Structured productIn structured finance, a structured product, also known as a market linked investment,

is generally a pre-packaged investment strategy based on derivatives, such as a

single security, a basket of securities, options, indices, commodities, debt issuance

and/or foreign currencies, and to a lesser extent, swaps. The variety of products just described

is demonstrative of the fact that there is no single, uniform definition of a structured product. A feature of

some structured products is a "principal guarantee" function, which offers protection

of principal if held to maturity. For example, an investor invests 100 dollars, the issuer

simply invests in a risk free bond that has sufficient interest to grow to 100 after the

five-year period. This bond might cost 80 dollars today and after five years it will grow

to 100 dollars. With the leftover funds the issuer purchases the options and swaps needed to perform

whatever the investment strategy is. Theoretically an investor can just do this themselves, but the costs and

transaction volume requirements of many options and swaps are beyond many individual investors.[1]

As such, structured products were created to meet specific needs that cannot be met from the standardized

financial instruments available in the markets. Structured products can be used as an alternative to a direct

investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilize the current

market trend.

U.S. Securities and Exchange Commission (SEC) Rule 434[2] (regarding certain prospectus deliveries) defines

structured securities as "securities whose cash flow characteristics depend upon one or more indices or that

have embedded forwards or options or securities where an investor's investment return and the issuer's

payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets,

indices, interest rates or cash flows."

The Pacific Stock Exchange defines structured products as "products that are derived from and/or based on a

single security or securities, a basket of stocks, an index, a commodity, debt issuance and/or a foreign

currency, among other things" and include "index and equity linked notes, term notes and units generally

consisting of a contract to purchase equity and/or debt securities at a specific time."[citation needed]

Risks

The risks associated with many structured products, especially those products that present risks of loss of

principal due to market movements, are similar to those risks involved with options.[3]The potential for serious

risks involved with options trading are well-established, and as a result of those risks customers must be

explicitly approved for options trading. In the same vein, the U.S.Financial Industry Regulatory

Authority (FINRA) suggests that firms "consider" whether purchasers of some or all structured products be

required to go through a similar approval process, so that only accounts approved for options trading would

also be approved for some or all structured products.

In the case of a "principal protected" product, these products are not always insured in the United States by

the Federal Deposit Insurance Corporation; they may only be insured by the issuer, and thus have the potential

for loss of principal in the case of a liquidity crisis, or other solvency problems with the issuing company. Some

firms have attempted to create a new market for structured products that are no longer trading. These

securities may not be trading due to issuer bankruptcy or a lack of liquidity to insure them. Some structured

products of a once solvent company have been known to trade in a secondary market for as low as pennies on

the dollar.[4]

The regulatory framework with regard to structured products is also hazy. These may fall in grey areas legally.

In India, equity related structured products seem to be in violation of the Securities Contract Regulation Act

(SCRA). SCRA prohibits the issue and trade of equity derivatives except those that trade on nationally

recognized stock and derivatives exchanges.

Origin

Structured investments arose from the needs of companies that wanted to issue debt more cheaply.

Traditionally, one of the ways to do this was to issue a convertible bond, that is, debt that under certain

circumstances could be converted to equity. In exchange for the potential for a higher return (if the equity value

would increase and the bond could be converted at a profit), investors would accept lower interest rates in the

meantime. However this trade-off and its actual worth is debatable, since the movement of the equity value of

the company could be unpredictable.Investment banks  then decided to add features to the basic convertible

bond, such as increased income in exchange for limits on the convertibility of the stock, or principal protection.

These extra features were all based around strategies investors themselves could perform using options and

other derivatives, except that they were prepackaged as one product. The goal was again to give investors

more reasons to accept a lower interest rate on debt in exchange for certain features. On the other hand the

goal for the investment banks was to increase profit margins since the newer products with added features

were harder to value, so that it was harder for the banks' clients to see how much profit the bank was making

from it.

Interest in these investments has been growing in recent years and high net worth investors now use structured

products as way of portfolio diversification. Nowadays the product range is very wide, and reverse convertible

securities represent the other end of the product spectrum (yield enhancement products). Structured products

are also available at the mass retail level - particularly in Europe, where national post offices, and even

supermarkets, sell investments on these to their customers.

Below is a brief description of how structured products are manufactured.

Combinations of derivatives and financial instruments create structures that have significant risk/return and/or

cost savings profiles that may not be otherwise achievable in the marketplace. Structured products are

designed to provide investors with highly targeted investments tied to their specific risk profiles, return

requirements and market expectations.

These products are created through the process of financial engineering, i.e., by combining underlyings

like shares, bonds, indices or commodities with derivatives. The value of derivative securities, such

as options, forwards and swaps is determined by (respectively, derives from) the prices of the underlying

securities.

