Concept of Value in Corporate Finance - Essay Example

?INTERNATIONAL FINANCE (concept of value in corporate finance Section A – Academic Essay When trying to understand value, the following issue is likely to appear: are the elements of value standardized across environment of different characteristics? The answer to this question should be negative. This issue is also highlighted in the statement of Broughton (2010), which is analyzed in this paper. Three are the key issues highlighted in the specific statement: a) the term value is quite common but in the context of the business environment its importance is much higher compared to the daily life, b) as an element of the business environment, the term value can be given different interpretations, reflecting different aspects of each organization and c) when trying to define the context of value, as related to business processes, it would be preferable to focus on specific issues; a simple definition of value would be also applicable in businesses with different characteristics. In the statement of Broughton in regard to value, reference is also made to risk, as influencing value. The methods used for pricing risk are analyzed below. At the same time, the different levels of risk related to different cash flows are explained. In this way, the concept of value, which is highly influenced by risk, is made clearer. Being aware of value, as part of business environment, and risk, it is easier to understand the criteria on which the identification of a firm’s future value will be based. At a first level, the statement of Broughton (2010) on value and its role in business should be critically analyzed. Then it would be possible to explain the interaction between value and risk, as these two concepts can highly affect business processes. In any case, reference should be primarily made to the context of value; then, its aspects would be easier understood. Abrams (2004) notes that a general definition of value cannot reflect the precise nature or the role of value. However, Abrams (2004) explains that such definition cannot be rejected. Rather it should be used as the basis for developing an accurate definition of value. For example, reference can be made to the following definition: ‘value is a fair return or equivalent in goods, services or money for something exchanged’ (Abrams 2004, p.6). This definition is accurate, as possible; still, it is not effective enough for covering all aspects of the activities of a particular organization. The definition of business value provided by Babar (2010) reflects another aspect of the specific concept; according to the above researcher business value ‘is defined according to the level that the customer uses a particular product’ (Babar 2010, p.136). A series of standards, as for example ‘the Fair Market Value and the Investment Value’ (Abrams 2004, p.6) has been introduced for ensuring that the different aspects of value, as an element of the business environment are made clear. Kontio and Conradi (2002) promote the following definition of value: ‘value is the trade-off between benefits and sacrifices’ (Kontio and Conradi 2002, p.260). It is also made clear that in business value can be related both to monetary and non-monetary elements; for example, in business area, value can be used for reflecting the position of an organization within the local or the international market (Kontio and Conradi 2002, p.260). Of course, the use of the term value for reflecting different aspects of organizational activities is always possible. For example, the term value can be use for showing the perceptions of a firm’s shareholders in regard to the financial status of their organization (Useem 1993); these perceptions are commonly described using the term shareholder value (Useem 1993). From a similar point of view, the term value can be used for showing the financial strength of an organization, as the firm’s managers evaluate this strength after reviewing the firm’s financial performance but also its assets (Segal 2011). One of the key characteristics of value, according to Broughton (2010) is the following one: value is a term highly used in daily life so that all people are aware, more or less, of its elements; as part of the business environment, the context of value is differentiated, being related to different goals and priorities. The particular view of Broughton (2010) is verified by the literature published in regard to this issue. For example, Fishman, Pratt and Morrison (2006) refer to the context of fair value and explain that the above term can be widely used in different cases, such as ‘financial reporting and divorce’ (Fishman, Pratt and Morrison 2006, p.23). It is also made clear that the context of fair value ‘depends on its use’ (Fishman, Pratt and Morrison 2006, p.23). Moreover, Babar (2010) presents the results of a research focusing on the characteristics of business value; in the above research, customers had asked to define business value. The explanations that customers give in regard to business value prove the differences in the perceptions of customers on business value but also the high range of the aspects of value, a fact verifying the view of Broughton (2010) for the existence of differences between value as a term used in daily life and value as a term used in business. In the context of the above research, business value is related to ‘the functionality of a product, the expected profit of the organization involved or the customers’ expectations’ (Babar 2010, p.136). The differences in the definitions of value can be made clear through the following case: when referring to a business, the term value can reflect the financial strength of the organization, including its assets or the cash available (Stewart and Donleavy 1995). However, the term value can be also used for showing the social ethics, or values, on which the organization’s ethics and objectives are based (Stewart and Donleavy 1995, p.22). In the study of Persico and Morris (1997) emphasis is given on the following definition of value: ‘meeting the needs of customers at an acceptable cost’ (Persico and Morris 1997, p.14). The