Corporate finance covers businesses’ capital investment and capital funding decisions. This branch of finance deals with how corporations fund their operations to optimize shareholder returns and minimize costs. Chief financial officers (CFOs) are responsible for overseeing corporate finance. They do this by monitoring cash flows, implementing accounting practices, designing financial instruments, and dealing with taxes.
Capital structure is imperative to corporate finance. It refers to the mix of debt and equity that companies use to acquire assets or fund their projects. Debt encompasses the funds organizations borrow for use and is due for repayment to the lender after an agreed upon time and interest rate. On the other hand, equity refers to the ownership rights that a business issues to investors in exchange for money.
CFOs focus on balancing their company’s debt-to-equity ratio. After achieving a desirable balance, corporations can attract investors and grow their wealth. Businesses that receive most of their financing from debt are considered risky for shareholders and owners since they have a high probability of default.
Capital investment, capital financing, and managing returns are the major tasks in corporate finance. Capital investment determines where to place an organization’s long-term capital assets to generate returns. Using financial analysis tools, businesses evaluate various projects to identify the ones with the best risk-adjusted profit potential and which ones to avoid.
Moreover, corporations employ financial accounting tools to estimate capital expenditures and cash flows, both inflow and outflow, from the chosen projects. This information helps attract investors, since it indicates the project’s financial viability against the benchmark of expectations on their money.
Capital investment also employs financial modeling to determine a project’s economic impact. CFOs utilize the net present value (NPV) and the internal rate of return (IRR) to evaluate if a project is a better investment than other proposals.
Capital financing is the next step in corporate finance, which involves deciding how to fund the project put forward in capital investment. Businesses primarily rely on debt, equity, or a combination of both. Financial institutions issue debt in the form of secured and unsecured loans and mortgages.
Secured debt requires collateral to back the agreement in case of default. The asset’s value is usually more than the amount of money they borrow, and in case a business fails to repay, its assets are liquidated to service the loan. Unsecured debt, as the name implies, does not require collateral. Instead, lenders assess the borrower’s credit profile to determine its creditworthiness. Mortgages are essential for real estate investments, and the property is used as collateral.
Equity, on the other hand, raises money by issuing stock to investors. Businesses can choose to issue common or preferred stock. Common stock grants investors a claim on the company’s profits and a voting right. Businesses, therefore, allow common stockholders to control corporate policies and management issues.
Preferred stock issuance guarantees stockholders a fixed dividend but not the right to vote for board members. If CFOs combine debt and equity, it is crucial to lower the weighted average cost of capital (WACC) to balance the capital structure. This approach avoids diluting the company’s earnings and value for its original investors.
Managing returns is the last task in corporate finance that involves deciding how to utilize returns. CFOs advise corporations on when and how to pay dividends to investors. Sometimes, organizations initiate share buybacks to retrieve ownership and voting rights.
Alternatively, businesses can retain earnings to fund growth and expansion. Here, shareholders do not receive the profits or may receive a small portion. Retained earnings are a good source of funding for corporations, since they do not dilute the equity value that comes with issuing additional shares.