The market for derivative securities has grown quickly in recent years. The main reason for this lies in the

economic function of derivatives; it enables the transfer of risk, for a fee, from those who do not want to bear it

to those who are willing to bear risk.

Benefits of structured products may include:

• principal protection (depending on the type of structured product)

• tax-efficient access to fully taxable investments

• enhanced returns within an investment (depending on the type of structured

product)

• reduced volatility (or risk) within an investment (depending on the type of

structured product)

• the ability to earn a positive return in low yield or flat equity market environments

Disadvantages of structured products may include: .[5]

• credit risk - structured products are unsecured debt from investment banks

• lack of liquidity - structured products rarely trade after issuance and anyone

looking to sell a structured product before maturity should expect to sell it at a

significant discount

• no daily pricing - structured products are priced on a matrix, not net-asset-value.

Matrix pricing is essentially a best-guess approach

• highly complex - the complexity of the return calculations means few truly

understand how the structured product will perform relative to simply owning the

underlying asset

Structured products are by nature not homogeneous - as a large number of derivatives and underlying

can be used - but can however be classified under the following categories

• Interest rate-linked notes and deposits

• Equity-linked notes and deposits

• FX and commodity-linked notes and deposits

• Hybrid linked notes and deposits

• Credit-linked notes  and deposits

• Constant proportion debt obligations  (CPDOs)

• Constant Proportion Portfolio Insurance  (CPPI)

• Market-linked notes and deposits

How good is Reliance Capital’s equity-linked debenture, Series B-57?••••

• 3 comments

• + COMMENT MONEYLIFE DIGITAL TEAM | 27/09/2012 04:23 PM |     

If you are an HDFC Bank customer, you may have been approached to buy equity-linked debenture of Reliance Capital. Should you? 

Reliance Capital, which has investments in broking, insurance and asset management andinvestments through private equity and investment banking, has launched its S&P CNX Nifty Index Linked Debenture named Series B-57, and its exclusive distribution has been handed over to HDFC Bank. Many of the bank’s

customers are being wooed to buy this product. Does it make sense? 

Key Features of ELD The product is a 40-month equity-linked debenture (ELD), whose performance is linked to S&P CNX Nifty with the following return structure: 

• If at the end of the 36th month, the market is higher than the initial level (by any quantum), the investor gets an absolute return of 49%, which equals an annualised compounded rate of return of 12.68%

• If at the end of the 36th month, the market is lower than the initial level, the return willreduce by 2.45 times of each percentage reduction in the index. For example, if the market falls by 5% the return will reduce by (2.45*5)%, that is, 12.25%. Therefore, the final return for the investor in this case would be 49-12.25=36.75%, which is an annualised rate of return of around 9.9%. The compounded return comes to 9.9%.

• If the market falls beyond 20%, the rate of return becomes 0% (because 20*2.45=49%), and the investor gets back only his/her initial investment. 

The following table gives a complete scenario at different Nifty levels.

 

Initial investment

Market movement

Return (percentage)

Return in rupee terms

Annualised rate of return

Rs50,000 + 10% 49% Rs74,500 12.68%Rs50,000 +5% 49% Rs74,500 12.68%Rs50,000 0% 49% Rs74,500 12.68%

Rs50,000 -5% (49-(2.45*5))=36.75% Rs68,000 9.9%

Rs50,000 -20% (49-(2.45*20))=0% Rs50,000Nil, you get back you initial investment

Rs50,000 -30%(49-(2.45*30))=    -24.50%, but you will get 0%

Rs50,000Nil, you get back you initial investment

 What works in its favour:  • It is an AAA-rated security and therefore has the highest degree of safety in terms of getting timely returns. The rating, however, can be revised and changed whenever the rating agency gets new information about the financial condition of

the company.• Your initial investment is secure till maturity. Even if the markets crash in the 36th month of your investment period, you still get back your investment.• A coupon rate of 49% for 40 months works out to be an annualised compounded return of 12.68%, a good return for a fixed investment in a stagnant or falling interest rate market.  What works against it: • If you do not hold the debenture till 40 months, your initial investment is not guaranteed. That means if you want to withdraw your money, your returns may be linked with the actual return of the market. The brochure does not give any information on this issue.• Also, if the company buys back the debentures, the return will be calculated on basis of fair market value and that could hurt your initial investment as well.• Besides these, credit risks attached to debentures stand Does it make sense? Every single recommendation regarding this product will start by saying: “If you are bullish about the markets...” In effect, the onus is on you to make the product work for you. Remember, the essential factor behind the success of the product is your successful market call. Do you want to be a market forecaster to make 12% plus?   Apart from this, there is another basic flaw in all these structured products. It never makes sense to mix fixed income products with market-linked products. You cannot calculate the odds of total returns if you mix fixed income products with market index. They are essentially totally different products in nature and all you are doing is reducing the effectiveness of one with the other. You must stick to an asset allocation plan which will mean investing in a systematic manner in fixed income (bonds, bond funds, fixed deposits and debentures) to protect your wealth and separately in shares or well-chosen equity mutual funds to grow your wealth.  In this case, who really knows what the Nifty will do three years from now and why would you want to bet on that outcome? Also, 12.68% compounded return in the best of circumstances is nothing attractive; there are perpetual bonds, for instance, which could give you similar fixed returns with an upside if the interest rates fall, without you having to bet on the direction of the Nifty.  