specific definition is characterized as pragmatic, meaning that it reflects more effectively the use of value in daily business processes (Persico and Morris 1997, p.14). Indeed, the above explanation of value seems to be more realistic, highlighting an issue that is of key importance for all businesses: if organizations are not able to understand and respond to the needs of their customers, then their market performance can be set in severe risk. Pratt, Reilly and Schweihs (1998) also note that value has many different explanations; when having to use the particular term, efforts should be made for identifying the issues addressed through the above term in the case involved having in mind the fact that the term value can have different context for each individual (Pratt, Reilly and Schweihs 1998). The specific fact is also highlighted in the study of Pratt and Niculita (2007) where emphasis is given on the following phenomenon: there are many, different, definitions of value; each of these definitions refers to specific aspects of value, meaning those aspects that are of importance in each particular case, a phenomenon which is clearer when trying to use the term value in business (Pratt and Niculita 2007). For this reason it is suggested to avoid use the specific term without examining clearly in advance the environment and the context to which the term value has to be related (Pratt and Niculita 2007). Under these terms, the argument of Broughton (2010) that the term value is highly differentiated according to the sector in which it is involved is fully verified. Also, the view of Broughton (2010) that value in business is different than in other fields is also adequately supported. As for the high range of meanings of value in business, as highlighted in the statement under examination, this has been fully verified and explained. It has been also proved that the differences in the perceptions of people on value, as noted by Broughton, are unavoidable. As already explained earlier, value, as the term described above, is closely related to risk. Therefore, any discussion on value should necessary include appropriate explanations of the relationship between value and risk. The presentation and the analysis of risk, as appearing in businesses, are necessary for understanding the impact of risk on value and vice versa. The following issue should be primarily addressed: how risk is priced? Sundaram (2011) notes that in business environment, risk can have four different dimensions: a) operating risk, reflecting the influence of each organization by the local or the global economic trends, b) event risk, a term used for showing ‘the unexpected events that can influence business performance’ (Sundaram 2011, p.6), c) price risk, meaning the changes in the pricing of a firm’s ‘inputs and outputs’ (Sundaram 2011, p.6) and c) credit risk, a term used for showing the potential lack of funds available for supporting critical business plans but also the unexpected changes on the terms of a firm’s financing, such as the radical increase of interest rates in regard to a firm’s loans (Sundaram 2011, p.6). On the other hand, Chandra (2008) notes that when referring to business activities, five types of risk can be identified: ‘technological, economic, financial, performance and legal’ (Chandra 2008, p.1037). In other words, in modern businesses risk can be related to different parts of business activities, including the technology necessary for daily business operations, the market demands, the decisions of the local financial institutions in regard to interest rates, the downturns in each firm’s profits and the legal rules regulating business activities in each country (Chandra 2008). Glantz (2003) notes that the evaluation of risk related to a firm’s activities requires the good understanding of all parts of the business environment, including ‘the level of lending available to consumers, the effects of product cycle on business performance and the liquidity of the market’ (Glantz 2003, p.54). This means that the rules on which the evaluation of risk in each business can be based are not standardized, an issue, which is also promoted in the study of Rugman and Collinson (2008). The above researchers claim that firms can choose among different strategies for controlling risk related to their activities; for example, a firm would either decide to fully avoid risk or just to appropriately change its activities so that risk is diversified (Rugman and Collinson 2008, p.207). According to the issues discussed above, risk can be priced using different criteria, depending on the priorities set in each particular case. At the next level, the following phenomenon should be explored: different cash flows seem to carry different levels of risk. According to the existing literature, the exposure of cash flows to risk is different according to the level of the cash flows, a phenomenon more common in firms operating globally (Buckley 2004). The interaction between risk and cash flow is proved through the following fact: each firm has a particular cost of capital, different from that of its rivals (McDonald, Ward and Smith 2007). The different cost of capital will lead firms to offer different discount rates, a fact that will highly affect their cash flows (McDonald, Ward and Smith 2007). Moreover, Ramos (2000) note that each portfolio can be based on different types of cash flow; reference is made to a portfolio based on ‘a risk – free cash flow and to a cash-flow with issuer risk’ (Ramos 2000, p.258). It is explained that the risk related to each category of cash flow is different, so that specific investment targets are achieved. Also, Choudhry (2001) explains that portfolios, which are based on cash flows that are highly dispersed usually, bear high risks, compared to portfolios where cash flows are not dispersed (Choudhry 2001, p.960). Thus, different cash flows are related to different levels of risk. Under these terms, the potential identification of the future prospects of a business can be achieved only if risk related to the firm’s processes is carefully measured. Then, the potentials of the