Basics of Corporate Finance

Definition and Introduction:

Corporate finance is a branch of finance which deals with the financial activities of a corporation starting from selection of the sources of fund to the capital structure of the corporation. The primary objective of corporate finance is maximizing shareholder value by means of both long and short-term planning and implementing different strategies. Corporate finance is essential for any business whether big or small. In short, corporate finance helps a company in finding sources of funds, expansion of business, planning the future course of actions, managing finance and assuring healthy profitability and economic viability. The core of the corporate financial theory is the goal of maximizing the corporation’s value as well as minimizing the risk.

Basic Principles of Corporate Finance:

The investment, financing and dividend principles are the three basic principles of corporate finance.

Investment Principle:

The most efficient allocation of the business’s resources is the basic concept of the investment principle. The investment decisions should result in revenue opportunities as well as save fund for future. This principle also involves the working capital decisions like the allotment of credit days to the customers etc. Corporate finance also ascertains the feasibility of the investment or project by calculating the return on the investment decision and making a comparison of it with the cost of capital.

Financing Principle:

Businesses are financed mostly with debt or equity or both. The financing principle ascertains whether the debt-equity mix is right or not. The corporate-financier has to study conditions in which the optimal financing mix minimizes the cost of capital and evaluate the effects on the value of the company because of a change in capital structure. After the optimal financing mix has been defined, the decision has to be made whether to take it on a long-term or short-term basis. Then other factors like taxes, decisions regarding the structure of financing, the risk-return trade-off, i.e. the riskier the asset, the higher the expected return, etc. are considered.

Dividend principle:

A business reaches a certain phase in its lifecycle in which it grows and the cash flows generated exceeds the expected cost of capital. Then the business finds it necessary to ascertain the means of paying back the owners with it. So here decision has to be taken whether the excess cash should be paid to the owners/investors or should be kept in the business. A public limited company has both the options, either paying off dividends or buying back shares.

Basic Concepts of Corporate Finance:

Corporate finance has a very wide area of discussion. It includes various concepts and fundamentals. Among those, a few basic concepts are briefly discussed here.

Capital Budgeting:

The planning procedure of expenditures on such fixed assets, which will generate cash flows more than one year, is called capital budgeting. Here, “capital” means long-term assets and “budget” is a detailed plan of the projected cash flows (both in and out) over the specified future period.

The basic approaches used during project selection are discussed below:

Net Present Value (NPV):

Under this method, all cash inflows and outflows are discounted at the cost of capital of the project and then those cash flows are added. If NPV gives a positive value, the project will be accepted.

NPV = Σ [CFt/ (1 + k) t]

Where CFt =expected cash flow at time, t,

CFT = expected cash flow at time t,

k = the project’s cost of capital.

Internal Rate of Return (IRR):

IRR is the discount rate which makes the value of NPV of a project zero.

NPV = Σ[CFt/(1 + IRR)t];

IRR = expected rate of return on a project. The NPV and IRR methods have the same accepting or rejecting criteria.

Payback period:

Payback period is the number of years in which the original or initial investment will be recovered. Cumulative net cash flows will be zero in payback period. The payback period should be as short as possible. A company should set a standard payback period and should reject the project when payback is greater than the standard.

Time Value of Money:

A certain unit of money today is worth more than the same unit of money tomorrow.

If a person has 10 Taka today, s/he can earn interest on it and has more than 10 Taka next year. For example, Taka 100 of today’s money invested for one year and earning 5% interest will be worth Taka 105 after one year.

Annuity

An Annuity is a series of regularly made equal payments or structured payments, such as paid monthly or yearly.

Perpetuity

A perpetuity is an equal amount of annuity having an infinite number of cash flows.  In other words, it is a never-ending annuity.

Cost of Capital:

A necessary factor of production is capital which has a cost. The providers of capital want a return on their investment. A company must clearly ensure that shareholders or the lenders of the fund such as financial institutions, banks, receive the return that they want. The cost of capital is the rate of return used when analyzing capital projects. The project will be acceptable when it returns greater than the cost of the project.

Weighted Average Cost of Capital (WACC) is one of the common methods of calculating the cost of capital which is the weighted average of the costs of debt, preferred stock, and equity or common stock. It is also known as the marginal cost of capital (MCC).

Working Capital Management:

Working capital management includes the relationship between the short-term assets and short-term liabilities of a company. The motive of working capital management is ensuring a company’s continued operation by enabling it to pay short-term debt and future operational expenses. Working capital management consists of managing cash, inventories, accounts receivables, and payables.

Measures of Leverage:

A company has a certain amount of fixed costs which is known as leverage.

These fixed costs include fixed operating expenses like equipment or building leases; fixed financing costs like interest paid on debt. Greater the leverage, greater will be the volatility of the company’s operating earnings after tax and net income after tax.

Corporate finance is a vast area of finance. Here, the basic principles and only a few basic concepts are discussed briefly. Business people should have a clear understanding of the basics of Corporate Finance before accepting any business project and to maximize the business’s value as well as minimizing the risk.