What is Corporate Finance? – Meaning and Important Concepts

Corporate finance is one of the most important subjects in the financial domain. It is deep rooted in our daily lives. All of us work in big or small corporations. These corporations raise capital and then deploy this capital for productive purposes. The financial calculations that go behind raising and successfully deploying capital is what forms the basis of corporate finance. Here is a short introduction:

Separation of Ownership and Management

The basis of corporate finance is the separation of ownership and management. Now, the firm is not restricted by capital which needs to be provided by an individual owner only.

The general public needs avenues for investing their excess savings. They are not content with putting all their money in risk free bank accounts. They wish to take a risk with some of their money. It is because of this reason that capital markets have emerged. They serve the dual need of providing corporations with access to source of financing while at the same time they provide the general public with a plethora of choices for investment.

Liaison between Firms and Capital Markets

The corporate finance domain is like a liaison between the firm and the capital markets. The purpose of the financial manager and other professionals in the corporate finance domain is twofold.

1. Firstly, they need to ensure that the firm has adequate finances and that they are using the right sources of funds that have the minimum costs.

2. Secondly, they have to ensure that the firm is putting the funds so raised to good use and generating maximum return for its owners.

These two decisions are the basis of corporate finance and have been listed in greater detail below:

Financing Decision

As stated above the firm now has access to capital markets to fulfill its financing needs. However, the firm faces multiple choices when it comes to financing.

The firm can firstly choose whether it wants to raise equity capital or debt capital. Even within the equity and debt capital the firm faces multiple choices. They can opt for a bank loan, corporate loans, public fixed deposits, debentures and amongst a wide variety of options to raise funds.

With financial innovation and securitization, the range of instruments that the firm can use to raise capital has become very large. The job of a financial manager therefore is to ensure that the firm is well capitalized i.e. they have the right amount of capital and that the firm has the right capital structure i.e. they have the right mix of debt and equity and other financial instruments.

Investment Decision

Once the firm has gained access to capital, the financial manager faces the next big decision. This decision is to deploy the funds in a manner that it yields the maximum returns for its shareholders.

For this decision, the firm must be aware of its cost of capital. Once they know their cost of capital, they can deploy their funds in a way that the returns that accrue are more than the cost of capital which the company has to pay. Finding such investments and deploying the funds successfully is the investing decision. It is also known as capital budgeting and is an integral part of corporate finance.

Capital budgeting has a theoretical assumption that the firm has access to unlimited financing as long as they have feasible projects. A variation of this decision is capital rationing.

Here the assumption is that the firm has limited funds and must choose amongst competing projects even though all of them may be financially viable. The firm thus has to select only those projects that will provide the best return in the long term.

Financing and investing decisions are like two sides of the same coin. The firm must raise finances only when it has suitable avenues to deploy them. The domain of corporate finance has various tools and techniques which allow managers to evaluate financing and investing decisions. It is thus essential for the financial well being of a firm.