Understanding Corporate Finance and Its Main Activities
Corporate finance departments are charged with governing and overseeing their firms’ financial activities and capital investment decisions. Such decisions include whether to pursue a proposed investment and whether to pay for the investment with equity, debt, or both. They also include whether shareholders should receive dividends, and if so, at what dividend yield. Additionally, the finance department manages current assets, current liabilities, and inventory control.
What is Corporate FINANCE
Corporate finance is the subfield of finance that deals with how corporations address funding sources, capital structuring, accounting, and investment decisions.
Corporate finance is often concerned with maximizing shareholder value through long- and short-term financial planning and the implementation of various strategies. Corporate finance activities range from capital investment to tax considerations.
Activities that Govern Corporate Finance
#1 Investments & Capital Budgeting
Investing and capital budgeting includes planning where to place the company’s long-term capital assets in order to generate the highest risk-adjusted returns. This mainly consists of deciding whether or not to pursue an investment opportunity, and is accomplished through extensive financial analysis.
By using financial accounting tools, a company identifies capital expenditures, estimates cash flows from proposed capital projects, compares planned investments with projected income, and decides which projects to include in the capital budget.
Financial modeling is used to estimate the economic impact of an investment opportunity and compare alternative projects. An analyst will often use the Internal Rate of Return (IRR) in conjunction with Net Present Value (NPV) to compare projects and pick the optimal one.
#2 Capital Financing
This core activity includes decisions on how to optimally finance the capital investments (discussed above) through the business’ equity, debt, or a mix of both. Long-term funding for major capital expenditures or investments may be obtained from selling company stocks or issuing debt securities in the market through investment banks.
Balancing the two sources of funding (equity and debt) should be closely managed because having too much debt may increase the risk of default in repayment, while depending too heavily on equity may dilute earnings and value for original investors.
Ultimately, it’s the job of corporate finance professionals to optimize the company’s capital structure by lowering its Weighted Average Cost of Capital (WACC) as much as possible.
#3 Dividends and Return of Capital
This activity requires corporate managers to decide whether to retain a business’s excess earnings for future investments and operational requirements or to distribute the earnings to shareholders in the form of dividends or share buybacks.
Retained earnings that are not distributed back to shareholders may be used to fund a business’ expansion. This can often be the best source of funds, as it does not incur additional debts nor dilute the value of equity by issuing more shares.
At the end of the day, if corporate managers believe they can earn a rate of return on a capital investment that’s greater than the company’s cost of capital, they should pursue it. Otherwise, they should return excess capital to shareholders via dividends or share buybacks.
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