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What is Corporate Finance?
Corporate finance is, in a nutshell, the study of the financial decisions of a business. As all businesses exist to make a profit, financial decisions are essentially all that really matters, which makes corporate finance the single most important part of business management.
In this guide, TFG will provide an overview of corporate finance, including what it involves, the sub-disciplines of corporate finance, and some key methodology.
Ultimately, the goal of corporate finance is to maximise the value of the company for its shareholders. Corporate finance strives to achieve this by making the best money-related decisions regarding investment and financing possible – it aims to minimise expenses and maximise revenues through the acquisition and allocation of resources.
This involves both short-term and long-term decision-making and, as such, corporate finance focuses its efforts in two separate areas, which we can think of as the two sub-disciplines of corporate finance. These are:
- Capital budgeting (long-term)
- Working capital management (short-term)
These sub-disciplines work together to maximise the company’s value.
In the long term, capital budgeting decides which investments to fund and how these investments will be financed, and in the short term, working capital management takes care of all of the operating decisions regarding short-term assets and liabilities.
Let’s explore each of these sub-disciplines in more detail, starting with capital budgeting.
Capital Budgeting
As we already mentioned, capital budgeting involves deciding which investment opportunities should be funded and how the business will finance these investments. Consequently, we can further sub-categorise capital budgeting into two categories:
- Investment decisions
- Financing decisions
Investment Decisions
All investment decisions are made on the basis of long-term profitability and value added to the company. Growth companies typically earn higher returns on invested capital than companies which have reached maturity levels and, as such, stand to gain more long-term added value from pursuing investment opportunities.
Therefore, growth companies will typically invest most of their capital resources on investment opportunities. If, however, no more growth is possible, and the company has a cash surplus, it will typically use this surplus to pay dividends to shareholders.
It’s the job of the corporate financier to determine whether growth is possible or dividends should be paid. If growth is possible, it’s also their job to determine which investment project offers the best returns in terms of added value.
There are many different types of projects that could potentially increase the value of a company, such as mergers and expansion policies, and each of these opportunities will be competing for the limited company resources.
They must try to determine which proposal is the best choice and offers the optimal return on investment – but how exactly do they determine this?
Capital Budgeting Methods
There are two types of methods which businesses can use to weigh up the costs and benefits of a proposal to determine which is best: traditional methods and discounted methods. The main difference between these two methods is that discounted methods account for the time value of money whereas traditional methods don’t.
There are several methods within each of these categories, and the business will use whichever is most appropriate to their financial goals and priorities.
Some businesses may prioritise quick returns and will calculate and select the proposal which offers the lowest possible payback period (the number of years it takes to break even on the investment), whereas others may prefer the proposal which offers the largest average annual profit over the duration of the project.
To learn more about each of these methods and the calculations and methodology used within them, we recommend reading this article.
Financing Decisions
Financing and investment decisions work hand in hand. It’s only necessary to raise finances if the business can deploy these finances in suitable avenues.
If the business does have suitable avenues to employ these finances, the first choice to make is whether to finance the investment with equity or debt capital. Whichever of these avenues the business chooses to go down, there will be many more decisions to make.
For example, they have the choice of raising capital via bank loans, corporate loans, public fixed deposits – the list goes on and on. There is a wide range of options that need to be considered and the job of the financier is to analyse each of these options and select the best one.
Working Capital Management
Working capital management involves looking at short-term cash flows, assets and liabilities to ensure the business has enough funds to meet its financial obligations and continue operations.
This involves selecting appropriate sources of short-term financing to cover any shortfalls, managing inventory as efficiently as possible, and general cash management – the last of which we’ve written more about here.
References:
https://www.investopedia.com/walkthrough/corporate-finance/1/goals-financial-management.aspx
https://en.wikipedia.org/wiki/Corporate_finance
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