 Structured product market in a spot over RBI regulation

Final decision on time-gap between successive issuances key, say experts

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The Reserve Bank of India (RBI)’s move to regulate the time gap on issuance of debentures by non-banking financial companies (NBFCs) has created some confusion for the Rs 12,000 crore structured product market.

The central bank had on June 27 come out with a note asking NBFCs to space out their debenture issuances by at least six months. This resulted in a halt in the launch of such products as it put restrictions on NBFCs who issue debentures for the structured product space, according to wealth management officials.

“We had plans to come out with a structured product issuance, but shelved the same following the RBI’s notification. All structured products would have been impacted by the circular,” said one person with a foreign wealth management firm.

RBI subsequently came out with a clarification on July 2, saying it was deferring its earlier move. “A decision on the appropriate minimum time gap would be taken by the Bank in due course,” it said.

But this hasn’t completely eased concerns.

“They have simply postponed the decision on that matter. We don’t know if they will actually make it three months or something like that,” said a senior official with a domestic wealth management firm.

The head of wealth management at another Indian wealth manager also said no clear indication of the final guidelines had been communicated to the NBFCs as of yet.  “They will reconsider it… NBFCs have made a representation to the central bank on the issue… We don’t know yet what form the final regulation will take,” said the person.

Structured products are debentures generally sold by wealth management firms to high networth individuals. They offer returns linked to the movement of an asset class like equity. For example, a debenture’s returns may track the National Stock Exchange’s Nifty index. Industry insiders say RBI’s circular last Thursday would have severely limited their issuance. To be sure, RBI’s intention seems to have been to curb retail exposure to such securities.

The circular noted that NBFCs raised capital through issuing debentures either by public issue or private placement. In the case of public issue of such securities, institutions and retail investors can participate. Private placement, on the other hand, may involve institutional investors.

“It has, however, been observed that NBFCs have lately been raising resources from the retail public on a large scale, through private placement, especially by issue of debentures,” said the RBI

notification.

The central bank has subsequently asked NBFCs (including those coming out with debentures for the purpose of issuing structured products) to provide a detailed plan for how often they plan to come out with such issuances.     

“NBFCs, in the meantime, are advised to put in place before the close of business on September 30, 2013, a board approved policy for resource planning which, inter-alia, should cover the planning horizon and the periodicity of private placement,” it said in the July 2 note.

Meanwhile, if RBI does go ahead with its earlier decision to take a six-month gap, the structured product market could take a significant hit, say experts.  

“It’s likely that the issuers will try to space out their issues to avoid hitting the market all at the same time. Overall, the impact could be 30 per cent though it’s probable that it could be higher,” said the person.

The India Wealth Report released by Karvy Private Wealth in November 2012 stated the assets in structured products in the form of equity-linked debentures are Rs 12,000 crore. Another Rs 150 crore is in debentures linked to the price of gold, according to the report.

Investment bankingAn investment bank is a financial institution that assists individuals, corporations, and governments in raising

capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may

also assist companies involved in mergers and acquisitions and provide ancillary services such as market

making, trading of derivatives and equity securities, and FICC services (fixed income instruments, currencies,

and commodities).

Unlike commercial banks and retail banks, investment banks do not take deposits. From 1933 (Glass– Steagall

Act) until 1999 (Gramm–Leach–Bliley Act), the United States maintained a separation between investment

banking and commercial banks. Other industrialized countries, including G8 countries, have historically not

maintained such a separation. As part of the Dodd-Frank Act 2010, Volcker Rule asserts full institutional

separation of investment banking services from commercial banking.

There are two main lines of business in investment banking. Trading securities for cash or for other securities

(i.e. facilitating transactions, market-making), or the promotion of securities (i.e. underwriting, research, etc.) is

the "sell side", while buy side is a term used to refer to advising institutions concerned with buying investment

services. Private equity funds, mutual funds, life insurance companies, unit trusts, and hedge funds are the

most common types of buy side entities.

An investment bank can also be split into private and public functions with an information barrier which

separates the two to prevent information from crossing. The private areas of the bank deal with private insider

information that may not be publicly disclosed, while the public areas such as stock analysis deal with public

information.

