Corporate Finance | Understanding the Concept and Principles

Introduction to Corporate Finance

You would have heard a lot about the term “Corporate Finance”, if you belong to the finance domain. Corporate Finance forms the most basic component of how a business is run. I am sure you would be interested to know why. But before we dig into the details of this broad area, let’s take this example. Suppose you want to start a business. Let me ask you this, apart from the skills and ideas that you would require to begin with it, what is the other most basic element required? Yes, it’s quite simple, the answer is money. Any economic activity whether big or small requires finance, rightly considered to be the lifeblood of business. There are various sources through which you would raise funds such as your personal savings, borrowing from friends, family, etc. You would not only require finance to start your business as promotional finance but also as development finance to sustain in the long run. This same concept applies to corporations. Read on to get a gist of all you wanted to know about Corporate Finance and any inhibitions you have had regarding it.

Business involves decisions that have financial consequences and any decision that involves the use of money is said to be a corporate finance decision. Corporate finance is one of the most important part of the finance domain as to whether the organization is big or small they raise and deploy capital in order to survive and grow. There are various roles that corporate finance plays, which are very interesting and challenging, one of the main roles is that of being a financial adviser. Corporate finance in investment banks is different from departments like sales or trading, as they are not trading or making markets but rather they help companies with certain financial situations. In simple words they act as a broker or consultant when companies need to raise capital, are considering to merge or buy another company or want to issue debt – all of which may enhance the value of their company. This can comprise helping to manage investments or even suggesting a mergers and acquisitions (M&A) strategy. Along with this, the corporate finance people at the investment bank will help the M&A deals go through as well.

In short as a corporate financier you would be working for a company to aid them find sources through which funds could be raised, expand the business, plan the future course of actions, manage money and ensure sound profitability and economic viability.

The objective of maximizing the value of the corporation while minimizing the risk is the soul of corporate financial theory.

Principles of Corporate Finance

Let’s understand the three most fundamental principles in corporate finance which are- the investment, financing, and dividend principles.

1. Investment Principle

This principle revolves around the simple concept that businesses have resources which need to be allocated in the most efficient way. The first and important decision that needs to be made in corporate finance is to do this wisely, i.e. decisions that not only provide revenue opportunities but also saves money for the future. This also encompasses the working capital decisions such as the credit days to be allotted to the customers etc. Corporate finance also measures the return on a planned investment decisions by comparing it to the minimum tolerable hurdle rate and deciding if the project/investment is feasible to be undertaken.

2. Financing Principle

Most often businesses are funded with either debt or equity or both. In the investment decision that we earlier discussed once we have finalized the mix of equity and debt and its effects for the minimum acceptable hurdle rate, the next step would be to determine if the mix is the right one in the financing principle section.

The job here for the corporate-financier is to make sure that the business has right amount of capital and the right mix of debt, equity and other financial instruments.

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In order to determine the optimal mix, we need to study conditions where the optimal financing mix minimizes the acceptable hurdle rate. We also need to analyze the effects on firm value due to the change in capital structure. After we have defined the optimal financing mix, next we need to consider would be whether it would be a long term or a short term financing. We then include other considerations such as taxes and land up with strong decisions on the structure of financing.

“The risk return tradeoff” – Riskier assets yield higher expected returns.

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3. Dividend Principle

Businesses reach a stage in their life cycle where they grow and mature and the cash flow they generate exceeds the expected hurdle rate. At this stage, the company needs to determine the ways of rewarding the owners with it. So the basic discussion here is that if the excess cash should be left in the business or given away to the investors/owners. A company that is publicly held has the option of either pay off dividends or buy back stocks.

Understanding the Concept

Corporate finance is a very vast area of finance. There are so many fundamentals and concepts that need you should have a knack of. Let’s understand a few of them;

1. Capital Budgeting

Capital budgeting is the process of planning expenditures on assets (fixed assets) whose cash flows are expected to extend beyond one year. Managers study projects and decide which ones to include in the capital budget.

The “capital” refers to long-term assets.
The “budget” is a plan which details projected cash inflows and outflows during future period.

