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. The financial calculations that go behind raising and successfully deploying capital is what forms the basis of corporate finance. This guide covers what corporate finance means, the two fundamental rules that underpin every decision made in this field, and how cash flows spread across different time periods get valued.
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.
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.
These two decisions are the basis of corporate finance and have been listed in greater detail below:
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.
Investment Decision
Once the firm has gained access to capital, the financial manager faces the next big decision. This decision involves deploying funds to yield maximum returns for 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 assumes that the firm has access to unlimited financing as long as it has 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.
Fundamental Rules of Corporate Finance
Corporate finance is based on two fundamental rules. All of its tools and techniques are really just ways and means of implementing these rules — they can be found at the beginning of almost any corporate finance textbook. One rule relates to the concept of return, the other to the concept of risk.
Rule #1: Money Today is Worth More Than Money Tomorrow
The timing of cash flows is of paramount importance, and we want that timing to be as soon as possible. The sooner a company gets its cash, the better. Every dollar the company has in cash today is worth more than the same dollar in cash tomorrow, for two reasons:
- Inflation: Inflation eats into the purchasing power of the company’s funds with the passage of time. The same nominal amount of money buys more today than it will a year from now, so to offset the effect of inflation, companies must ensure that cash is received as soon as possible.
- Opportunity Cost: Every dollar a company isn’t yet receiving carries an opportunity cost of capital. Say a company’s debtors owe it $100 and pay that $100 a year later. The nominal value paid is $100, but the real value is less — had the debtors paid immediately, the company could have invested that cash in risk-free securities and earned a year’s interest on it. By accepting the same $100 a year later, the company has effectively loaned $100 to its debtors, interest-free.
Rule #2: Risk-Free Money is Worth More Than Risky Money
Corporate finance involves exchanging present cash flows for future ones, and companies routinely face projects offering different future cash flows. But not all of these cash flows are equally likely to materialize — some are almost certain, like investing in treasury bonds, while others are highly uncertain, like projected returns from stock market investments. The second rule says that each of these cash flows must be adjusted for risk before any comparison or selection is made. Two factors matter here:
- Return of Capital: Some projects are extremely risky, and the real question is whether the money invested will be recovered at all. A higher rate of return must be demanded from such projects to offset the risk of losing the entire capital invested.
- Return on Capital: In less uncertain cases, the lower risk itself becomes a factor to weigh before deciding.
The bottom line: before making a choice, all projects have to be made comparable — by adjusting for cash flows received in different time periods, and by adjusting for the different amounts of risk involved.
Valuing Cash Flows Across Time
Cash flows vary from project to project. In some cases they occur evenly over time — similar amounts spread out at regular intervals. In others, payments are irregular with no real pattern. The challenge in corporate finance is to value these different streams of cash flows.
Present Value of a Stream of Cash Flows
The present value of a stream of cash flows can be expressed as a single lump sum amount, once all the expected future receipts are converted to their present-day values. Summing those individual present values yields the overall value of the expected cash flow stream.
Nature of Cash Flows
How you calculate the present value of a future stream of money depends on the nature of the cash flows. If they’re spread out evenly, shortcuts like annuities and perpetuities can be used, and the value of even large streams can be calculated easily. If the cash flows are uneven, each individual payment has to be discounted to its present value separately, and then all of those values added up.
Inflation Forecasts May Change Over Time
Many investments run for periods of 10, 15, or more years, and the inflation forecast doesn’t stay constant over that kind of horizon — historically, inflation shifts every time the business cycle changes. For investments over a long period, multiple inflation forecasts may be required, using different rates in different years.
Uncertainty Increases with Time
In projects where cash flow continues for multiple years, uncertainty increases with time as well. It’s a fundamental rule in corporate finance that the farther out an expected payment is, the more uncertain it is — over an extended period, political, economic, or social changes can all affect the cash flows. Different discount rates may therefore be used for different years to get a more accurate picture.
Multiple Discount Rates
Analysts almost always use multiple discount rates to represent the different uncertainties inherent in cash flows across different years. The value of future cash flows is also highly sensitive to the discount rate used, so small changes in that rate can bring about large changes in valuation. Combined with the fact that discount rates are difficult to predict in advance, this is part of why investing is as much an art as a science.
| Concept | What It Governs | Key Takeaway |
|---|---|---|
| Financing decision | How the firm raises capital | Choose the funding mix (debt/equity) with the lowest cost and right structure |
| Investment decision | How the firm deploys capital | Only invest where returns exceed the cost of capital (capital budgeting) |
| Rule 1: Time value of money | How cash flow timing affects value | Money received sooner is worth more, due to inflation and opportunity cost |
| Rule 2: Risk adjustment | How cash flow certainty affects value | Risk-free money is worth more than risky money of the same nominal amount |
| Valuing uneven cash flows | How multi-year cash flow streams are discounted | Later, less certain payments may need higher/variable discount rates |
Frequently Asked Questions
-
What are the two main decisions in corporate finance?
The financing decision (how a firm raises capital, and at what cost) and the investment decision (how it deploys that capital to generate returns above its cost of capital).
-
What are the two fundamental rules of corporate finance?
Money received sooner is worth more than money received later, and risk-free money is worth more than risky money of the same nominal amount.
-
Why does the value of cash flows change based on when they occur?
Because of inflation, the opportunity cost of not having that money sooner, and because cash flows further in the future are more uncertain and may need to be discounted at different rates.
-
What is capital budgeting?
It’s the process of evaluating and selecting investment projects so that the funds a firm raises are deployed where they generate returns above the firm’s cost of capital.