An advisor who provides investment banking services in the United States must be a licensed broker-

dealer and subject to Securities & Exchange Commission  (SEC) and Financial Industry Regulatory

Authority (FINRA) regulation.[1]

• 1   Organizational structure

• 2   Core investment banking activities

• 2.1   Front office

• 2.1.1   Investment banking

• 2.1.2   Sales and trading

• 2.1.3   Research

• 2.2   Front office/Middle office

• 2.2.1   Risk Management

• 2.3   Middle office

• 2.4   Back office

• 2.4.1   Operations

• 2.4.2   Technology

• 2.5   Other businesses

• 3   Industry profile

• 3.1   Global size and revenue mix

• 3.2   Top 10 banks

• 4   Financial crisis of 2008

• 5   Criticisms

• 5.1   Conflicts of interest

• 5.2   Compensation

• 6   See also

• 7   External links

• 8   Further reading

• 9   References

Organizational structure

Investment banking is split into front office, middle office, and back office activities. While large service

investment banks offer all lines of business, both sell side and buy side, smaller sell-side investment firms such

as boutique investment banks and small broker-dealers focus on investment banking and

sales/trading/research, respectively.

Investment banks offer services to both corporations issuing securities and investors buying securities. For

corporations, investment bankers offer information on when and how to place their securities on the open

market, an activity very important to an investment bank's reputation. Therefore, investment bankers play a

very important role in issuing new security offerings.[2]

Core investment banking activities

Investment banking has changed over the years, beginning as a partnership form focused on underwriting

security issuance (initial public offerings and secondary offerings), brokerage, andmergers and acquisitions  and

evolving into a "full-service" range including sell-side research, proprietary trading, and investment

management. In the modern 21st century, the SEC filings of the major independent investment banks such

as Goldman Sachs and Morgan Stanley reflect three product segments: (1) investment banking (fees for M&A

advisory services and securities underwriting); (2) asset management (fees for sponsored investment funds),

and (3) trading and principal investments (broker-dealer activities including proprietary trading ("dealer"

transactions) and brokerage trading ("broker" transactions)).[3]

In the United States, commercial banking and investment banking were separated by the Glass–Steagall Act,

which was repealed in 1999. The repeal led to more "universal banks" offering an even greater range of

services. Many large commercial banks have therefore developed investment banking divisions through

acquisitions and hiring. Notable large banks with significant investment banks include JPMorgan Chase, Bank

of America, Credit Suisse, Deutsche Bank, Barclays, and Wells Fargo. After the financial crisis of 2007–

2008 and the subsequent passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act,

regulations have limited certain investment banking operations, notably with the Volcker Rule's restrictions on

proprietary trading.[2]

The traditional service of underwriting security issues has declined as a percentage of revenue. As far back as

1960, 70% of Merrill Lynch's revenue was derived from transaction commissions while "traditional investment

banking" services accounted for 5%. However, Merrill Lynch was a relatively "retail-focused" firm with a large

brokerage network.[2]

Front office

Investment banking

Corporate finance is the traditional aspect of investment banks which also involves helping customers

raise funds in capital markets and giving advice on mergers and acquisitions (M&A). This may involve

subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target.

Another term for the investment banking division is corporate finance, and its advisory group is often

termed mergers and acquisitions. A pitch book of financial information is generated to market the bank to a

potential M&A client; if the pitch is successful, the bank arranges the deal for the client. The investment banking

division (IBD) is generally divided into industry coverage and product coverage groups. Industry coverage

groups focus on a specific industry – such as healthcare, public finance (governments), FIG (financial

institutions group), industrials, TMT (technology, media, and telecommunication) – and maintains relationships

with corporations within the industry to bring in business for the bank. Product coverage groups focus on

financial products – such as mergers and acquisitions, leveraged finance, public finance, asset finance and

leasing, structured finance, restructuring, equity, and high-grade debt – and generally work and collaborate with

industry groups on the more intricate and specialized needs of a client.The Wall Street Journal , in partnership

with Dealogic, publishes figures on investment banking revenue such as M&A in its Investment Banking

Scorecard.[4]

Sales and trading

On behalf of the bank and its clients, a large investment bank's primary function is buying and selling products.