The most common approaches that are used in project selection are discussed below:

Net Present Value (NPV):

This method discounts all cash flows (including both inflows and outflows) at the project’s cost of capital and then sums those cash flows. The project is accepted if the NPV stands positive.

NPV = Σ [CFt/ (1 + k) t]

Where CFt is the expected cash flow at period t, k is the projects where CFT is the expected cash flow at period t, k is the project’s cost of capital and n is its life.

Internal Rate of Return (IRR):

It is the discount rate that forces a project’s NPV to equal to zero.

NPV = Σ[CFt/(1 + IRR)t]

Note this formula is simply the NPV formula solved for the particular discount rate that forces the NPV to equal zero. The IRR is the expected rate of return on a project. The NPV and IRR approaches will usually lead to the same accept or reject decisions.

Payback period:

It is the expected number of years required to recover the original investment. Payback happens when the cumulative net cash flow equals 0. The shorter the payback period, the better it is. A firm should establish a benchmark payback period and reject the proposal if payback is greater than benchmark.

2. Time Value of Money

“A dollar today is worth more than a dollar tomorrow”

If you have a dollar today, you can earn interest on it and have more than a dollar next year. For example, $100 of today’s money invested for one year and earning 8% interest will be worth $108 after one year.

Annuity

An Annuity is a bunch of structured payments or equal payments made regularly, like every month or every year

Perpetuity

A perpetuity is a special kind of annuity – it has an infinite number of cash flows, all of the same dollar amount. Thus, it is an annuity that never ends!

3. Cost of Capital

Capital is an essential factor of production and has a cost. The suppliers of capital require a return on their money. A firm must evidently ensure that stockholders or those that have lent the firm money, such as banks, receive the return that they seek. The cost of capital is significant for a firm to calculate, as this is the rate of return that must be used when evaluating capital projects. The return from the project must be superior than the cost of the project in order for it to be acceptable.

One of the methods to calculate the cost of capital is Weighted Average Cost of Capital (WACC). The weighted average cost of capital (WACC) is defined as the weighted average cost of the component costs of debt, preferred stock, and common stock or equity. It is also referred to as the marginal cost of capital (MCC) which is the cost of obtaining another dollar of new capital.

4. Working Capital Management

Working capital management involves the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has adequate ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital encompasses managing inventories, accounts receivable and payable, and cash.

5. Measures of Leverage

Leverage, in the sense we use it here, refers to the amount of fixed costs a firm has. These fixed costs might be fixed operating expenses, such as building or equipment leases, or fixed financing costs, such as interest payments on debt. Greater leverage leads to greater variability of the firm’s after-tax operating earnings and net income.

With this we have touched upon the important concepts of corporate finance. There is a lot more to learn in this vast area.

Overview of Corporate Finance Career

As we all know that business makes money which has to be managed well, which is when corporate finance team comes into the picture. Corporate finance professionals are accountable to manage the money of the organization i.e. to know from where to source it, deciding how to spend it to get the maximum returns at the lowest possible risk. They seek to find ways to ensure the flow of capital, increasing profitability and decreasing the expenses. They have to monitor the other departments on their expenditure and if the company is in a position to take the risk of additional expenditure. They explore the best ways to help the company expand whether it is through acquisition or investing internally.

Well, there is a different career profile of corporate finance in Investment Banks, here the corporate financiers must not only be aware of the finance world but also have clear viewpoints on investing, stocks and how to value companies. They can use their creativity here by listening to what the client wants to achieve and then suggesting interesting and potentially revolutionary ways they can go about making their thoughts a reality. Yes, the corporate finance team does get a lot of the glory and while salaries can go sky-high, you’ll have to work hard for it.

Are you thinking to pursue a career in corporate finance and interested to know more about this? Read this article on “Corporate Finance Jobs”.

A career in Corporate Finance is quite challenging, and the demand for this field is accelerating with time. It has great career prospects if you feel you would enjoy doing all that we have discussed above. Hope this would have helped you in understanding all you wanted to know about Corporate Finance. All the Best!!! 🙂

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