What is Corporate Finance and How does it Work? | Overview

Corporate Finance

Corporate finance aims to explain financial contracts and actual investment behavior that results from the interaction between managers and investors. Research in corporate finance assumes a broad rationale.

Agents are designed to develop unbiased predictions of future events and use them to make decisions that best serve their interests, efficient, with prices that rationally reflect public information about fundamental values.

Likewise, investors can assume that managers are acting in their own best interests and responding rationally to incentives provided by compensation agreements, the corporate control market, and other governance mechanisms.

What is Corporate Finance? 

Corporate finance is the area of ​​finance that deals with sources of finance, the capital structure of companies, what managers are doing to increase business value for shareholders, and the tools and analysis used to allocate funds. Corporate finance consists of maximizing or increasing shareholder value. 

What are the three main areas of corporate finance? 

Corporate finance is divided into three sub-areas: capital budgeting, capital structure, and working capital management.

  1.  Capital budgeting is long-term and includes the decision as to which money-generating areas of a company should be financed and to what extent. The capital budget deals with the definition of criteria according to which value-adding projects should receive investment funds and whether these investments should be financed with equity or debt. 
  2. The capital structure determines how a company receives the long-term funding it needs. This can be borrowed capital, equity capital, or internal income. 
  3. Working capital management comprises the short-term monitoring and administration of a company’s funds. Inventory credits and everything else. Think of working capital as a business “credit card” that covers short-term expenses and generally pays them off faster than other debt tranches. Working capital management is the management of the company’s funds, which deal with the short-term operating balance of working capital and liabilities; The focus here is on managing cash, inventory, and short-term loans and credits (such as customer loan terms).

Note that corporate finance can also be used in the context of investment banking. In this case, however, the term refers to financial management at the executive level.

Understanding Corporate Finance 

Corporate finance departments have the task of controlling and monitoring the financial activities and investment decisions of their companies; These decisions include whether to pursue a planned investment and whether to pay for the investment with equity, debt, or both, should they receive dividends and if so, at what dividend yield.

In addition, the finance department manages current assets, current liabilities, and inventory control. A company’s corporate finance duties are often overseen by its chief financial officer (CFO).

The primary goal of financial management is to continuously maximize or increase shareholder value. To maximize shareholder value, managers must be able to balance equity funding between investments in “projects” that increase profitability and long-term sustainability of the company and excess cash in the form of dividends to shareholders.

Achieving high returns on capital employed will use the majority of the company’s capital and excess cash on investments and projects so that the company can continue to grow its business in the future. The managers of these companies use the excess cash to pay dividends to shareholders.

Managers must analyze to determine the appropriate distribution of the company’s capital resources and cash surplus between projects and dividend payments to shareholders and to settle liabilities to creditors. Therefore, investment projects will be based on several interrelated criteria.

The company’s management seeks to maximize the company’s value by investing in projects that, when valued at an appropriate discount rate, generate a positive net present value taking into account the risk. These projects must also be adequately financed.

If the company cannot grow and the company does not need excess cash, financial theory suggests that management should return some or all of the excess cash to shareholders. (i.e. distribution through dividends). This “capital budget” is the planning of long-term corporate finance projects that add value to and influence the investments financed by the company’s capital structure.

Management must divide the company’s limited resources among competing options. Capital planning also involves setting criteria for which projects should receive investment finance to increase the company’s value and whether this investment is financed with equity or debt.

Investments should be made based on added value for the future of the business. Projects that add value to a business can include a variety of different types of investments, including, but not limited to, the policy of expansion or mergers and acquisitions.

When a company is unable to grow or expand and has excess cash and it is not needed, management is expected to pay some or all of the excess income in the form of cash dividends or to buy back the company’s assets through a share buyback program.

Three Most Important Activities for Corporate Finance

Capital Budgeting and Investing:

Capital budgeting and investing involve planning where to put the company’s long-term investments to achieve the highest risk-adjusted returns. This consists primarily in deciding whether or not to pursue an investment opportunity and it is achieved through extensive financial analysis.

Using financial accounting tools, a company identifies capital expenditures, estimates cash flows from planned capital projects, compares planned investments to projected revenues, and decides which projects to include in the capital budget.

To assess the economic impact of an investment opportunity and compare alternative projects. An analyst often uses the internal rate of return (IRR) along with the net present value (NPV) to compare projects and choose the optimal one.