In market making, traders will buy and sell financial products with the goal of making money on each

trade. Sales is the term for the investment bank's sales force, whose primary job is to call on institutional and

high-net-worth investors to suggest trading ideas (on acaveat emptor  basis) and take orders. Sales desks then

communicate their clients' orders to the appropriate trading desks, which can price and execute trades, or

structure new products that fit a specific need. Structuring has been a relatively recent activity

as derivatives have come into play, with highly technical and numerate employees working on creating complex

structured products which typically offer much greater margins and returns than underlying cash securities. In

2010, investment banks came under pressure as a result of selling complex derivatives contracts to local

municipalities in Europe and the US.[5] Strategists advise external as well as internal clients on the strategies

that can be adopted in various markets. Ranging from derivatives to specific industries, strategists place

companies and industries in a quantitative framework with full consideration of the macroeconomic scene. This

strategy often affects the way the firm will operate in the market, the direction it would like to take in terms of its

proprietary and flow positions, the suggestions salespersons give to clients, as well as the

way structurers create new products. Banks also undertake risk through proprietary trading, performed by a

special set of traders who do not interface with clients and through "principal risk"—risk undertaken by a trader

after he buys or sells a product to a client and does not hedge his total exposure. Banks seek to maximize

profitability for a given amount of risk on their balance sheet. The necessity for numerical ability in sales and

trading has created jobs for physics, mathematics and engineering Ph.D.s who act as quantitative analysts.

Research

The equity research division reviews companies and writes reports about their prospects, often with "buy" or

"sell" ratings. Investment banks typically have sell-side analysts which cover various industries. Their

sponsored funds or proprietary trading offices will also have buy-side research. While the research division may

or may not generate revenue (based on policies at different banks), its resources are used to assist traders in

trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients.

Research also serves outside clients with investment advice (such as institutional investors and high net worth

individuals) in the hopes that these clients will execute suggested trade ideas through the sales and trading

division of the bank, and thereby generate revenue for the firm. Research also covers credit research, fixed

income research, macroeconomic research, and quantitative analysis, all of which are used internally and

externally to advise clients but do not directly affect revenue. All research groups, nonetheless, provide a key

service in terms of advisory and strategy. There is a potential conflict of interest between the investment bank

and its analysis, in that published analysis can affect the bank's profits. Hence in recent years the relationship

between investment banking and research has become highly regulated, requiring a Chinese wall between

public and private functions.

Front office/Middle office

Risk Management

Risk management involves analyzing the market and credit risk that an investment bank or its clients take onto

their balance sheet during transactions or trades. Credit risk focuses around capital markets activities, such as

loan syndication, bond issuance, restructuring, and leveraged finance. Market risk conducts review of sales and

trading activities utilizing the VaR model and provide hedge-fund solutions to portfolio managers. Other risk

groups include country risk, operational risk, and counterparty risks which may or may not exist on a bank to

bank basis. Credit risk solutions are key part of capital market transactions, involving debt structuring, exit

financing, loan amendment, project finance, leveraged buy-outs, and sometimes portfolio hedging. Front office

market risk activities provide service to investors via derivative solutions, portfolio management, portfolio

consulting, and risk advisory. Well-known risk groups in JPMorgan Chase, Goldman Sachs and Barclays

engage in revenue-generating activities involving debt structuring, restructuring, loan syndication, and

securitization for clients such as corporates, governments, and hedge funds. J.P. Morgan IB Risk works with

investment banking to execute transactions and advise investors, although its Finance & Operation risk groups

focus on middle office functions involving internal, non-revenue generating, operational risk controls.[6][7][8] Credit

default swap, for instance, is a famous credit risk hedging solution for clients invented by J.P. Morgan's Blythe

Masters during the 1990s. The Loan Risk Solutions group[9] within Barclays' investment banking division and

Risk Management and Financing group[10] housed in Goldman Sach's securities division are client-driven

franchises. However, risk management groups such as operational risk, internal risk control, legal risk, and the

one at Morgan Stanley are restrained to internal business functions including firm balance-sheet risk analysis

and assigning trading cap that are independent of client needs, even though these groups may be responsible

for deal approval that directly affects capital market activities. Risk management is a broad area, and like

research, its roles can be client-facing or internal.

Middle office

This area of the bank includes treasury management, internal controls, and internal corporate strategy.

Corporate treasury is responsible for an investment bank's funding, capital structure management, and liquidity

risk monitoring.

Financial control tracks and analyzes the capital flows of the firm, the Finance division is the principal adviser to

senior management on essential areas such as controlling the firm's global risk exposure and the profitability

and structure of the firm's various businesses via dedicated trading desk product control teams. In the United

States and United Kingdom, a Financial Controller is a senior position, often reporting to the Chief Financial

Officer.

Internal corporate strategy tackling firm management and profit strategy, unlike corporate strategy groups that

advise clients, is non-revenue regenerating yet a key functional role within investment banks.

This list is not a comprehensive summary of all middle-office functions within an investment bank, as specific

desks within front and back offices may participate in internal functions.[11]

Back office

Operations

This involves data-checking trades that have been conducted, ensuring that they are not erroneous, and

transacting the required transfers. Many banks have outsourced operations. It is, however, a critical part of the

bank.