firm to control risk in the long term have to be judged. At this point, the following issue seems to be of critical importance: the responses of a firm’s shareholders to the firm’s initiatives for securing its financial stability in the long term are not standardized (Arnold 2008), at the level that shareholders can support or reject relevant plans taking into consideration their own interests. In such cases, the following practice should be developed: the expected performance of the organization, as influenced by existing market forces should be explained to the firm’s shareholders (Madura 2009); this strategy is critical especially if the firm’s operates in the global market where losses from wrong business plans or from persistence to change can be severe (Madura 2009). The effectiveness of communication between the firm and its shareholders and the performance of the firm in managing risk are key criteria for deciding the future prospects and risks of the organization in the local or the international market. (Words 2142) Section B - Statement of Learning (See Table 1, Appendix) a. The material taught in the classroom, as followed by the guidelines of the tutor, has given me the opportunity to be informed on a series of critical issues which are quite common in real world business activities. For example, the terms under which the financing decisions of multinationals are taken (an issue discussed in the 4th week, see Table 1, blog post 1) are important since multinationals represent a key part of the market and it is quite possible for any individual to be hired in such organization. Ventures also and foreign subsidiaries, the financing problems of which were also discussed in week 4, are quite common business types. Moreover, since the reading of financial newspapers has been a key part of learning process, I’ve become familiar with the study of the specific resources, which are valuable for taking any financial decision; having learned the practical implications of financial decisions, as presented through the financial newspapers, I’ve become more capable of handling financial problems of organizations, as appeared in real world. At this point, emphasis should be given on the following fact: each week a particular topic related to international finance has been covered; in this way, all aspects of the topic were made clear and their use in real world business practices has become easier. Reference should be also made to the fact that all aspects of international finance have been addressed during the 11 weeks of the course. As a result, students, including myself, have become competent in facing practical problems of corporations in related to international finance, especially since these problems have been already addressed through lectures; for example, the following themes have been analyzed, as of their practical aspects, in the classroom: the tax implications of multinationals, an issue discussed in week 5 (see blog post 2), or the use of mergers of acquisitions as a tool to expand internationally, an issue discussed in week 7 (see blog post 4). In addition, reference should be made to another characteristic of the learning process: students have been given the chance to discuss, within the classroom, in regard to the practical aspects of the issues under examination; ideas were exchanged on the questions that the tutor set and suggestions were made in regard to the solutions available. In this way, students have learned to search for the practical aspects of each problem referring to corporate finance; theory has been used as supporting evidence, along with findings from newspapers. Thus, students, including myself, have learned how they should manage any problem of corporate finance not only as of its theoretical foundation but, mostly, of its practical needs and challenges. The above view is verified through the following fact: in weeks 9 and 10, students were assigned a particular task: they were asked to prepare a response, backed with appropriate evidence and findings from financial newspapers, in regard to the issues covered in weeks 8 and 9. This means that students were given the chance to act as consultants, suggesting solutions for addressing particular corporate finance problems. In other weeks also, i.e. in weeks 4, 5, 6, 7, 10 and 11, students were asked to develop written tasks, as incorporated in the textbook. The active involvement of students in retrieving solutions for real-world problems of multinationals has highly enhanced the problem-solving ability of students, including myself, as related to the ability to develop appropriate research for resolving problems of this type. b. As already explained above, the material covered through the lectures incorporates all aspects of international finance. Of course, certain lectures have focused on issues, which are quite complex and difficult to be understood. For example, the concept of FDI has been developed in week 6 while the aspects of mergers and acquisitions, as related especially to multinationals, have been analyzed in week 7. However, there have been two weeks, weeks 8 and 9 where all issues of contemporary finance have been discussed, so that students become familiar with the particular subject. In other words, due to the structure of lectures, there have been no gaps left in regard to the financial challenges of international businesses. Even in regard go issues for which the time available for analysis has been limited, alternative modes of study have been employed, meaning especially the assignment to the students of weekly tasks, in relation to the material covered in weeks 8 and 9. This distinction of themes related to international corporate finance has helped to the easier understanding of its aspects and challenges. It was for this reason that students, including myself, have become able to respond to the needs of in-class discussions and written tasks effectively. c. One of the key issues that financial managers have to face when having to decide in regard to the financial strategy of a multinational is the following one: the effects of financial strategies on corporate performance are