Basics of Corporate Finance

Basics of Corporate Finance

Meaning Of Corporate Finance

Corporate finance is a branch of finance which deals with the financial activities of a corporation starting from the selection of the sources of funds to the capital structure of the corporation.

Corporate finance involves the planning and financing of investments made by a company. It also involves the distribution or reinvestment of the income generated by such investments.

One of the main purposes of corporate finance is to maximise shareholder value through implementing various financial strategies that include both short-term and long-term investments.

In addition, Corporate finance is essential for any business whether big or small. Corporate finance helps a company in finding sources of funds, expansion of business, planning the future course of actions, managing finance, and assuring profitability and economic viability. The core of the corporate financial theory is the goal of maximizing the corporation’s value as well as minimizing the risk. I will explain the basics of corporate finance, what the basic principles and concepts are.

What are the basics principles of corporate finance

Corporate finance can be broken down into three principles or areas of activity that together complete the full spectrum of corporate finance. These core principles of corporate finance are:

  • Capital budgeting
  • Capital financing
  • Reinvestments and dividends 

Capital budgeting

Capital budgeting is the planning process for company investment. To ensure the highest returns for a company’s short-term and long-term capital assets, the corporate finance activity of capital budgeting will need to be planned carefully. 

The most efficient allocation of the business’s resources is the basic concept of the investment principle. Investment decisions should always involve vigilant financial analysis, so businesses use a variety of advisory experts and accountancy tools to inform their decisions. Corporate finance specialists are used to helping businesses recognise opportunities for capital expenditures and gauge the available cash generated by any potential financial projects. 

This form of financial modeling plans out the intended expenditure for a particular investment and projects the estimated income, thus informing the decision on whether to invest or not. The capital budgeting phase of corporate finance usually compares the projections of multiple similar opportunities to identify the most suitable for investment.

In addition, this principle also involves the working capital decisions like the allotment of credit days to the customers, etc. Corporate finance also ascertains the feasibility of the investment or project by calculating the return on the investment decision and making a comparison of it with the cost of capital.

Basics of Corporate Finance

Capital financing

The investment opportunities identified during the capital budgeting phase of corporate finance then undergo the capital financing activity – working out the best way to finance the investments.

The capital investments can be financed through debt or equity, and sometimes both. Other options include issuing debt securities through investment banks or selling stock to raise cash for investments. These latter options are especially useful for long-term capital expenditure or very large investments. 

This activity can be problematic if an accurate journal of corporate finance is not kept to monitor both the debt and equity involved in the financing of investments. A corporate finance advisory professional will always recommend ensuring debt is kept to a minimum to reduce the risk of default. The levels of equity involved will also need to be kept balanced, as using too much can have a detrimental effect on the company’s income and affect the value of the business for the original investors.

The corporate-finance professional has to study conditions in which the optimal financing mix (debt and equity) minimizes the cost of capital and evaluate the effects on the value of the company because of a change in capital structure. After the optimal financing mix has been defined, the decision has to be made whether to take it on a long-term or short-term basis. Then other factors like taxes, decisions regarding the structure of financing, the risk-return trade-off, i.e. the riskier the asset, the higher the expected return, etc. are considered.

Reinvestments and dividends

The corporate finance professional at a company will also decide what to do with the return of capital. The extra income from successful investments can fund the operations of the business itself or reinvested in new investment opportunities. 

Another option is the distribution of the additional income to shareholders as dividends. This is not the only way shareholders benefit, as the extra income is kept within the business can help it grow, thus increasing the value of the original shares overall.

Usually, the decision as to whether to use the money to grow the business, reinvest it in new opportunities or give back to the shareholders via dividends will be decided based on the most economically viable option. If retaining the money can earn a rate of return on an investment bigger than the cost of capital, then this will be the most beneficial decision for all.

So here decision has to be taken whether the excess cash should be paid to the owners/investors or should be kept in the business. A public limited company has both options, either paying off dividends or buying back shares.

Basics of Corporate Finance

Basic Concepts of Corporate Finance:

Corporate finance has a very wide scope of discussion. It includes various concepts and fundamentals. Among those, a few basic concepts are briefly discussed here.

Capital Budgeting:

The planning procedure of expenditures on such fixed assets, which will generate cash flows for more than one year, is called capital budgeting. Here, “capital” means long-term assets, and “budget” is a detailed plan of the projected cash flows (both in and out) over the specified future period.

The basic approaches used during project selection are discussed below:

Net Present Value (NPV):

Under this method, all cash inflows and outflows are discounted at the cost of capital of the project and then those cash flows are added. If NPV gives a positive value, the project will be accepted.

NPV = Σ [CFt/ (1 + k) t]

Where CFt =expected cash flow at time, t,

CFT = expected cash flow at time t,

k = the project’s cost of capital.

Internal Rate of Return (IRR):

IRR is the discount rate that makes the value of the NPV of a project zero.

NPV = Σ[CFt/(1 + IRR)t];

IRR = expected rate of return on a project. The NPV and IRR methods have the same accepting or rejecting criteria.

Payback period:

The payback period is the number of years in which the original or initial investment will be recovered. Cumulative net cash flows will be zero in the payback period. The payback period should be as short as possible. A company should set a standard payback period and should reject the project when payback is greater than the standard.

Time Value of Money:

A certain unit of money today is worth more than the same unit of money tomorrow.

If a person has 10 Taka today, s/he can earn interest on it and has more than 10 Taka next year. For example, Taka 100 of today’s money invested for one year and earning 5% interest will be worth Taka 105 after one year.

Annuity

An Annuity is a series of regularly made equal payments or structured payments, such as paid monthly or yearly.

Perpetuity

A perpetuity is an equal amount of annuity having an infinite number of cash flows.  In other words, it is a never-ending annuity.

Related: 3 Valuation Methods That Financial Professionals Use To Value A Company

Basics of Corporate Finance

Cost of Capital:

A necessary factor of production is capital which has a cost. The providers of capital want a return on their investment. A company must clearly ensure that shareholders or the lenders of the fund such as financial institutions, banks, receive the return that they want. The cost of capital is the rate of return used when analyzing capital projects. The project will be acceptable when it returns greater than the cost of the project.

Weighted Average Cost of Capital (WACC) is one of the common methods of calculating the cost of capital which is the weighted average of the costs of debt, preferred stock, and equity or common stock. It is also known as the marginal cost of capital (MCC).

Working Capital Management:

Working capital management includes the relationship between the short-term assets and short-term liabilities of a company. The motive of working capital management is ensuring a company’s continued operation by enabling it to pay short-term debt and future operational expenses. Working capital management consists of managing cash, inventories, accounts receivables, and payables.

Measures of Leverage:

A company has a certain amount of fixed costs which is known as leverage.

These fixed costs include fixed operating expenses like equipment or building leases; fixed financing costs like interest paid on debt. The greater the leverage, the greater will be the volatility of the company’s operating earnings after tax and net income after tax.

Corporate finance specialists

The complicated processes involved in corporate finance have given rise to a wealth of specialist professionals. Corporate brokers, for example, are experts on capital markets transactions. They will advise companies on how best to generate new finance for the likes of acquisitions, IPOs, or secondary equity issuance.

While most of the senior corporate finance positions will be some sort of advisory role, other specialists are integral to the activities. These include the transaction services specialists who can be hired to perform specific tasks such as due diligence on a potential investment. 

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