Corporate Finance: The Three Decisions Every Company Makes

Corporate finance is the study of three decisions a company makes with money: where to put capital, how to raise it, and how much to send back to its owners. One test judges all three. A decision adds value when the return on the capital it uses beats what that capital costs. Sankalp Industrial Systems Limited, invented, earns 15.00 per cent on capital costing 12.00 per cent.

The three decisions are easier to see on a footpath than in a set of accounts, so begin with a tiffin service rather than a company. A woman cooks lunches at home and delivers them by cycle. Demand is beyond what one cycle can carry, so she wants a second one, plus a bigger set of vessels: Rs 60,000 in all. She has Rs 20,000 put aside. Her brother-in-law will lend her the other Rs 40,000, and he is not doing it out of affection. He had that money in a deposit that was paying him something, and he wants at least as much back. At the end of the year she looks at what came in, keeps some of it in the business for the next round of vessels, and takes the rest home.

She has just made all three decisions. Where the money goes: a second cycle rather than a signboard or a phone. Where the money comes from: some of her own, some of her brother-in-law's, and each has a price attached even when only one of the two prices is written down. How much leaves at the end: what she takes home rather than leaving inside. Change the words to capital expenditure, capital structure and payout and that is the whole of corporate finance, at a scale of Rs 60,000 rather than Rs 12,00,00,00,000, and nothing else about the subject is different.

One idea sits underneath all three, and it is the idea the brother-in-law supplied for free. Money put into a business could have been somewhere else. The return that money could have earned somewhere else, at the same risk, is what it costs to keep it here. The forgone return is why the price of her own Rs 20,000 is not zero even though nobody sends her an invoice for it, and it is why a company that reports a large profit may still have wasted every rupee it used. Every corporate finance decision is a comparison between a return and a cost, and the gap between the two is the only place value comes from.

What does corporate finance actually decide, and what does it leave to somebody else?

Corporate finance decides what to do with money, and it decides nothing else. The claim sounds thin until the size of what sits outside it becomes clear. Corporate finance does not decide what the accounts say, how a machine is depreciated, or when revenue is recognised. Accounting settles all three, and corporate finance reads that output rather than producing it. Strategy decides what the product should be, and strategy decides which market to enter and how a competitor will respond. Corporate finance does not decide what a share is worth on any given day either. Share pricing is a separate question with its own machinery.

The list it does decide is short and unglamorous: which projects get money, where that money is borrowed or raised, and how much of what comes back is handed to the people who supplied it. Corporate finance is the discipline of allocation, and its whole claim to importance is that a company can be good at everything else and still be destroyed by getting allocation wrong for a decade.

Throughout this guide the worked example is Sankalp Industrial Systems Limited, an invented listed manufacturer of industrial valves, precision castings and the aftermarket parts and service that go with them. Its last completed year is called Year 0 throughout.

What are the three decisions every company makes with money?

The three are conventionally named investment, financing and payout, and the reason for separating them is that each has a different person asking, a different thing moving, and a different shape of answer. Set them beside each other once and they stop being confusable. A great deal of loose talk about companies comes from mixing them up.

Decision one, investment: where the capital goes, and on what test

The investment decision is the decision about assets. A company takes capitalMoney committed to a business for long enough that it could have been somewhere else instead. and turns it into a third valve line, a warehouse, an automation cell, a bigger stock of castings, longer credit for a customer. At Sankalp Industrial Systems Limited, invented, the plan for each of the next five years is to put a further Rs 1,00,00,00,000 of net new capital into the business. Net new capital is what remains after the year's capital expenditure has been netted against depreciation and the movement in working capital has been added back.

The test is the same every time: does the return on that money beat what the money costs? Ranking several projects against each other, handling the ones that cannot both be built, and dealing with the project that has to be done whatever its arithmetic says, are all covered separately. Only the shape of the question belongs here, and the shape never changes.