Technology

Every major investment bank has considerable amounts of in-house software, created by the technology team,

who are also responsible for technical support. Technology has changed considerably in the last few years as

more sales and trading desks are using electronic trading. Some trades are initiated by

complex algorithms for hedging purposes.

Firms are responsible for compliance with government regulations and internal regulations.

Other businessesGlobal transaction banking  is the division which provides cash management, custody

services, lending, and securities brokerage services to institutions. Prime brokerage with hedge

funds has been an especially profitable business, as well as risky, as seen in the "run on the bank"

with Bear Stearns in 2008.

• Investment management  is the professional management of various securities (shares, bonds, etc.) and

other assets (e.g., real estate), to meet specified investment goals for the benefit of investors. Investors

may be institutions (insurance companies, pension funds, corporations etc.) or private investors (both

directly via investment contracts and more commonly via collective investment schemes e.g., mutual

funds). The investment management division of an investment bank is generally divided into separate

groups, often known as Private Wealth Management and Private Client Services.

• Merchant banking  can be called "very personal banking"; merchant banks offer capital in exchange for

share ownership rather than loans, and offer advice on management and strategy. Merchant banking is

also a name used to describe the private equity side of a firm.[12] Current examples include Defoe Fournier

& Cie.  and JPMorgan's One Equity Partners and the originalJ.P . Morgan & Co.  Rothschilds, Barings,

Warburgs and Morgans were all merchant banks. (Originally, "merchant bank" was the British English term

for an investment bank.)

• Commercial banking : see commercial bank.

• Real Estate Increased Equity Collateral Sale  Also called REIECS Advanced Financial Model in which a

Real Estate Asset Value is increased thought an Investment Banking Institution (Usually only the Biggest

Investment Banks are able to handle REIECS.

Industry profile

There are various trade associations throughout the world which represent the industry in lobbying, facilitate

industry standards, and publish statistics. The International Council of Securities Associations (ICSA) is a

global group of trade associations.

In the United States, the Securities Industry and Financial Markets Association (SIFMA) is likely the most

significant; however, several of the large investment banks are members of the American Bankers

Association Securities Association (ABASA)[13] while small investment banks are members of the National

Investment Banking Association (NIBA).

In Europe, the European Forum of Securities Associations was formed in 2007 by various European trade

associations.[14] Several European trade associations (principally the London Investment Banking Association

and the European SIFMA affiliate) combined in 2009 to form Association for Financial Markets in

Europe (AFME).

In the securities industry in China (particularly mainland China), the Securities Association of China is a self-

regulatory organization whose members are largely investment banks.

Global size and revenue mix

Global investment banking revenue increased for the fifth year running in 2007, to a record US$84.3 billion,

[15] which was up 22% on the previous year and more than double the level in 2003. Subsequent to their

exposure to United States sub-prime securities investments, many investment banks have experienced losses.

As of late 2012, global revenues for investment banks were estimated at $240 billion, down about a third from

2009, as companies pursued less deals and traded less.[16] Differences in total revenue are likely due to

different ways of classifying investment banking revenue, such as subtracting proprietary trading revenue.

In terms of total revenue, SEC filings of the major independent investment banks in the United States show that

investment banking (defined as M&A advisory services and security underwriting) only made up about 15-20%

of total revenue for these banks from 1996 to 2006, with the majority of revenue (60+% in some years) brought

in by "trading" which includes brokerage commissions and proprietary trading; the proprietary trading is

estimated to provide a significant portion of this revenue.[3]

The United States generated 46% of global revenue in 2009, down from 56% in 1999. Europe (with Middle

East and Africa) generated about a third while Asian countries generated the remaining 21%.[15]:8 The industry is

heavily concentrated in a small number of major financial centers, including City of London, New York

City, Frankfurt, Hong Kong and Tokyo.

According to estimates published by the International Financial Services London, for the decade prior to the

financial crisis in 2008, M&A was a primary source of investment banking revenue, often accounting for 40% of

such revenue, but dropped during and after the financial crisis.[15]:9 Equity underwriting revenue ranged from

30% to 38% and fixed-income underwriting accounted for the remaining revenue.[15]:9

Revenues have been affected by the introduction of new products with higher margins; however, these

innovations are often copied quickly by competing banks, pushing down trading margins. For example,

brokerages commissions for bond and equity trading is a commodity business but structuring and

trading derivatives has higher margins because each over-the-counter contract has to be uniquely structured

and could involve complex pay-off and risk profiles. One growth area is private investment in public

equity (PIPEs, otherwise known as Regulation D or Regulation S). Such transactions are privately negotiated

between companies and accredited investors.

Banks also earned revenue by securitizing debt, particularly mortgage debt prior to the financial crisis.