not standardized in the global market. Multinationals with similar characteristics can respond differently to the same financial strategy, a fact probably related to the different resources engaged in these projects. In this context, understanding the criteria that financial managers use for selecting a financial project is vital for evaluating this project’s value and potentials, especially in the long term. The lectures have provided the information required for developing such task; valuable information has been provided on risk and FDI, two concepts that are of key importance in order to identify effective financial projects for firms operating globally. At the same time, in the lectures, the financing needs and characteristics of multinationals have been extensively analyzed, in week 4. Also, the practical implications of financial projects have been analyzed, both through in-class discussions and through written tasks assigned to students from week 4 up to week 11. Thus the students’ ability, including myself, to respond to practical aspects of financial projects of multinationals, has been significantly supported. (Words 979) References Abrams, J. (2004) How to Value Your Business and Increase Its Potential. Columbus: McGraw-Hill Professional. Babar, A. (2010) Product-Focused Software Process Improvement: 11th International Conference, Profes 2010, Limerick, Ireland, June 21-23, 2010, Proceedings. New York: Springer. Boakes, K. (2008) Reading and Understanding the Financial Times. Essex: Pearson Education. Brigham, E., and Houston, J. (2012) Fundamentals of Financial Management. Belmont: Cengage Learning. Buckley, A. (2004) Multinational Finance. Essex: Pearson Education. Chandra, P. (2008) Financial Management. New Delhi: Tata McGraw-Hill Education. Choudhry, M. (2001) The Bond and Money Markets: Strategy, Trading, Analysis Securities Institute Professional Reference Series. Oxford: Butterworth-Heinemann. Fishman, J., Pratt, S., and Morrison, W. (2006) Standards of Value: Theory And Applications. Hoboken: John Wiley & Sons. Glantz, M. (2003) Managing Bank Risk: An Introduction to Broad-Base Credit Engineering. California: Academic Press. Kontio, J., and Conradi, R. (2002) Software Quality-ECSQ 2002: Quality Connection-7th European Conference, Helsinki, Finland, June 9-13, 2002: Proceedings. New York: Springer. Madura, J. (2009) International Financial Management. Belmont: Cengage Learning. McDonald, M., Ward, K., and Smith, B. (2007) Marketing Due Diligence: Reconnecting Strategy to Share Price. Oxford: Elsevier. Persico, J., and Morris, P. (1997) The New Business Values for Success in the Twenty-First Century: Improvement, Innovation, Inclusion, Incentives, Information. London: Routledge. Pratt, S., and Niculita, A. (2007) Valuing a Business: The Analysis and Appraisal of Closely Held Companies. Columbus: McGraw-Hill Professional. Pratt, S., Reilly, R., and Schweihs, R. (1998) Valuing Small Businesses and Professional Practices. Columbus: McGraw-Hill Professional. Ramos, J. (2000) Financial Risk Management: A Practical Approach for Emerging Markets. Washington: IDB. Rugman, A., and Collinson, S. (2008) International Business. Essex: Pearson Education. Segal, S. (2011) Corporate Value of Enterprise Risk Management: The Next Step in Business Management. Hoboken: John Wiley & Sons. Stewart, S., and Donleavy, D. (1995) Whose Business Values?: Some Asian and Cross-Cultural Perspectives. Hong Kong: Hong Kong University Press. Sundaram, J. (2011) Derivatives and Risk Management. New Delhi: Pearson Education India. Useem, M. (1993) Executive Defense: Shareholder Power and Corporate Reorganization. Boston: Harvard University Press. Appendix Table 1 - Learning outcomes – on weekly basis No of blog post Week Learning outcome – Blog posts 1 4 Understanding the financial needs of multinational organizations and ventures Being informed on the potential financing options of multinationals/ ventures and the risks involved Understanding the tools for evaluating the potentials of multinationals and ventures to respond to specific repayment modes, as parts of the chosen financing schemes 2 5 Understanding the concept of risk as related to the activities of corporations Understanding of the relationship between risk and tax Being informed on the common tools for assessing the tax of multinationals 3 6 Understanding the characteristics and the challenges of Foreign Direct Investment Understanding of the use of FDI as a tool for promoting the expansion of multinationals in new markets Understanding of the differences between FDI and other forms of international investment 4 7 Increasing knowledge on international investment choices Understanding the role of mergers and acquisitions in the expansion of multinationals Understanding of the risks and benefits of mergers and acquisitions compared to other international investment tools 5 8 Understanding contemporary issues of corporate finance 6 9 Understanding contemporary issues of corporate finance Understanding the practical implications of multinationals’ financial decisions – written assessment Developing key business research skills, gathering and processing material necessary for suggesting solutions in regard to common financial problems of multinationals 7 10 Understanding the context of capital structure and its use for developing financial decisions related to multinationals Understanding the different forms of capital structure and their implications Understanding the influence of business environment on capital structure Understanding the criteria on which the decisions of business owners/ shareholders in regard to capital structure are based Developing key business research skills, gathering and processing material necessary for suggesting solutions in regard to common financial problems of multinationals 8 11 Understanding the characteristics of dividend policy and its role in critical financial decisions of international organizations Understanding the effects of dividend policy on organizational performance Understanding the interaction between dividend policy and other financial decisions of managers in multinationals Read More