Dividends and Return on Investment:

In this activity, business leaders must decide whether to retain a company’s excess profits for future investments and operational needs or to distribute the profits to shareholders in the form of dividends or share buybacks. It can be used to finance company expansion.

This can often be the best source of funding as it doesn’t create additional debt or dilute the value of equity by issuing more shares. If company managers believe that they can generate a return on an investment that is greater than the company’s cost of capital, this is what they should strive for at the end of the day; otherwise, they will have to return the excess capital to shareholders through dividends or share buybacks.

Equity Financing:

This core activity includes making decisions about how to optimally finance equity investments through equity, debt, or a combination of both, or issuing debt, or securities on the market through investment banks.

The balance of the two sources of funding (stocks and debt) needs to be carefully managed because too much debt can increase the risk of default, while too much reliance on stocks can dilute the returns and value of the original stocks.

Ultimately, it is the job of corporate finance experts to optimize the company’s capital structure by lowering the weighted average cost of capital (WACC) as much as possible.

Other types of corporate finance activities include:

  1. Mergers and Acquisitions (MandA) and divisions involving private companies 
  2. Mergers, divisions, and acquisitions of public companies, including public transactions with private companies 
  3. Takeovers, acquisitions, or the like of companies, departments, or subsidiaries by management, usually through private equity. 
  4. Issuance by companies, including listed companies on a recognized stock exchange through an initial public offering (IPO) and using online stock trading and investment platforms; The purpose may be to raise capital for the development or restructuring of the property. 
  5. Financing and structuring of joint ventures or project financing made up of both and related securities for corporate refinancing and restructuring. 
  6. Raising seed capital, start-up, development, or expansion. 
  7. Raising capital for specialized corporate investment funds such as private capital, venture capital, debt capital, real estate, and infrastructure funds.

What is the Importance of Corporate Finance? 

Large companies need insights into data that can help them make decisions, such as shareholder dividends, investment option proposals, debt, asset, and equity management.

These areas not only illustrate the importance of corporate functions but is critical to maximizing company value. Its structure can be a combination of long-term and short-term debt, or common and preferred capital.

The ratio of a company’s liabilities to its capital is often the basis that determines how well balanced or risky its equity financing is. A heavily leveraged company has a more aggressive capital structure and therefore potentially has four more stakeholders at risk; However, this risk is often the number one driver of a company’s growth and success.

The importance of corporate finance is divided equally into the following phases:

  1. Risk management
  2. Planning finances
  3. Investments
  4. Raising capitals

In addition to the phases listed above, here’s a summary of the importance of corporate finance: Corporate finance sets goals that improve company valuation and make investors happy.

The function makes strategic growth or restructuring decisions that relate to the mix of regions, business areas, products/company services to improve the assessment of a MandA activity and avoid or manage business risks.

Advisory Roles in Corporate Finance 

In professional service companies such as auditing firms, law firms, and independent corporate finance advisors, services and professionals working in the corporate finance area are described differently as advising, financial advising, transactional advising, transactional advising, transactions, agreements.

At investment banks, deal advisors are often referred to as advisors to MandA intermediaries or corporate brokers who focus on capital market transactions, including raising new finance for IPOs, issuing secondary stocks, and making acquisitions.

They are active in accounting firms, appointed by any company, or by an investor, lender, or acquirer of a company, asset, or project to provide financial and other forms of due diligence and transactional services.

This can be determined by investor/buyer needs or regulation and the reports issued may be private or public depending on the purpose; For capital market transactions, issuers commission reporting auditors with the duty of care and comment on the information to be published in a prospectus or shareholders’ circular.

Attorneys involved or published in an investment circular in law firms, attorneys providing advice on corporate finance, including performing legal due diligence, work in departments commonly known as corporate or corporate finance.

Major Financing Concepts

These are the financing concepts that have undergone three major changes: 

The first established concept for the financing concept is that it is a means of raising funds from corporations to meet their financial needs; 

The second approach is that finance is related to all functional areas of an organization, such as Marketing, Production, and Research and Development. 

The third approach also called the Modern / Management Approach to Finance, is a broadly accepted and balanced approach for profitable projects.

Conclusion

Corporate finance involves a lot of reporting and the controller is responsible for holding the CFO accountable. Financial managers present historical financial information to the company and its decision-makers; If this information is inaccurate it could do serious harm as many decisions are based on the numbers presented. For your company to be successful, you need a successful corporate finance leader.

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