Decision two, financing: where the capital comes from, and what each source charges

Money arrives through two doors. Shareholders put it in and are paid last; lenders put it in and are paid on a contract. At Year 0 and measured at market, Sankalp Industrial Systems Limited, invented, is funded Rs 18,00,00,00,000 by equity, being 20,00,00,000 shares at Rs 90.00, and Rs 6,00,00,00,000 by debt, on a total of Rs 24,00,00,00,000. The mix is exactly 75.0 per cent equity and 25.0 per cent debt. Blended, that mix has a cost of capitalThe return the providers of a company's money could get elsewhere at the same risk, blended across all of them. of 12.00 per cent.

The 12.00 per cent is the single most reused number in this worked record, and it enters as a given. How it is assembled input by input, and where each input can go wrong, is covered separately; Aswath Damodaran's valuation material at pages.stern.nyu.edu is where a reader who wants that machinery early would go. All that matters here is that the money is not free and that its price is 12.00 per cent.

Decision three, payout: what goes back to the owners, and when

Whatever is not spent inside the business and not used to repay lenders can be handed to shareholders. In Year 0 Sankalp Industrial Systems Limited, invented, paid a regular dividend of Rs 2.60 a share and a special dividend of Rs 1.00 a share, being Rs 3.60 in all, or Rs 72,00,00,000 across the 20,00,00,000 shares. Of that, Rs 52,00,00,000 is the regular part and Rs 20,00,00,000 the special part.

Notice that a payoutWhat a company hands back to its shareholders, as a dividend or by buying its own shares back. decision is not a reward for a good year. A payout is the mirror of the investment decision: money handed out is money not put to work inside, so the board is implicitly saying that it could not find enough uses inside the company earning more than 12.00 per cent. How much should be paid rather than kept, and what a buyback does that a dividend does not, are covered separately.

Why are the three really one decision seen from three sides?

Because the same rupee passes through all of them. The rupee enters through the financing decision, goes to work through the investment decision, and leaves through the payout decision, and whatever does not leave is capital again next year without anybody raising it afresh. Split into three, the decisions look independent. Followed as a circuit, they are visibly three points on one loop.

The single loop is why a board cannot decide one of them alone. Raise more debt and the mix changes. A changed mix changes what the capital costs, and a changed cost of capital changes the test every project has to pass. Approve a large project and either the payout falls or new money has to be raised. Increase the dividend and the money available for projects shrinks. Every one of the three decisions is a constraint on the other two, and treating them separately is a teaching device rather than a description of a company.

One clarification trips people, and it is worth making before the arithmetic starts. The Rs 24,00,00,00,000 of financing and the Rs 12,00,00,00,000 of invested capital are not the same quantity written twice. The first is what the providers of the money hold at market. The second is what the business has actually tied up inside it. The two figures are different measurements taken for different purposes, and each is used only where it belongs: the market figures for the mix, the invested figure for the return.

How Corporate Finance Decisions Create Value: where does the value come from?

From one place only, and it is worth stating flatly before any figures appear. Value is created when the return earned on the capital used is higher than the cost of that capital, and by nothing else. Not by being large. Not by growing. Not by reporting a bigger profit than last year. Growth on capital that earns less than it costs destroys value faster, not slower. There is simply more of it to be wrong about.

Making that operational needs two quantities. The first is invested capitalThe total the business has tied up inside it: net working capital plus net fixed assets., being everything the business has tied up. For Sankalp Industrial Systems Limited, invented, at Year 0 that is net working capital of Rs 1,80,00,00,000 plus net fixed assets of Rs 10,20,00,00,000, giving Rs 12,00,00,00,000. The second is net operating profit after taxOperating profit taxed as though the company had no borrowings at all, so the figure belongs to every provider of capital rather than to shareholders alone., being operating profit taxed as though the company had no debt at all. Operating profit in Year 0 is Rs 2,40,00,00,000, and the company's own assumed effective tax rate of 25.0 per cent leaves Rs 1,80,00,00,000.

Dividing the second by the first gives the return on invested capitalOperating profit after tax divided by the capital tied up to produce it, stated as a percentage.: Rs 1,80,00,00,000 over Rs 12,00,00,00,000 is exactly 15.00 per cent. Set that against the 12.00 per cent the capital costs and the spreadThe return on invested capital less the cost of capital, stated in percentage points. is exactly 3.00 points. The two numbers 15.00 and 12.00 are the whole of the test, and every other technique in this subject is a more careful way of estimating one or the other of them.

