What Is Corporate Finance: Types, Principles, and More
Jun 06, 2024
From startups to multinational conglomerates, corporate finance is a vital component in guiding companies toward their financial goals, optimizing resources, and maximizing shareholder value. It involves the planning and financing of investments made by a company as well as the distribution or reinvestment of the income generated by them.
But what exactly is corporate finance, and why is it so important?
In this blog, we'll explore the world of corporate finance, its different types and fundamental principles, and its critical role in shaping companies' financial well-being.
What Is Corporate Finance?
Corporate finance is a branch of finance concerned with how corporations address funding sources, capital structuring, investment decisions, and accounting. Overall, it deals with how businesses fund their operations to maximize profits and minimize costs. In addition, corporate finance is concerned with maximizing shareholder value through long-term and short-term strategies and the day-to-day demands on business cash flow.
The financial management of a corporation involves two functions:
- Resource acquisition: This function involves generating funds from internal and external sources at the lowest possible cost to the corporation. The two main categories of resources are equity and liability. Equity refers to proceeds from the sale of stock, retained earnings, and returns from investments. Meanwhile, liabilities refer to commitments from which an entity derives value. They include bank loans or other debt, product warranties, accounts payable, etc.
- Resource allocation: This function refers to investing funds with the goal of increasing shareholder wealth over time. The two main categories of investments are current assets and fixed assets. Current assets encompass cash, inventory, and accounts receivable, whereas fixed assets are buildings, real estate, and machinery.
The Importance of Corporate Finance
Regardless of the size or the type of business operation, each company seeks to streamline its corporate financing for optimal wealth distribution and return generation. Corporate finance is crucial for ensuring a company's long-term financial health and sustainability for several reasons. First, it helps a company allocate its capital effectively by determining which incidents will generate the highest returns and which projects should be funded. It also aids in managing risks by balancing the tradeoff between risk and return.
Furthermore, corporate finance helps companies maximize shareholder value by increasing profitability and share price. It also helps identify and evaluate growth opportunities by analyzing the financial feasibility of new projects and assessing their impact on the company's financial position. Lastly, corporate finance enables companies to gain a competitive advantage through financial decisions that allow them to outperform competitors. This can involve investing in new technologies, acquiring other companies, or investing in new technologies.
In summary, corporate finance plays a fundamental role in ensuring a company's long-term success by facilitating informed financial decision-making, managing risks, and maximizing shareholder value.
Principles of Corporate Finance
Corporate finance can be divided into three principles that serve as guidelines for financial decision-making. These principles help companies evaluate investment opportunities, assess risks, and make informed decisions that align with their financial goals and objectives. Let's delve into each of them.
Time value of money: This principle recognizes that a sum of money is worth more now than the same sum will be in the future due to the potential to invest and earn a return. It guides decision-making as it determines whether a project or investment with an initial cash outflow and subsequent cash inflows will be profitable.
Risk-return tradeoff: It states that higher risk is associated with a greater probability of higher return. This principle can guide financial decision-making by helping companies assess the risk and potential return when making investment choices.
Diversification: It’s a principle that involves spreading portfolio resources or capital to a mix of investments to reduce portfolio risk. It can guide financial decision-making by helping companies mitigate the impact of adverse events on their financial performance. Moreover, some investors find diversification useful when researching new companies or exploring different asset classes.
Types of Corporate Finance
Corporate finance involves different financial activities businesses undertake to maximize shareholder value and achieve their strategic goals. The main types of corporate finance include capital budgeting, capital structure, and financial planning and analysis. Each of these areas plays a crucial role in shaping the financial health and performance of a company.
Capital budgeting
Capital budgeting is the process of determining which long-term investments will generate positive returns and contribute to the company's strategic objectives. This process can involve almost anything, including acquiring land or purchasing fixed assets like machinery or a new truck.
Due to the long-term nature of capital budgets, there are more risks, uncertainty, and things that can go wrong. Therefore, companies often periodically reforecast their capital budget as the project moves along.
But what makes capital budgeting so important? Capital budgeting is crucial because it establishes accountability. Before investing resources in a project, a company must understand the associated risks and returns. Additionally, capital budgeting is important in deciding where to allocate resources, labor hours, and capital where it is limited.
To assess the viability of investment projects, companies use methods such as:
- Net present value (NPV): NPV refers to the difference between the present value of cash inflows and the present value of cash outflows over a period of time. This method is utilized in capital budgeting to analyze the profitability of a projected investment or project. If the NPV is positive, the project is considered worthwhile, while a negative NPV indicates that it is not.
- Internal rate of return (IRR): IRR refers to the discount rate that would result in a net present value of zero. As the NPV of a project is correlated with the discount rate, if the discount rate increases, future cash flows become more uncertain and worth less. After calculations, an IRR higher than the weighted average cost of capital indicates that the capital project can be profitable.
Capital structure
Capital structure relates to how much money or capital supports a company and funding its operations. It refers to the combination of debt and equity a company uses to finance its overall operations and growth.
Debt capital is money borrowed to help support a company's capital structure. It can be borrowed over either short-term or long-term periods and acquired through loans and bonds.
On the other hand, equity capital refers to the money owned by the shareholders or owners and consists of two different types:
- Retained earnings: the part of the profit kept separately by the company to help strengthen the business.
- Contributed capital: the amount of money company owners have invested at the time of founding the company or have received from shareholders as a price for ownership.
Another important type of capital structure is optimal capital structure, which refers to the perfect mix of debt and equity financing that helps maximize a company's market value while minimizing its capital cost.
The major factors that can influence a company's capital structure decisions include:
- Risk: Companies must assess their risk tolerance when determining their capital structure.
- Cost of capital: The cost of capital can be defined by predicting the return that a firm needs on the cost spent on a project before considering it.
- Flexibility: Maintaining financial flexibility is crucial for a company to cope with different market and business situations.
Financial planning and analysis
Financial planning and analysis is the process of forecasting a company's financial performance and evaluating its financial health. It plays a crucial role in supporting major corporate decisions of the CFO, CEO, and the Board of Directors.
It also involves creating and maintaining financial models and forecasts, analyzing historical financial data and trends, and projecting future outcomes. Moreover, financial planning and analysis assist in allocating resources effectively by identifying areas that require investment and those that may need to be scaled back.
The Bottom Line
Corporate finance is a vast field that deals with proper budgeting, raising capital to meet company needs and objectives, and efficiently managing a company's current assets and liabilities. It also guides companies in managing their financial resources to maximize shareholder value. This field encompasses capital budgeting, capital structure, and financial planning and analysis and adheres to principles such as time value of money, risk-return tradeoff, and diversification.
If you're interested in a career in this field, check out our Financial Analysis and Corporate Performance certification program and gain experience in several areas of applied finance, such as corporate finance, financial analysis, portfolio management, and more.
Frequently Asked Questions (FAQs)
How important is a company's capital structure in corporate finance?
A company's capital structure is crucial as it determines how the business finances its operations and growth. It represents the company's overall financial health.
How does corporate finance differ from personal finance?
Corporate finance and personal finance differ in scale. While personal finance focuses on the financial decisions and activities of an individual or household, corporate finance deals with managing finances for a business.
What are the main types of corporate finance activities?
The main types of corporate finance activities include capital budgeting, capital structure, and financial planning and analysis.