Finance has three main categories, and corporate finance is one of them, and it can bedefined like this,“the practice of dealing with finance, decisions related to investments, reporting, and capital structuring in context with corporations (companies, firms, etc.).”As one can easily interpret from the definition that corporate finance and accounting deals with financial matters of organizations or corporations. It is worth mentioning that the primary objective of corporate finance is the interest of shareholders and how to maximize the value of shareholders of a corporation. It includes short term and long term strategies.
Now, one must understand that corporate finance is a very broad spectrum, and it covers so many subcategories. Corporate finance is different from managerial finance because it covers the financial issues of corporations as well as firms. It plays the role of a liaison between the corporations and capital markets. When we talk about maximizing the value of shareholders, it includes every activity that helps the organizations to grow and increase their market value and maximize the profits and returns while minimizing the expenditures.
Corporate finance is then further divided mainly into three sub-divisions, including capital budgeting and investments, capital financing, and return of profit on the invested capital. Let us have a detailed overview of these categories:
A-Capital budgeting (Investing):Capital budgeting includes the allocation of financial resources of an organization for long term purposes. Capital budgeting may include a company’s capital expenditures, acquisitions of fixed assets, investment policies, and similar activities. Before investing, there are certain things that need to be answered, and they include future cash flows related to that investment, how much revenue can a certain investment generates in the future, and what are the risk factors attached to that investment. Capital budgeting is undoubtedly one of the most important tasks for any organization because the future of any organization depends on these important decisions. A poor capital budgeting strategy can have seriously adverse implications. Wrong capital budgeting can lead to destabilization of an organization’s financial position if the funds are not channelized properly Investopedia.
Capital budgeting is done through various formal techniques that may have shortcomings but is used worldwide. Let us have a brief overview of some of these techniques:
- Accounting rate of return: it is a concept that is based on a view that does not account for money’s time value theory. It simply excludes that factor out of the equation. It considers two elements for the calculation, and they are average annual profit and initial investment where average profit (annually) is taken as the numerator, and the initial investment is taken as the denominator. If the expected or anticipated return rate is lower than the average annual return, the investment will be viewed as a profitable investment and vice versa.
- Payback period: payback period is a method in which a corporation analyzes how much time it will take for recouping the resources or funds invested. That is, how long it will take to equalize the amount of profit and the initial investment. Let us say a company invests $1 million and is earning $ 0.5million every year as a return on investment. It will take two years to recoup the initial investment, and that is called the payback period. Companies prefer shorter payback periods.
- Net present value (NPV): This method is arguably a more reliable and widely used technique because it accounts for money’s time value theory, which holds vitality while discussing the worth of any investment. Present values of cash inflow and outflow are taken for this purpose, and their difference is the NPV of any investment. A resulting positive figure would mean that the expected or anticipated earnings will exceed the expected costs. It is to be noted that present values of expected earnings and expected costs are taken into consideration for this method. If the expected earnings are more than expected costs, then this investment is termed a profitable investment.
- Profitability index: This method is also very helpful for cost and benefit analysis. In this method, the value is obtained with the division of future cash flow (present value) with an initial or principal investment of the project. A value of 1.0 or greater would mean that it will be wise to invest, and if that figure is lesser than 1.0, then this is not considered as a profitable investment. Greater the profitability index, the better will be the future outcomes and vice versa. This method also does not account for money’s time value theory.
- Internal rate of return (IRR): It is calculated through the same formula as NPV, but in this calculation, cash flow’s NPV is considered as zero. The higher value of IRR means the investment is satisfactory in terms of return or profitability and vice versa.
B- Financing the capital: Now, as we have discussed the capital budgeting and how important it is from an organization’s point of view to have your resources in healthy investments. Good capital budgeting can lead to positive effects in terms of profitability and growth, and vice versa. But, before making investment decisions, another important decision that management has to make is capital financing. Where and how should you get those funds that you are going to invest? There are two primary sources to collect those funds, and they are debt capital and equity capital. Let us have a brief overview of both.
- Equity Capital: one of the most common and worldwide practices of collecting funds is issuing shares or stocks. Shares are basically an agreement in which the shareholder pays the value of the share, and in return, he is entitled to have a share in the profits of the company and have a say in the company’s decision making. Stocks or shares are divided into two major and renowned categories. One of them is common stocks, while the other one is preferred stocks. Preferred stocks are given preference over the common stocks in terms of dividends and claims over the company’s assets. Dividend rates generally vary, and it is not necessary that dividend is paid every year. The biggest problem with issuing the shares is that the company cannot buy back its shares unless it is explicitly mentioned in its memorandum or articles of association, and consent of the shareholder is essential in this matter as well. This means, once the shares are issued, the company will have to pay dividends for the lifetime (until the company is dissolved or buyback its shares).
- Debt capital: One major source for the organizations to collect funds is through the “debt capital” method. Sometimes, corporations have to rely on funds borrowing. It may include a loan from a bank or a financial institution, or the company can issue bonds or debentures. The problem with bonds, debentures, and loans is that companies have to pay the interest amount regularly, unlike shares. This means, even if the company is going through bad times, it still has to pay the interest. Moreover, interest rates are generally higher as compared to dividend rates. However, if the company is no longer in need of funds, they can settle the amount borrowed and stop the cycle. Bonds and debenture holders have more substantial claims over the company’s assets as compared to the shareholder.
Choosing one option for fundraising is not recommended for companies. Sometimes they need funds temporarily; in this situation, borrowing is a good option. Issuing shares can allow companies to have funds for longer periods. Decision-makers always prefer a blend of both.
C- Returning the capital (Dividends):Another major decision related to corporate finance is how to deal with the surplus funds? Managers have to make choices in this regard. Should they reinvest the surplus for expansion, or should they announce dividends for the shareholders? Reinvesting is always good because expansion and growth lead to stability, increased profitability, and stronger financial standings.
But, there is more to that than just reinvesting. Shareholders invest their money with the objective of getting profits (dividends) on their investment and appreciation in their investment (increase in stocks’ value). They want their “money” to flourish and get regular profits as well. Now, if a company is not declaring dividends and just reinvesting every penny of the surplus, its shareholders may get restless and start considering other options, and this can dent the stocks’ value. Managers are given this responsibility to maintain a balance between things.
Importance of Accounting in corporate finance:Every decision, every choice the management makes, is based on some reliable and solid information. Management cannot make decisions just with the help of assumptions or using the “hit and trial” method. This is where accounting plays its role, and it is considered as the backbone of decision making. Financial statements accurately depict the financial condition of any corporation. The statement of comprehensive income (income statement) portrays the success rate of any corporation. It tells the management whether they earned profit this year or suffered losses? And where they can make improvements? A statement of financial position (balance sheet) explains the current position of a company in terms of assets, liabilities, and equity. A cash flow statement tells the story of inflows and outflows of the cash, when and where the company invested or sold an asset, or how much they borrowed from others. It is safe to say that it is impossible for any company to make decisions without this financial information Wiki.