The spread, worked: 15.00 per cent against 12.00 per cent on Rs 12,00,00,00,000

Percentages do not pay for anything, so turn the spread into rupees. Two routes lead to the same answer, and running both is the check that they agree. The first charges the capital directly. Twelve per cent of Rs 12,00,00,00,000 is a capital chargeWhat the capital tied up in a business would cost for a year at its own cost of capital. The charge appears in no set of accounts. of Rs 1,44,00,00,000. Take that off net operating profit after tax of Rs 1,80,00,00,000 and Rs 36,00,00,000 is left. The second multiplies the spread by the base: 3.00 per cent of Rs 12,00,00,00,000 is Rs 36,00,00,000. Same figure, arrived at from opposite ends.

The Rs 36,00,00,000 is the economic profitWhat is left of operating profit after tax once the capital used has been charged for at its own cost. of Sankalp Industrial Systems Limited, invented, in Year 0. The name and the framing come from Koller, Goedhart and Wessels, Valuation, where growth, the return on capital and value are put into one expression. Nothing about it is exotic. Economic profit is what the accounts would show if they charged for shareholders' money the way they charge for lenders' money.

Now the shape of that arithmetic. The shape explains something people find surprising. Value created is a rectangle. The spread is its height and the invested capital is its width, and only the area matters. A thin spread on a very large base and a wide spread on a small one can create exactly the same rupees, so neither number alone settles anything. Three points on Rs 12,00,00,00,000 gives Rs 36,00,00,000. So would thirty points on Rs 1,20,00,00,000.

How to Evaluate a Corporate Finance Decision: what are the five steps, in order?

The test is easy to state and slippery to apply, so here it is as a fixed sequence. The sequence works on a project, on a refinancing, on a dividend and on a decision to hold more stock in a warehouse. All four are the same object: capital moving, cash changing, and a rate to judge it against.

Steps one and two: name the capital that moves, then the cash it changes

Step one is a rupee figure, not a description. At Sankalp Industrial Systems Limited, invented, the capital that moves is Rs 1,00,00,00,000 in each of the next five years. The Rs 1,00,00,00,000 is not the capital expenditure line. The figure is what is left after the year's capital expenditure has had depreciation netted off it and the movement in working capital added on. The leftover is the amount by which the capital tied up in the business actually grows.

Step two is the cash consequence, and it must be a change rather than a level. The forecast has net operating profit after tax rising by exactly Rs 18,00,00,000 in each of the five years, from Rs 1,80,00,00,000 in Year 0 to Rs 2,70,00,00,000 in Year 5. The rise is what the extra capital is being credited with, and the discipline of step two is refusing to credit a decision with cash that would have arrived anyway.

Steps three, four and five: name the rate, compare, then name what would have to be true

Step three names the rate. For this company the rate is 12.00 per cent, the blended cost of its capital. Step four is the comparison and it takes one line. Rs 18,00,00,000 of extra profit after tax on Rs 1,00,00,00,000 of extra capital is a return of 18.00 per cent, a full 6.00 points clear of the 12.00 per cent the capital costs. On the arithmetic, the decision passes.

Step five is where the honesty lives, and it is the step almost everybody skips. What would have to be true for that 18.00 per cent to hold? The new valve line, the new cell and the new warehouse have to earn more on their money than the plant already standing does. The capital already in the ground returns 15.00 per cent while the new capital is credited with 18.00. The claim that new capital earns 18.00 per cent against 15.00 per cent on the existing base is the single most load-bearing assumption anywhere in this worked record, and there is no evidence for it in the record at all. New equipment often is more efficient than old, so the assumption may well be right. The 18.00 per cent is still an assumption, and a write-up that prints it without saying so has presented somebody's choice as a fact.

Following the assumption out shows what it does. By Year 5 the invested capital has grown from Rs 12,00,00,00,000 by five years of Rs 1,00,00,00,000, giving Rs 17,00,00,00,000, and net operating profit after tax has reached Rs 2,70,00,00,000. The return on invested capital is therefore 15.88 per cent rather than 15.00, and it has risen for exactly one reason: better-earning new capital has been mixed into a lower-earning old base. Remove the assumption and the improvement disappears with it.