Investment banks have become concerned that lenders are securitizing in-house, driving the investment banks

to pursue vertical integration by becoming lenders, which is allowed in the United States since the repeal of the

Glass-Steagall act in 1999.[citation needed]

Top 10 banks

Further information: List of investment banks

The ten largest investment banks as of December 31, 2012, are as follows (by total fees from all advisory).

[17] The list is just a ranking of the advisory arm of each bank and does not include the generally much larger

portion of revenues from sales and trading and asset management.

Rank Company Fees ($m)

1. JP Morgan Chase $5,467.07

2. Bank of America $4,600.05

3. Goldman Sachs $4,150.52

4. Morgan Stanley $3,740.89

5. Citi $3,617.11

6. Credit Suisse $3,442.95

7. Deutsche Bank $3,319.32

8. Barclays $3,232.53

9. UBS $2,197.52

10. Wells Fargo $1,894.03

World's biggest banks are ranked for M & A  advisory, syndicated loans, equity capital markets and debt capital

markets.

The Financial Times, The Wall Street Journal and Bloomberg often cover Mergers and Acquisitions and Capital

Markets. League tables are also available:

• Investment Banking Review , Financial Times.

• Investment Banking Scorecard , Wall Street Journal.

• Global M & A Financial Advisory Rankings , Bloomberg.

• Global Capital Markets League Tables , Bloomberg.

Financial crisis of 2008

The 2008 financial credit crisis led to the notable collapse of several banks, notably including the bankruptcy of

large investment bank Lehman Brothers and the hurried sale of Merrill Lynch and the much smaller Bear

Stearns to banks which effectively rescued them from bankruptcy. The entire financial services industry,

including numerous investment banks, was rescued by government loans through the Troubled Asset Relief

Program (TARP). Surviving U.S. investment banks such as Goldman Sachs and Morgan Stanley converted to

traditional bank holding companies to accept TARP relief.[18] Similar situations occurred across the globe with

countries rescuing their banking industry. Initially, banks received part of a $700 billion Troubled Asset Relief

Program (TARP) intended to stabilize the economy and thaw the frozen credit markets.[19] Eventually, taxpayer

assistance to banks reached nearly $13 trillion, most without much scrutiny,[20] lending did not increase[21] and

credit markets remained frozen.[22]

The crisis led to questioning of the business model of the investment bank[23] without the regulation imposed on

it by Glass-Steagall.[neutrality is disputed] Once Robert Rubin, a former co-chairman of Goldman Sachs, became part of

the Clinton administration and deregulated banks, the previous conservatism of underwriting established

companies and seeking long-term gains was replaced by lower standards and short-term profit.[24] Formerly, the

guidelines said that in order to take a company public, it had to be in business for a minimum of five years and

it had to show profitability for three consecutive years. After deregulation, those standards were gone, but small

investors did not grasp the full impact of the change.[24]

A number of former Goldman-Sachs top executives, such as Henry Paulson and Ed Liddy  were in high-level

positions in government and oversaw the controversial taxpayer-funded bank bailout.[24]The TARP Oversight

Report released by the Congressional Oversight Panel found that the bailout tended to encourage risky

behavior and "corrupt[ed] the fundamental tenets of a market economy".[25]

Under threat of a subpoena, Goldman Sachs revealed that it received $12.9 billion in taxpayer aid, $4.3 billion

of which was then paid out to 32 entities, including many overseas banks, hedge funds and pensions.[26] The

same year it received $10 billion in aid from the government, it also paid out multi-million dollar bonuses; the

total paid in bonuses was $4.82 billion.[27][28] Similarly, Morgan Stanley received $10 billion in TARP funds and

paid out $4.475 billion in bonuses.[29]

Criticisms

The investment banking industry, and many individual investment banks, have come under criticism for a

variety of reasons, including perceived conflicts of interest, overly large pay packages, cartel-like or oligopolic

behavior, taking both sides in transactions, and more.[30] Investment banking has also been criticised for its

opacity.[31]

Conflicts of interest

Conflicts of interest may arise between different parts of a bank, creating the potential for market manipulation,

according to critics. Authorities that regulate investment banking (the FSA in theUnited Kingdom  and

the SEC in the United States) require that banks impose a Chinese wall to prevent communication between

investment banking on one side and equity research and trading on the other. Critics say such a barrier does

not always exist in practice, however.

Conflicts of interest often arise in relation to investment banks' equity research units, which have long been part

of the industry. A common practice is for equity analysts to initiate coverage of a company in order to develop

relationships that lead to highly profitable investment banking business. In the 1990s, many equity researchers

allegedly traded positive stock ratings for investment banking business. Alternatively, companies may threaten

to divert investment banking business to competitors unless their stock was rated favorably. Laws were passed

to criminalize such acts, and increased pressure from regulators and a series of lawsuits, settlements, and

prosecutions curbed this business to a large extent following the 2001 stock market tumble after the dot-com

bubble.

