What is Corporate Finance?

Corporate finance is a branch of finance that focuses on how corporations approach capital structuring, funding sources, investments, and accounting decisions.¹ Its primary goal is to maximize shareholder value while striking a balance between risk and profitability. It entails long- and short-term financial planning and implementing various strategies, capital investment, and tax considerations.

Read on to explore the significance of corporate finance, principles that guide it, and several important areas of focus within the field.

The Importance of Corporate Finance

Corporate finance evaluates how companies obtain funding to support their operations.² It involves determining how to allocate the funds appropriately to help a company achieve its goals. Corporate finance is a broad subject comprised of many topics, including capital structure, capital financing, risk management, capital budgeting, and the time value of money.

What is corporate finance? It’s a concept that plays an essential role in businesses because it's the metric upon which companies can decide how to use their financial resources. For example, it’s the guiding factor when a company wants to invest in new equipment or expand its operations.

Corporate finance is crucial because it enables corporations to manage their financial risks—by, for example, hedging against stock market or interest rate fluctuations. Enterprises can also control their exposure to currency risk. In the long run, corporate finance provides the necessary tools to enable businesses to make sound financial decisions for growth and success.

Types of Corporate Finance

There two primary types of corporate finance:

Equity Financing

This involves the money a company raises from retained earnings or through equity issuance. It takes the form of common stock or preferred stock. An enterprise can sell its shares through the stock exchange or over-the-counter exchanges. Trading too much equity reduces divided shares and dilutes shareholders' voting rights.

Debt Financing

This term refers to obtaining finance through loans from financial institutions or issuing bonds. Debt financing attracts regular interest payments, and the principal amount is payable at the end of the loan tenure. Companies should be wary of too much debt as it induces the risk of bankruptcy and default in case of loan non-repayment.

Four Crucial Elements of Corporate Finance

Corporate finance includes four significant areas of focus:³

Capital Financing

Capital financing is the central pillar that entails deciding how to finance investments at an optimal level. Financing happens through a company's debt, equity, or both. Long-term financing for significant investments or expenditures may come from issuing debt securities through investment banks or selling company stocks.

It's important to balance the two funding sources of equity and debt. Corporate finance professionals have a task to optimize the company's capital structure. They achieve this by lowering the company's Weighted Average Cost of Capital (WACC)⁴—the average rate that a company expects to pay to finance its assets. The WACC represents a business’ average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt.⁵

Capital Budgeting

The capital budgeting process reveals the viability of investment proposals and enables businesses to invest in profitable projects. Its primary goal is to enhance growth and maximize profitability. Part of capital budgeting entails analyzing the present and future values of various investment alternatives to interpret risk-return ratios in relation to organizational goals. Only the most profitable projects are given priority in corporate financing.

Various financing tools exist to enable businesses to achieve the goal of capital budgeting. It becomes possible to identify capital expenditures, compare planned investments, and estimate cash flows from proposed investment projects. Financial modeling also comes into play to determine the economic impact of an investment opportunity. Two vital components in financial modeling are:

The Net Present Value (NPV)—the difference between the present value of cash inflows and the present value of cash outflows over a period of time⁶
The Internal Rate of Return (IRR)—a metric used to estimate the profitability of potential investments; this discount rate makes the NPV of all cash flows equal to zero in a discounted cash flow analysis⁷

Dividend Distribution

Public companies are answerable to their shareholders, mainly because they must pay dividends from business profit. If a company decides to reinvest the surplus value as retained earnings, it must back this up with a firm conviction that the sum will help the business experience growth. Furthermore, a certain amount of dividend distribution is crucial for businesses to serve their shareholders better.

Working Capital

This is the day-to-day capital used for business operations. With proper financial management, businesses can maintain adequate cash flow in line with their policies. Liquidity in a company plays a role in saving an organization from going bankrupt.

Principles of Corporate Finance

Various principles govern corporate finance for checks and balances.⁸ They include:

Raising Capital

This refers to generating funds for the business through debt financing or equity.

Investment

A company should only invest in projects that maximize its value. This principle suggests that investors should focus on putting their money into projects that can earn a more significant return than the minimum acceptable value.

Dividend

When paying dividends to shareholders, the aim should be to maximize shareholder value. This principle provides that a company should pay dividends to shareholders only if it has excess earnings.

Financing

A company should use a mix of debt and equity to lower capital costs. The financing principle guides a firm to finance its investments with the most affordable source of income.

Examples of Corporate Finance

Corporate finance has many arms, each requiring different input to control how businesses, markets, assets, investors, and financial institutions interact. Examples of corporate finance activities include:

Growth Planning Strategies

Businesses must create a plan for future growth. That involves expanding into new markets, increasing capacity, or launching new products.

Risk Management

This involves identifying and addressing the operational and financial opportunities available, as well as market risks.

Finance Management

A company must implement measures to manage its financial resources efficiently and effectively. As such, it must create financial plans, make wise investment decisions, and monitor cash flow.