Corporate Finance: What Is It and Why Is It So Important?

Behind every business innovating in a space, enriching communities, or making people's lives better there is a science of managing the funds of that business to ensure the business can continue to exist in a healthy way into the future. Ensuring there is enough money, managing it, and making sure the business has some left over to profit are all attributes which corporate finance contributes to. Corporate finance is the key to a business understanding their financial position and driving priorities for that business. Understanding the pieces of corporate finance are important to knowing the fundamentals of business. 

What is Corporate Finance?

• Broadly, corporate finance is a line of work that focuses on raising money for the business, strategically spending that money, and ensuring the business is making the best decisions with its money as possible 
• Not to be confused, general finance is fore focused on financial activities at the more personal level

The 3 Main Areas of Corporate Finance

There are a few main areas of corporate finance which could be considered the domain of corporate finance:

• Capital Budgeting Involves creating budgets for the business units which may roll up into the companys’ master budget and monitoring spend against these
• Capital Structure Involves raising money for the business, whether through investment or strategically taking on more debt so the business will have the working capital needed to continue functioning and investing
• Working Capital Management Managing the available funds of the business, whether allocated to a budget or not, to ensure the business has the cash available to take advantage of opportunities or pay unexpected costs

Main Principles of Corporate Finance

There are three principles which corporate finance is based on are found below. These are basic principles involving the borrowing and investing of the businesses funds and the expectations. 

• The Investment Principle: The principle which states that if an investment is made, the expectation is that in the future that investment will grant a return to the investor. 
• The Financing Principle: The principle that borrowing money for the right type of investment strikes a balance of interest paid and interest gained.
• Dividend Principle: The dividend principle states that if there are no longer any investments that will create the return the business is looking for, the best course of action is to return the capital to the businesses owners.

Important Concepts of Corporate Finance

There are a few concepts which most decisions in corporate finance are based on. These fundamentals serve as the basics on which understanding the financial position of the business and determining what next best step exists:

• Time Value of Money: Time value of money states that having a dollar today is worth more than having a dollar tomorrow. This essentially considers that money you have today can be invested and generate interest income, which creates the opportunity cost of no longer having that cash.
• Cost of Capital: Cost of capital is the mechanical interest expense that a company must pay in order to borrow money from another institution, thus creating a cost of obtaining that money. 
• Risk and Return: Risk and return is the school of thought surrounding the analysis of a risk, and what reward it may yield. Corporate finance typically has a tolerance for risk, whether adverse to it, or leaning in, which guides decisions.
• Financial Statements: Financial statements are the core financial performance tools which report on results. These typically can be analyzed to show more historical health metrics and evaluated for whether decisions made in the past have yielded the results desired.

Overview on Corporate Finance Theories

While fundamentals of corporate finance are driven by these principles and concepts, there is an element of theory which ties into the practice of corporate finance. Different businesses may use different theories to form their overall finance strategy, made famous by Joel Dean. 

• Capital Structure Theory: A theory that states that a company can become more valuable from borrowing, or taking on debt, to a limit. After this limit the value of the business declines from too much borrowing.
• Agency Theory: A management theory which looks at the relationships between principals, or owners acting in their own self interest and their agents, or workers, who also act in their own self interest. This type of behavioral study was in the academic domain of David B. Hertz.
• Market Timing Theory: A theory surrounding how businesses issue equity, selling equity, or ownership, of the business when the price is high, and buying it back when prices are low.

Examples of Corporate Finance Activities

Once a business has its principles and understanding of how it wants to operate, the actual activity of corporate finance happens. Below are a few examples of activities a corporate finance department may engage in. 

• Capital structuring and financing decisions: decisions around making investments on behalf of the business and how to pay for those investments, whether through debt or cash. 
• Raising capital: Activities regarding the raising of cash for the business
• Initial Public Offering (IPO): Bringing a private business public, or available for public investors to purchase equity in the business, commonly seen as purchasing shares of a stock
• Mergers and Acquisitions (M&A): The purchase of another business by the buying business, selling your business to another, or joining businesses for a variety of reasons
• Dividend Policy: Policy around when and how much a business will pay dividends to its shareholder or owners
• Financial Risk Management: Managing risks which may damage the overall value of the business. An example of this may be accepting credit card payments from customers, a business may find a certain percentage of these transactions end up in a chargeback; the department would consider mitigations from there. 
• Financial Planning and Analysis: Activities such as creating budgets, monitoring spend against those budgets, and understanding where the business could better allocate resources from these results.

Corporate Finance vs Investment Banking: How Are They Different?

It's possible to get corporate finance and investment banking confused but there are a few key differences. Corporate finance involves managing the finances of a business from within that company. It is also responsible for larger decisions around strategy and where the business wants to be in the future.

Investment banking on the other hand specialize in large financial transactions and pulling the decisions of a corporate finances department together. For example, if a corporate finance department and the business which it operates wants to IPO, an investment banker would support that transaction with various activities.

What Does the Capital Raising Process Look Like?

Raising capital can come in many forms but most commonly thought of as generating cash from outside sources in return for paying back the amounts or offering equity in the business. Here are a few of those steps which may be followed:

• Pulling Together Investor Materials: A business will want to show investors or debtors why it is a good opportunity for both parties. The business will prepare documentation on the reason for a raise, what the other parties will get in return, and timing among other items
• Meet with Investors: Present materials and answer any questions of the interested party
• Negotiate: At this point there will be discussion of the specific nuance of the deal, where both parties will need to come to an agreement on the details of the deal
• Finalize Agreement: After investors or debtors have agreed on the terms, and potentially completed any diligence necessary, the deal will close and the businesses will continue to follow the agreement set out

Types of Debt Securities in Corporate Finance

Here are a few of the most common types of debt securities that companies can issue to raise capital:

• Bonds: Bonds represent debt issued by the company, with a promise to repay that debt with interest in the future to the purchaser of that bond 
• Commercial Paper: Commercial papers are similar to bonds in that they are promises to repay in the future for debts, however these are unsecured, or not backed by assets and are typically more short term in nature
• Convertible Securities: An investment instrument which can be converted into a different type of security in the future such as stock.

Types of Equity Securities in Corporate Finance

List the most common types of equity securities that companies can issue to raise capital. Add more/modify if necessary:

• Common Stock: Units of ownership in the business offered to investors are called common stock. They may or may not have voting power and typically can be found on exchanges for sale such as the New York Stock Exchange
• Stock Warrants: When a company makes a contract with someone, where the company allows the owner of the stock warrant to trade that stock at a predetermined price before a specific date. 
• Equity Options: A company allowing another entity the right to buy or sell equity in the business at a predetermined price, before a specific date.

The Main Business Valuation Techniques Used in Corporate Finance

Knowing that you can buy and sell ownership of businesses through various instruments is a great way investors can diversify, but how do you know if you’re paying a fair price?

Business valuation is the method in which a company is valued and there are a few ways to go about it. Check out this excellent guide. This has been studied at length by former Harvard Business School senior lecturer Timothy Luehrman.

Final Word

Corporate finance is happening in the background of businesses each and every day. As businesses set financial goals, invest, take on new debts, shareholders and owners of businesses are affected as the value of their ownership changes. This in turn creates opportunity and risk for those owners, and ultimately an ecosystem of risk and reward. While corporate finance could be seen as the backbone of a single business, its actually just one piece of a complex system in the overall economy.