate finance in two ways. Firstly, firm exposure to business and market
risk is a direct result of previous capital financial investments. Secondly, both disciplines share the
goal of enhancing, or preserving, firm value. There is a fundamental debate [32] relating to "Risk
Management" and shareholder value. Per the Modigliani and Miller framework, hedging is irrelevant
since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the
other hand hedging is seen to create value in that it reduces the probability of financial distress. A
further question, is the shareholder's desire to optimize risk versus taking exposure to pure risk (a
risk event that only has a negative side, such as loss of life or limb). The debate links the value of risk
management in a market to the cost of bankruptcy in that market.