Philip Augar, author of The Greed Merchants, said in an interview that: "You cannot simultaneously serve the

interest of issuer clients and investing clients. And it’s not just underwriting and sales; investment banks run

proprietary trading operations that are also making a profit out of these securities."[30]

Many investment banks also own retail brokerages. During the 1990s, some retail brokerages sold consumers

securities which did not meet their stated risk profile. This behavior may have led to investment banking

business or even sales of surplus shares during a public offering to keep public perception of the stock

favorable.

Since investment banks engage heavily in trading for their own account, there is always the temptation for them

to engage in some form of front running – the illegal practice whereby a broker executes orders for their own

account before filling orders previously submitted by their customers, there benefiting from any changes in

prices induced by those orders.

Documents under seal in a decade-long lawsuit concerning eToys.com's IPO but obtained by New York

Times Wall Street Business columnist Joe Nocera  alleged that IPOs managed by Goldman Sachs and other

investment bankers involved asking for kickbacks from their institutional clients who made large profits flipping

IPOs which Goldman had intentionally undervalued. Depositions in the lawsuit alleged that clients willingly

complied with these demands because they understood it was necessary in order to participate in future hot

issues.[32] Reuters Wall Street correspondent Felix Salmon retracted his earlier, more conciliatory, statements

on the subject and said he believed that the depositions show that companies going public and their initial

consumer stockholders are both defrauded by this practice, which may be widespread throughout the

IPO finance industry.[33] The case is ongoing, and the allegations remain unproven.

Compensation

Investment banking is often criticized for the enormous pay packages awarded to those who work in the

industry. According to Bloomberg Wall Street's five biggest firms paid over $3 billion to their executives from

2003 to 2008, "while they presided over the packaging and sale of loans that helped bring down the

investment-banking system." [34]

The highly generous pay packages include $172 million for Merrill Lynch & Co. CEO Stanley O'Neal from 2003

to 2007, before it was bought by Bank of America in 2008, and $161 million for Bear Stearns Co.'s James

Cayne before the bank collapsed and was sold to JPMorgan Chase & Co. in June 2008.[34]

Such pay arrangements have attracted the ire of Democrats and Republicans in Congress, who demanded

limits on executive pay in 2008 when the U.S. government was bailing out the industry with a $700 billion

financial rescue package.[34]

Writing in the Global Association of Risk Professionals, Aaron Brown, a vice president at Morgan Stanley, says

"By any standard of human fairness, of course, investment bankers make obscene amounts of money.

Corporate financeFrom Wikipedia, the free encyclopedia

Corporate finance

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. The primary 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 thancorporations 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.

Short-term finance is the management of the company's monetary funds that deal with the short-term 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.

• 1   Outline of corporate finance

• 1.1   Investment analysis and capital budgeting

• 1.2   Maximizing shareholder value

• 1.3   Return on investment

• 2   Capital structure

• 2.1   Capitalization structure

• 2.2   Sources of capital

• 2.2.1   Debt capital

• 2.2.2   Equity capital

• 2.2.3   Preferred stock

• 3   Investment and project valuation

• 3.1   Valuing flexibility

• 3.2   Quantifying uncertainty

• 4   Dividend policy

• 5   Working capital management

• 5.1   Working capital

• 5.2   Management of working capital

• 6   Relationship with other areas in finance

• 6.1   Investment banking

• 6.2   Financial risk management

• 7   See also

• 8   References

• 9   Further reading

Outline of corporate finance

Investment analysis and capital budgetingMain 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 such value

can be added through the capital budgeting process 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 positive NPV projects exist 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

The primary objective 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, this is a difficult task,

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

Return on investment is the concept of an investment in some resource or asset yielding an 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 levels cannot be accurately forecasted, investors are advised to benchmark their

investments against comparable assets (such as to evaluate industry standard best practices and to do a

company analysis in stock valuation) to help them estimate the earnings multiplier or the return on capital likely

to be received in the future.

Capital structure

Capitalization structure

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 andequity (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] (SeeBalance 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 andAPT) 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

Further information: Security (finance)

Debt capital

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

Corporations can alternatively sell shares of the company to investors to raise capital. Investors, or

shareholders, expect that the value of the company will appreciate over time to make their investment a

profitable venture. 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

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

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. SeeFinancial 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

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 ofgold; 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

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": ΔNPV / Δfactor.

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.

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 project’s 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 histogramof 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

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. By withholding

current dividend payments to shareholders, managers of growth companies are hoping that dividend payments

will be increased proportionality higher in the future, to offset the retainment of current earnings and the internal

financing of present investment projects.

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

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

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

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

Investment banking

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 company’s

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

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