Corporate finance decisions are primarily made to increase the market value of equity or improve the current value of the firm’s shares.
In summary, corporate finance management involves maximizing the firm’s value by budgeting for capital, restructuring the capital structure, and maintaining net working capital. The financing associated with corporations is known as corporate finance in very simple terms.
- Investing decisions:
Is the company interested in long-term assets (like land or buildings) or short-term assets (like inventory or raw materials)? Additionally, these decisions include how much and in what proportion the company should invest in such assets.
- Financial decisions:
When a company should take public funding (via an IPO) or seek funding from VC/PE firms, whether funds should be raised through equity sale (through shares) or debt financing (through loans or bonds), a decision should be made. Financial decisions also include choosing which financial institutions (e.g., IBs) the company should work with and which financial markets it should target.
- Decisions about risk aversion:
In making these decisions, the company aims to mitigate the risk associated with its various investments, not raise money. Hedging is the process of doing so. We can reduce the risk of our investments by using various financial instruments, such as futures and options. As an example, if we think the price of company X’s shares will rise, we can enter into a futures contract setting a price at which we will buy the shares. If the company’s share price rises and is greater than the spot price (price determined in the contract), we are in profit.
- Alternatives to debt financing:
The main advantage of corporate finance is that it provides an alternative financing source to debt. Startups that do not qualify for substantial bank loans can access angel investing, venture capital, and crowdfunding platforms. Equity financing does not involve the repayment of debt.
Suppose the company does not reach profitability right away through business finance. In that case, the company does not have to make a loan payment every month as debt financing is riskier than equity financing in this situation since the firm is not required to repay its investors.
- Keeping manufacturing costs low
Manufacturing costs can be minimized through financing. Raw materials, labor, etc., are increasingly expensive. Your management must take innovative steps to reduce the cost of manufacturing. Many organizations use finance to place a bulk order for raw materials, buy quality products at a discounted rate, buy software to reduce time-consuming paperwork, purchase automated machinery for mass production, etc.
- Ownership distribution:
Equity financing has a major disadvantage in that business owners give up some ownership and control. In the future, if the business is successful and profitable, a portion of the earnings must be distributed to shareholders in the form of dividends.
Venture capitalists typically require 30% to 50% ownership, especially for businesses with little financial experience. Founders and business owners are reluctant to give up so much control of their businesses, limiting their investment options.
- Tax shields aren’t in place:
Equity investments do not provide tax benefits compared to debt. It is not deductible to pay dividends to shareholders, but it is deductible to pay interest. As a result, equity borrowing becomes more costly.
The long-term cost of equity financing is perceived to be greater than that of debt financing due to investors’ desire for higher returns than lenders. Investors take on a great deal of risk when investing in a business, expecting a greater return.