What is corporate finance? Any manager, even non-financial managers, should have a ready answer to this question. In fact, understanding financial finance can help you better understand how your organization works. Corporate finance is that discipline that regulates the decision on spending money for any large organization, so understanding it will help you know why your budget was cut. Well, look no further because this post will explain what is corporate finance.
What is Corporate Finance?
Let’s go straight to the definition of corporate finance.
Corporate finance is the branch of finance that deals with financing and investment decisions. Financing decisions are about “where to get the money”, while investment decisions are about “how to use the money”.
This simple definition really answers the question “what is corporate finance”. Yet, we can dive deeper and understand the implications. Particularly, we can explain better the two parts of corporate finance: financing decisions and investment decisions. While they are commonly mentioned in that order, in general you do an investment decision first, and a financing decision as a consequence. In short we will see why.
- Investment decisions are about deciding which project to pursue, evaluating which projects make sense to undertake from a financial point of view, and how much each project is worth.
- Financing decisions are about deciding how to get the money to fund your project. Once you selected the project you want to pursue, you can use excess cash, borrow money, issue new stock to investors, or a combination of these.
Now that we have a general overview of corporate finance, we can deal with its two branches.
Investment Decisions
We cannot really answer “what is corporate finance” without addressing investment decisions. You know that already, these decisions are about how to invest money, selecting which projects and investments to pursue.
The idea is that any company will have multiple potential projects in the way at the same time. To better manage the company, you need to pick the best project among the alternatives that you have, and corporate finance can help you with that. With corporate finance, you can assess whether your project will be profitable, and compare it to other projects for profitability.
Since the company does not have unlimited money, you will have to select only the projects that are more valuable to the company, from the most valuable to the least valuable, until you don’t have money available any longer.
How does corporate finance decide how profitable is a project? There are many formulas to use: Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Rule. However, the best and more accurate way is to always use the NPV calculation. If you don’t know about it, you should definitely read the ultimate guide about NPV.
Financing Decisions
Once we decide which project or projects to pursue, corporate finance kicks in once again to decide how to obtain the money to do the projects. We need to address this part as well to better understand “what is corporate finance”.
There is no such thing as a free meal, nor as a free project. Everything has a cost, and most things cost money (in addition to other costs, such as time). So, it is crucial that we secure the funding that we need for our project.
This may sound like a complex decision, and it is, but conceptually it is surprisingly simple. You only have to select the proper mix of two components for the funding of your project.
- Debt, how much money to borrow from people/banks demanding a recurring payment afterwards
- Equity, how much money to raise from investors, who cannot demand a recurring payment but because of this uncertainty will ask you to pay higher interest
Wait, why do we have to choose only between debt and equity? Can’t we just use cash? Yes, of course we can use cash, but in reality using cash means increasing debt, so it counts as debt. In fact, holding cash in the bank means having a negative debt.
Let’s expand on this a bit. Imagine you have a loan for $10m, and you have $1m in cash in the bank. You could use that $1m of cash to repay part of the loan straight away, so your real net debt is $9m. If you didn’t have the loan and just had the cash, your net debt would be -$1m (negative debt). So, if you decide to use up part of your cash reserve, say $500k to fund your project, you will increase your debt (to $9.5m if you had the loan, to -$0.5m if you hadn’t).
Debt is cheaper: you pay lower interest. However, people lending you money demand payment, and if you are unable to meet the requests you will face bankruptcy. Hence, debt increases risk of bankruptcy for the company. Instead, equity is a more expensive way of funding because investors do not demand a specific payment schedule, but because of it will only settle for a higher return than lenders.
To sum it up, financing decisions are about trading off the cost of financing with the flexibility. Not only that, corporate financiers need to consider the whole picture and see how each project impact the debt-equity ratio for the entire company, and adjust financing accordingly. Most likely, not all projects will be funded in the same way in a large organization.
Who uses corporate finance?
Finally, to better understand “what is corporate finance”, we can look at who uses it. This is because all of this may sound a little abstract to people operating outside of finance departments, or in large divisional organizations that work in silos.
In short, all large organization use corporate finance. If they don’t, they probably have a structural problem that sooner or later will come to the surface. With large organizations, we do not mean large financing institutions such as banks or hedge funds. Those will use a lot of financial tools for sure, but here we mean large corporations. Top players like J&J, P&G, Apple, and so on.
Corporate finance is part of the curriculum of virtually any MBA program, so even small companies that hire MBAs to get their organization in check will likely implement corporate finance at some point.
Since corporate finance can help you make better decisions on which investments to pursue, and how to fund them, any organization can potentially benefit from this discipline, regardless of the size.
Caveats and Challenges to Corporate Finance
Now that you know the answer to “what is corporate finance?” you may have some questions buzzing into your mind, or even some challenges.
One of the most evident ones is: what about projects that do not have an apparent financial benefit? For example, a marketing campaign aiming to increase brand awareness and not necessarily boost sales. Corporate finance, by nature, assign a monetary value to every project (the NPV), that is benefit less cost to do the project. If the benefits (or the costs) are non-monetary, how can we use corporate finance? Well, we always need to estimate and convert everything into monetary terms. We can do that by estimating that brand awareness is worth $1m to us, or something like that. In fact, the biggest challenge with corporate finance is about making reliable estimates.
This leads us to our second caveat, which is precisely how to make reliable estimates. The best way is to look around us, both inside and outside the company, and compare them with what we are trying to do. Maybe even bring in a few consultants that have experience in similar projects. No matter how precise our estimates are, they will never be 100% precise. So, it is always recommended to do a sensitivity analysis.
Sensitivity analysis is about presenting how a change in an input value affects the NPV of the project. Imagine sales halve or double, or that the cost of the rent raises 30%, or that you will need 10% more of overtime that planned. For each variable, have a pessimistic, optimistic, and median value. