Corporate Finance Definition:
Well, corporate finance is the area of finance which is much concerned about managing the required funding and its sources. Also it oversees the capital structure and optimizes its proficiencies to maximize valuation of the company.
As a matter of fact, the primary objective of corporate finance is to enhance shareholder value in short and long run respectively. Shareholder value also determines success of the economic activity. In other words generating capitals and deploying them for productive purposes is what forms the basis of capital finance.
Ownership and management are the essence of capital financing. Now, what we need to understand is that any firm does not rely on an individual’s investment. The competitive market demands for numerous sources.
A common man is not content with depositing all his money in the bank. He looks for an alternative for investing their excess savings. He is ready to take a leap of faith by risking his own money. This very nature of general public is the very reason for emergence of capital markets. Not only do these capital markets act as a prominent source of financing but also they provide the general public with number of choices for investment.
Capital investment decisions play a significant role in corporate financing. These decisions include:
- Approving or rejecting the proposed investment. And if approved, should the company pay for it with debt or equity or with both.
- Whether or not the dividends should be given to shareholders on their investment in the company.
- Short-term assets and liabilities, inventory control, investments and other short-term financial issues are to be managed by a financial manager.
According to the Encyclopedia of Social Sciences corporate finance is related to understanding and preventing the financial problems of a corporation. The financial aspects of new enterprises, its promotion and administration during early development is dealt under corporate finance. Also it is concerned by the distinction between funds and revenue generated.
Principles of Corporate Finance:
Every discipline has first principles based on which it accomplishes the given objectives. The three principles on which the corporate finance is structured are:
1. The Investment Principle – According to investment principle, funds raised by the firm should be invested to obtain maximum ROI (return on investment). Also it is important to invest at minimum and acceptable hurdle rate. Hurdle rate reflects equity and debt of the project. As a matter of fact the hurdle rate is higher for riskier projects. The market today is very competitive investment decisions are expected to yield more than revenues and profits. Those decisions should save money and channelize an effective distributive system. During the assessment of any project prior to investment, the financial team should also consider the side costs and side benefits respectively.
2. The Financing Principle – The financing principle states that the ratio of debts and equity should be chosen to maximize the value of investment and to match the financing nature of the assets. Almost every economic activity is run by financing mix i.e. money borrowed from someone (debt) and owner’s funds (equity). It’s often noticed that optimal financing mix or the required financing mix is different from the current one. When this happens, the first thing finance manager does is the analyses of how to reach to the optimum level. The process involves determining short-term or long-term and fixed or variable investments to maximize the revenue cost ratio.
3. The Dividend Principle – Everyone wants to expand their business to their maximum potential. But as the business grows, it reaches its saturation point where the cash flow is more than the required fund and as this happens the owners begin their hunt for an alternative source to balance the monetary flow and capital required for investment. In most cases dividends, stocks and other assets of the owner are used to compensate. The dividend principle is about choosing the most effective asset among all.
Importance of Corporate Finance:
Corporate finance deals with financial prediction, monetary management, fund procurement, budgeting, credit administration and investment appraisal. Investment analysis, or as popularly known as capital budgeting determines the amount of investment in value-adding projects. Also it assess whether or not the corporation’s long-term assets are worth investing. If the approval comes through, finance manager does his calculation and decides whether to finance that investment with equity or debt capital. Importance of corporate finance in capital budgeting is listed below.
Important Methods and Techniques used in capital budgeting of corporate finance include the following techniques:
- Real Options Valuation.
- Payback Period.
- Equivalent Annual Cost.
- Profitability Index.
- Net Present Value.
- Average Accounting Return.
- Modified Internal Rate of Return.
- Internal Rate of Return.
- Accounting Rate of Return.
These techniques are considered “improper” by economists. Simplified and hybrid methods are used as well, such as payback period and discounted payback period in capital budgeting.
Investment Banking Vs Corporate Finance:
Investment banking is also related to corporate finance. To understand the connection and difference between Investment banking and corporate finance, you’ve to understand what does an investment banker does. Basically, an investment bank is a financial institution that evaluates the financial demands of an individual, company or a government and help them generate the required capital from different sources at minimum cost. You must be wondering where to find the connection. Hence in order to create and expand the current business and acquire new businesses the term corporate finance is often linked with the transactions in which capital is generated for this purpose.
In this e-learning tutorial lesson we have understood about what is corporate finance, significant role, importance of corporate finance and capital budgeting. Hope this corporate finance notes have given you enough knowledge in financial management of corporate finance.
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» e-Learning Chapter 3: Objectives of Financial Management
» e-Learning Chapter 4: Nature and Scope of Financial Management
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