In this post, we will give you 3 clear examples of corporate finance to explain what it is, and why it is important for business. If you are interested in pursuing a career in a corporation (not necessarily in finance), or start your own business, this is a must read. Let’s dive straight into the 3 clear examples of corporate finance.
What is Corporate Finance?
Before we dive into our 3 clear examples of corporate finance, a quick definition.
Corporate finance is the discipline of managing the financial resources of a company. It is about managing the investments the company makes (deciding where the money goes) and deciding how to fund these investments (deciding where the money must come from).
Simple enough, right? Well, as we will see in our examples of corporate finance, the ideas behind this definition are simple. In fact, corporate finance is quite simple – but it is not easy. Understanding it at a general level is straightforward, but making good corporate finance decisions is a whole different story.
This is no surprise – if it was easy, companies would not spend millions in their finance departments or pay whopping salaries to their Chief Financial Officers (CFOs) and Treasurers. Instead, companies know they need to invest in finance if they want to stay on top of their game.
3 Clear Examples of Corporate Finance
Example 1: Investment Decisions
The first of our examples of corporate finance is about investment decisions. These, however, are not the investments decisions that individuals or hedge funds make, not most of the time at least. In fact, individuals, hedge funds, banks and other financial institutions tend to buy stock, bonds, or other financial products. Instead, a company tend to make projects.
So, an investment decision for a company is about deciding which projects to pursue. Should we build a new factory? What about outsourcing the contact center operation? Is it the right time to launch a new advertisement campaign? You get the picture.
Of course, we call it corporate finance because we evaluate which projects to pursue at a financial level. To put it bluntly, we are trying to find out if we can make money out of a project. In order to do this, the finance department will have to account for all costs and potential benefits, as well as the uncertainty for each assumption. On top of that, they need to evaluate the time value of money, that is: how do we value money received in the future, compared to money received now?
All projects can be evaluated financially, even those that do not have direct financial benefits or costs. For example, refurbishing the cafeteria in the headquarter may just have costs, while the benefits will always be indirect: higher morale for employees, better image with customers and so on. We can estimate how these translate into financial terms, for example a higher morale may translate into a 5% productivity increase, and better image with customers may result in 2% more sales.
If you want to dive deeper into investments decisions, we have a detailed article on Net Present Value (NPV), which is the main tool we use to evaluate the financial viability of a project. Maybe you won’t become a CFO just by reading that article, but that is a good start anyway.
Example 2: Financing Decisions
The second of our 3 clear examples of corporate finance is about financing decisions. In our first example, we uncovered that corporate finance is about picking investments. Now, imagine we have decided a project worth pursuing: we will open a new factory in the Midwest.
We know our project is attracting from a financial point of view because the new factory will help us increase capacity, reach new customers, and cut down logistics costs around the area. We also know that this project is the best project we can pursue at this time. That is, it will generate more money than any other project we could undertake. To put it simply, we are 100% sure that the best use of our money is on this project.
While the destination of our money (the project) is clear, the source it is not. A financing decision will help us figure that out, and this is why we included it in our examples of corporate finance. In short, a company has three potential sources of money:
- Cash at hand, that they have in their accounts
- Issuing debt, promising a fixed payment to a lender
- Issuing equity, selling ownership of the company to investors
Corporate finance and financing decisions are all about finding the right blend of these sources for a given project. Without going too technical, know that cash is actually negative debt, because “having money” is the opposite of “borrowing money”. So, cash at hand and issuing debt are really all about debt anyway, so we only need to decide how to fund our project between debt and equity.
In short, debt is cheaper because you pay will have to pay a fixed amount to the lender, no matter the success of the project. As a result, the lender sees it as less risky and are willing to charge you lower interest than equity. This is because the return on equity totally depends on project or company performance, and investor may even lose it all. Hence, they demand a higher premium. Furthermore, debt payments are tax-deductible, while equity payments are not, making debt even more convenient.
There is a catch. With debt, you must make the payment, and if you are unable to the company will face bankruptcy. So, the more debt you have, the riskier the financial position of the company. Financing decisions are all about finding the right balance.
In our example, we can imagine that we are sure the factory will generate at least 1 million dollar a year even if things go south, so we can afford up to a 1 million dollar a year in interest payments without particular risk. If we pay 10% interest, then we can borrow 10 million and use it to finance the project. If the project costs 50 million, then we will have to come up with the remaining 40 million with equity.
Quick tip: when you hear about capital structure, it refers to this tradeoff between equity and debt.
Example 3: IPO, LBO, M&A and Other Corporate Transactions
Investment decisions and financing decisions are the bread and butter of corporate finance. In fact, these are the two examples of corporate finance that always hold true. There are special cases of investments and financial decisions that we may have to deal with exceptionally. We call the corporate finance transactions.
- IPO is the acronym of Initial Public Offering. It is “taking the company public”, which means you start with a company owned by owners or other private investors such as hedge funds and venture capitalists, and put it on the market: you make it tradable on the stock exchange. Before the IPO, it is hard to buy and sell company shares, and after it becomes much easier, and every day you have the quoted price the market is willing to pay for your company. This is mostly a financing decision
- LBO is the opposite of an IPO, it stands for Leveraged Buy-Out. It is “taking the company private”. Simply put, the company is already trading in the stock exchange, but decides to take on debt to buy its own stock. Generally, it happens when things are not going so well and the company needs to scale down. This is also a financing decision.
- M&A is short for Mergers and Acquisitions. With this approach, the company buys another company with the hope of creating synergies and better address the needs of the market. In a merger, a company merges with another company of similar size, creating a new, larger, company. In an acquisition, the company buys a smaller company and interiorize it. This is a financing decision but also an investment decision, because you think you will generate synergies with this transaction.
- Spin-off is the opposite of an M&A. Here, instead, the company decides to sell off a division or a business unit. It may sell it to a single investor, or to the market by an IPO only for the individual unit.
There are countless corporate finance transactions, and they are beyond the scope of this article of clear corporate finance examples. Nonetheless, you get the idea that corporate finance is involved in complex strategy operations the company tries to execute.
Corporate Finance Examples in Summary
We can have a quick recap (TL;DR) about these 3 clear examples of corporate finance.
Corporate finance is about investment decisions: deciding for the company which projects make sense financially. For example, it is deciding if a new plant is worth opening and if a new advertisement campaign is worth launching. Crucially, this is possible by estimating the net value of each project.
Corporate finance is also about financing decisions: once we know which projects to tackle, we need to decide on how to fund them. It involves trading off the cheapness of debt with the flexibility of equity, which is more costly (stockholders demand higher return than lenders).
We mentioned also many other corporate finance examples, related to corporate finance transactions. Those are exceptional events that can significantly change the nature and structure of the company.
With these examples of corporate finance you can start to better understand how things unfold in the corporate world, and hopefully start to think if a career in corporate finance is worth pursuing for you. If you want to go deeper, you can have a look on Investopedia.
