What is Corporate finance?
Corporate finance is that area of finance that deals with the sources of funding and the capital structure of corporations. Capital structure is nothing but the distribution of debt and equity in an organization. This area of finance also deals with the actions and decisions that the managers take to increase the value of the firm, so as to maximize the shareholders’ wealth, and also concentrates on the tools and analysis used to allocate the financial resources.
It basically consists of all the activities related to running a corporation and there is usually a separate department or division for looking into corporate finance. Since the main idea is to maximize the shareholders’ wealth, it also involves the planning and implementation of various short term and long term decisions and the division of various strategies.
**A very interesting fact about corporate finance is that it is very closely linked to investment finance. In fact, investment banking and capital investment both fall under the purview of corporate finance.
One of the major tasks which is a crucial part of corporate finance is making capital investments, and this is because, as discussed earlier, the corporate finance department is only responsible for the deployment of a company’s long term capital. This is mainly concerned with capital budgeting, which is a key corporate finance procedure.
In the process of capital budgeting, a company or an organisation identifies capital expenditures, estimates future cash flows and earnings from the proposed capital projects, compared planned investments with potential proceeds and the decides the projects that the company finally would go for.
This perhaps is the most important corporate finance task performed by an organization, since any decision taken in this regard has serious business implications. Poor capital budgeting decisions might cause over investment or under investment and this might lead to a very bad financial condition for the firm, either due to increased finance costs or under efficiency in operating capacity.
In addition to looking for prospective investments, corporate finance is also responsible for looking into the debt and equity genre i.e. sourcing capital. A company can either borrow funds from outside i.e. taking loans from commercial banks and other entities or it also has the option of issuing debt securities in the market through investment banks. Or else, another viable option with the organization is to sell equity stocks in the market, and this is extremely preferable when the company is in need of large amount of funding for expansion or other purposes.
Capital financing is an extremely crucial part of corporate financing. And the main reason why this is because capital financing decisions involve the deployment of a huge amount of funds and therefore, like capital investments, in case the decisions are not taken at the right time or are not implemented properly, the consequences can be highly severe. For instance, having too much debt on the plate can lead to default risk; however, relying heavily on equity can dilute earnings and value for early investors.
Goal of corporate finance
The major aim of corporate finance is to maximize the shareholders’ wealth or to continually increase shareholder value. This requires managers to be able to balance the investments between capital funding such that the firm is able to increase its long term profitability and sustainability, while it is also able to serve its shareholders well by paying them excess dividends.
For instance, managers of growth companies will use most of the company’s resources to continuously expand its operations, while when companies reach their maturity levels and the profits fall to average or below, managers use surplus cash to pay out dividends to the shareholders.
Another very important approach used in corporate finance is project valuation. Since large number of funds are invested in any project with the expectation of earning huge returns, companies, before investing the funds, value the project to look at the risk return trade off and the rate at which the project yields profits.
In general, the Discounted Cash Flow (DCF) technique is used to value a project, where the opportunity with the highest value, as measured by the net present value is take into consideration for investment. The NPV is affected by the discount rate and therefore, how the discount rate is calculated is of extreme importance here.
Uncertainty is also an important element here. Since project’s valuation may or may not be the same as expected, managers also need to quantify for uncertainty in the markets and look at the factors that can have a negative impact on the company’s value.
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