Corporate Financing

Corporate finance is the division of finance that deals with financing, capital structuring, and investment decisions. Corporate finance is primarily concerned with maximizing shareholder value through long and short-term financial planning and the implementation of various strategies. Corporate finance activities range from capital investment decisions to investment banking.

Corporate finance is one of the most important subjects in the financial domain. It is deep rooted in our daily lives. All of us work in big or small corporations. These corporations raise capital and then deploy this capital for productive purposes.

Corporate finance departments are charged with governing and overseeing their firms’ financial activities and capital investment decisions. Such decisions include whether to pursue a proposed investment and whether to pay for the investment with equity, debt, or both.

Principles of Corporate Finance

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

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.

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.

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.

Types of Corporate Finance

1. Capital Investments

Corporate finance tasks include making capital investments and deploying a company’s long-term capital. The capital investment decision process is primarily concerned with capital budgeting. Through capital budgeting, a company identifies capital expenditures, estimates future cash flows from proposed capital projects, compares planned investments with potential proceeds, and decides which projects to include in its capital budget.

Making capital investments is perhaps the most important corporate finance task that can have serious business implications. Poor capital budgeting (e.g., excessive investing or under-funded investments) can compromise a company’s financial position, either because of increased financing costs or inadequate operating capacity.

 Corporate financing includes the activities involved with a corporation’s financing, investment, and capital budgeting decisions.

2. Capital Financing

Corporate finance is also responsible for sourcing capital in the form of debt or equity. A company may borrow from commercial banks and other financial intermediaries or may issue debt securities in the capital markets through investment banks (IB). A company may also choose to sell stocks to equity investors, especially when need large amounts of capital for business expansions.

Capital financing is a balancing act in terms of deciding on the relative amounts or weights between debt and equity. Having too much debt may increase default risk, and relying heavily on equity can dilute earnings and value for early investors. In the end, capital financing must provide the capital needed to implement capital investments.

3. Short-Term Liquidity

Corporate finance is also tasked with short-term financial management, where the goal is to ensure that there is enough liquidity to carry out continuing operations. Short-term financial management concerns current assets and current liabilities or working capital and operating cash flows. A company must be able to meet all its current liability obligations when due. This involves having enough current liquid assets to avoid disrupting a company’s operations. Short-term financial management may also involve getting additional credit lines or issuing commercial papers as liquidity back-ups.

Importance/Significance of Corporate Financing

1. Separation of Ownership and Management

The basis of corporate finance is the separation of ownership and management. Now, the firm is not restricted by capital which needs to be provided by an individual owner only. The general public needs avenues for investing their excess savings. They are not content with putting all their money in risk free bank accounts. They wish to take a risk with some of their money. It is because of this reason that capital markets have emerged. They serve the dual need of providing corporations with access to source of financing while at the same time they provide the general public with a plethora of choices for investment.

2. Liaison between Firms and Capital Markets

The corporate finance domain is like a liaison between the firm and the capital markets. The purpose of the financial manager and other professionals in the corporate finance domain is twofold. Firstly, they need to ensure that the firm has adequate finances and that they are using the right sources of funds that have the minimum costs. Secondly, they have to ensure that the firm is putting the funds so raised to good use and generating maximum return for its owners.

3. Financing Decision

As stated above the firm now has access to capital markets to fulfill its financing needs. However, the firm faces multiple choices when it comes to financing. The firm can firstly choose whether it wants to raise equity capital or debt capital. Even within the equity and debt capital the firm faces multiple choices. They can opt for a bank loan, corporate loans, public fixed deposits, debentures and amongst a wide variety of options to raise funds. With financial innovation and securitization, the range of instruments that the firm can use to raise capital has become very large. The job of a financial manager therefore is to ensure that the firm is well capitalized i.e. they have the right amount of capital and that the firm has the right capital structure i.e. they have the right mix of debt and equity and other financial instruments.

4. Investment Decision

Once the firm has gained access to capital, the financial manager faces the next big decision. This decision is to deploy the funds in a manner that it yields the maximum returns for its shareholders. For this decision, the firm must be aware of its cost of capital. Once they know their cost of capital, they can deploy their funds in a way that the returns that accrue are more than the cost of capital which the company has to pay. Finding such investments and deploying the funds successfully is the investing decision. It is also known as capital budgeting and is an integral part of corporate finance.

Capital budgeting has a theoretical assumption that the firm has access to unlimited financing as long as they have feasible projects. A variation of this decision is capital rationing. Here the assumption is that the firm has limited funds and must choose amongst competing projects even though all of them may be financially viable. The firm thus has to select only those projects that will provide the best return in the long term.

Financing and investing decisions are like two sides of the same coin. The firm must raise finances only when it has suitable avenues to deploy them. The domain of corporate finance has various tools and techniques which allow managers to evaluate financing and investing decisions. It is thus essential for the financial well being of a firm.