Corporate Finance

The financial activities related to running a corporation.

A division or department that oversees the financial activities of a company. Corporate finance is
primarily concerned with maximizing shareholder value through long-term and short-term
financial planning and the implementation of various strategies. Everything from capital
investment decisions to investment banking falls under the domain of corporate finance.

Market Condition

Markets characteristic(s) such as number of the competitors, level or intensity of

competitiveness, and the markets growth rate that a firm walks into when introducing a
new product.

Debt vs. Equity

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In order to expand, it is necessary for business owners to tap financial resources. Business owners
can utilize a variety of financing resources, initially broken into two categories, debt and equity.
"Debt" involves borrowing money to be repaid, plus interest. "Equity" involves raising money by
selling interests in the company. The following table discusses the advantages and disadvantages
of debt financing as compared to equity financing.

ADVANTAGES OF DEBT COMPARED TO EQUITY

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Because the lender does not have a claim to equity in the business, debt does not dilute the
owner's ownership interest in the company.

A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and
has no direct claim on future profits of the business. If the company is successful, the owners reap
a larger portion of the rewards than they would if they had sold stock in the company to investors
in order to finance the growth.

Except in the case of variable rate loans, principal and interest obligations are known amounts
which can be forecasted and planned for.

Interest on the debt can be deducted on the company's tax return, lowering the actual cost of the
loan to the company.

Raising debt capital is less complicated because the company is not required to comply with state
and federal securities laws and regulations.

The company is not required to send periodic mailings to large numbers of investors, hold
periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions.

DISADVANTAGES OF DEBT COMPARED TO EQUITY

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Unlike equity, debt must at some point be repaid.

Interest is a fixed cost which raises the company's break-even point. High interest costs during
difficult financial periods can increase the risk of insolvency. Companies that are too highly
leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow
because of the high cost of servicing the debt.

Cash flow is required for both principal and interest payments and must be budgeted for. Most
loans are not repayable in varying amounts over time based on the business cycles of the
company.

Debt instruments often contain restrictions on the company's activities, preventing management
from pursuing alternative financing options and non-core business opportunities.

The larger a company's debt-equity ratio, the more risky the company is considered by lenders
and investors. Accordingly, a business is limited as to the amount of debt it can carry.

The company is usually required to pledge assets of the company to the lender as collateral, and
owners of the company are in some cases required to personally guarantee repayment of the loan.

Short Term vs. Long Term Debt

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Short-term debt is that with a maturity of one year or less. This usually takes the form of bank
loans, which carry a relatively low interest rate.

Long-term debt consists of loans and bonds that have a maturity longer than a year. These
bonds and loans generally carry a higher interest rate, as lenders demand a higher return
in exchange for taking on the greater risk of loaning money over a long period of time.

Illiquidity vs. Insolvency

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First, it is possible (at least, in principle) to differentiate between insolvent and illiquid firms (or
banks). The first is what economists call economic distress. The second is what economists call
financial distress. In the first instance, the firm does not have a viable future and should fail. In
the second the firm does have a viable future and has a temporary cash-flow crisis. These types of
firm should be rehabilitated.
The bankruptcy process exits to enforce the costs of failure and to maximise the value of firms
given that we know the exiting business model has failed. For those firms where a business model
will never succeed the firm should be liquidated, while for those where a business model can
succeed should be restructured. There is a huge economic literature on these ideas summarised
quite nicely in a volume by Jagdeep Bhandari and Lawrence Weiss. The difficulty in practice is in
determining whether any particular firm is economically distressed or financially distressed (think
of Ansett).

So I disagree with the notion that all illiquid firms are also insolvent firms. (Unless were arguing
about plain language definitions). But what about banks? Liquidity is the business of banking.
Here Jarnecics argument seems to be that any use of the lender of last resort is a government
bailout.
Im not convinced that this is correct. One of the consequences of a fractional reserve banking
system is that some banks will run out of cash. A retailer that temporarily runs out of inventory is
not normally considered to be economically distressed. It is not clear to me that a bank is different
in that regard. A retailer that cannot get resupplied because suppliers have no confidence in their
ability to on-sell the inventory is economically distressed. Again the difficulty is working out
which is which.
There is evidence to suggest that consumers can work out the difference. The standard theoretical
economic model describing bank runs by Douglas Diamond and Philip Dybvig suggests that
anything that causes depositors to anticipate a run will cause a run to actually occur. That
suggests that contagion should be a common cause of bank failure, i.e. that healthy banks will fail
during a banking crisis along with unhealthy banks. This model also suggests that bank failures
and banking panics will occur (somewhat) at random.
The empirical evidence, however, does not support this theoretical view. Gary Gorton
(subscription required) tests the view that bank failures occur at random by investigating bank
panics and failures during the US National Banking Era (1863 1914). He tests two hypotheses.
The first hypothesis is that bank failure and bank panics are unrelated to economic events (this
can be described as a pure panic hypothesis) and second hypothesis is that bank failure and
bank panics are related to economic events (the recession hypothesis or an information-based
run). His evidence is consistent with the view that bank panics occur when consumers perceive a
recession being imminent they then withdraw money from the banking system in anticipation of
bank failures. Banking crisis are not random events, but rather are a rational response to expected
future loss.
Similarly Charles Calomiris and Joseph Mason (subscription required) find that runs on Chicago
banks in the early 1930s were information based those banks that experienced runs were
already insolvent. It seems that depositors were able to differentiate between those institutions
that were insolvent and those that were not.

Matching Liabilities with Assets

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Asset-Liability Matching is the process of investing, purchasing, selling and otherwise adjusting a
company's asset holdings so that cash is available when it is needed to cover the company's
liabilities.

When the duration of the portfolio of assets and the portfolio of liabilities is equivalent, changes
in interest rates should have a negligible effect on the structure: the portfolio is said to be duration
matched. This is a prime example of the benefit of Asset-Liability Matching (ALM). Although,
there are risks other than changing interest rates. Furthermore, duration itself is not static, and
portfolio rebalancing must be dynamic to account for such changes. However, in principle, this
form of ALM can work to help investment managers put some control on at least one form of risk
in our ever-more complex investment world.

Corporate Strategy

The overarching strategy of a company developed by its leadership that reflects its
mission and core values in its goals and underlying business strategies for achieving
them. The corporate strategy provides clear direction for all the business units working in
concert to meet shareholder expectations while providing value to their customers and
employees.

Fixed Rate Financing

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An interest rate on a liability, such as a loan or mortgage, that remains fixed either for the entire
term of the loan or for part of this term. A fixed interest rate may be attractive to a borrower who
feels that the interest rate might rise over the term of the loan, which would increase his or her
interest expense. A fixed interest rate, therefore, avoids the interest rate risk that comes with a
floating or variable interest rate, wherein the interest rate payable on a debt obligation depends on
a benchmark interest rate or index.

While a home buyer in the United States can obtain a mortgage with a fixed interest rate for the
full 30-year term of his or her mortgage, in Canada, a home buyer can only "lock in" or obtain a
fixed interest rate for a maximum of five to seven years of a 25-year mortgage.
Borrowers are more likely to opt for fixed interest rates during periods of low interest rates, since
the opportunity cost, if interest rates go lower, is still much less than during periods of high
interest rates.

Call Protection
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A protective provision of a callable security prohibiting the issuer from calling back the security
for a period early in its life.

The call protection is advantageous to investors because it prevents the issuer from forcing
redemption early on in the life of a security. This means that investors will have a minimum
number or years, regardless of how poor the market becomes, to reap the benefits of the security.

The period for which the bond is protected is known as the "deferment period" or the "cushion".