What do all three decisions look like in one year of one company?

Three rows are what they look like, and this is the part worth reading slowly. Here the abstraction becomes something a person can point at. Here is Year 0 of Sankalp Industrial Systems Limited, invented, with each of the three decisions and its own figure, followed by the test run once across all of them.

The last two rows are worth reading once more. The capital charge is four fifths of the entire operating profit after tax. A company earning a respectable 15.00 per cent gives away four rupees in five simply to hold on to the money it is using, and what survives that is the only part that made anybody better off. The proportion is not unusual and it is not a sign of anything wrong. Four rupees in five is what a capital charge looks like when it is finally written down.

What does a positive spread leave unanswered?

A great deal, and this is where the test has to stop rather than push on. A positive spread answers one question completely and a second question not at all, and the two get run together constantly.

The question it answers is whether the capital used earned more than it cost. The first question is closed: at Sankalp Industrial Systems Limited, invented, in Year 0, the capital did, by Rs 36,00,00,000. The question it does not answer is whether that was the most those rupees could have done. Nothing about an alternative is anywhere inside the calculation. A division earning two points of positive spread is creating value and may still be the worst place in the company to put the next rupee, and the spread on its own can never show which. Choosing between uses is a comparison, and comparisons are covered separately.

Think of the household again. A woman who puts Rs 40,000 into a fixed deposit paying more than she could get anywhere else at that risk has done well. If she also had a chance to buy a second cycle that would have returned four times as much, she has still done well and she has also left money on the table. Both statements are true at once, and only the first is what a spread measures.

What goes wrong when somebody reads the profit line instead?

One reconciliation before leaving this. The reconciliation shows the two figures are the same company seen twice rather than two different companies. Net operating profit after tax is Rs 1,80,00,00,000. Take off the after-tax cost of the interest, being Rs 48,00,00,000 at 25.0 per cent relief, or Rs 36,00,00,000, and Rs 1,44,00,00,000 is left. Rs 1,44,00,00,000 is the profit for the year. Take off the Rs 6,00,00,000 belonging to the part of the subsidiary this company does not hold and Rs 1,38,00,00,000 remains, exactly the reported figure. Nothing is hidden and nothing is adjusted. The only thing the accounts leave out is the charge for equity, and that omission is the entire subject of this guide.

Who inside a company actually makes these decisions, and who reads them from outside?

Inside, they are split across three places and the split matters. The operating side proposes investments. Only the operating side knows what a second valve line would actually do. The treasury side handles financing. The mix, the maturities and the covenants are its craft. And the board decides payout. Handing money back to shareholders is the one decision nobody who works inside the company can be trusted to take on their own. The measure applied to each of them determines what each of them proposes, and the design of that measure is therefore a corporate finance decision in its own right.

The measure is also the mechanism behind the failure above. A person paid on reported profit will propose any project that adds to reported profit, including projects earning 6.00 per cent on capital costing 12.00 per cent. The accounts will show the profit going up and will show no charge for the money used. A person measured on economic profit cannot do the same. The charge follows the capital wherever it goes.

From outside, three different readers pull three different things off the same numbers. A lender looks first at whether the contractual promises can be kept. For Sankalp Industrial Systems Limited, invented, at Year 0 that means operating profit of Rs 2,40,00,00,000 against interest of Rs 48,00,00,000, a cover of exactly 5.00 times, and net borrowings of Rs 4,80,00,00,000 against earnings before interest, tax, depreciation and amortisation (EBITDA) of Rs 2,88,00,00,000, being 1.67 times. Neither of those figures is about value creation at all. Both are about survival, and survival is what a lender is entitled to care about.

An analyst looks at the spread and at whether it is widening or narrowing, and then at the company's assumption about new capital. Most of the future in any model actually lives in that assumption. And a shareholder looks at the payout and at whether the regular part of it, Rs 2.60 a share, has been raised again. A regular dividend is a commitment the board will be measured against next year, and a special one is structured precisely so that it is not.

None of these readers is doing something different from the others in kind. All three are asking a version of the same question the tiffin cook asked about the second cycle: is the money earning more than it costs, and is it going to keep doing so? The difference is only in which part of the answer each of them is entitled to insist on.