Corporate Finance

Definition of Corporate Finance

Corporate Finance has numerous definitions, but in simple terms, corporate finance can be defined as the financial/monetary activities carried out by a firm.

Main Areas of Corporate Finance

• Capital Investment Decision Making
• Working Capital Management
• Financial Risk Assessment and Risk Management

Capital Investment Decision Making

Capital Investment Decision Making can be further broken down into the following 3 decisions:

• The Investment Decision
• The Financing Decision
• The Dividend Decision

The Investment Decision

The Investment Decision involves making a decision as to whether or not to pursue a particular strategy or project. Examples of such strategies/projects may be to expand the business by investing in new machinery, new factory or warehouse space, new employees, developing new products etc.

In a perfect world, where companies have access to unlimited resources, a company can pursue all projects which are expected to generate net positive cash flows over the life of the project (after adjusting for taxes, time value of money etc).  However, in the real world, companies will only have access to a certain amount of finance, and must therefore pick and choose the most appropriate projects to generate the highest net cash flows, whilst also ensuring that the projects are consistent with their ethical values, and will not seek to undermine the company’s reputation or bring about any other negative implications for the company.

The Financing Decision

The Financing Decision involves making a decision as to the appropriate method and mix of financing, e.g. debt financing, equity financing, or a combination of both.  There are a number of theories aimed at explaining the most appropriate mix of debt and equity financing, each making different assumptions about the cost of equity and debt finance, and the likely goals and reactions of investors.

Equity finance is generally considered to represent lower risk to the business, since the cash flow requirements are less demanding and are more flexible.  However, equity finance results in dilution of ownership and control, since the equity instruments issued give certain rights to the financer.  As a result, equity finance often requires a higher required rate of return.

Debt finance on the other hand represents higher risk to the business, since defaulting on loan repayments may result in the bank taking ownership of the company’s assets, on which the debt is secured.  However, debt finance is often cheaper than equity finance, since it does not result in a dilution of ownership and control.

Achieving the most appropriate and efficient mix of financing will depend on a number of factors, e.g. marginal tax rate payable by company, current gearing of company (amounts of debt finance currently employed by the company), objectives and risk preferences of management and shareholders.

The Dividend Decision

The Dividend Decision refers to the decision as to whether or not to issue dividends, and at what level dividends should be set at.

Dividends are a key indicator of a company’s performance, and the level of dividends proposed will likely give rise to market responses, i.e. increases or decreases in share price.  The likely response of the market and shareholders is a key factor to be considered by management when determining dividends to be paid.

An alternative to paying cash dividends is to issue additional shares to shareholders in proportion to their current holdings, known as a bonus issue.

Working Capital Management

Working Capital Management refers to decision making relating to working capital (i.e. stock, debtors, creditors) and short-term financing.

Financial Risk Management

This involves the identification, measurement and response to financial risks faced by a particular organisation.  Examples of financial risks include:

• Default/credit risk – the risk of financial loss resulting from a customer defaulting on payment of a debt to the company
• Interest rate risk – the risk of financial loss resulting from adverse movements in interest rates.  For example, a company with a loan with a variable rate of interest, an increase in the interest rate will result in the company paying higher interest costs on the loan.
• Liquidity risk – this is the risk that an asset cannot be traded sufficiently quickly to prevent making a loss on the transaction
• Market risk – this is the risk that an asset or portfolio will fall in value, thus resulting in a financial loss, due to changes in market risk factors

Some methods of reducing or eliminating financial risks include:

• Financial instruments/derivatives – can be used to ‘hedge’ against changes in interest rates, commodity prices, foreign exchange rates, stock prices, as well as many other things
• Insurance – available to protect against default by customers on debts owed to the company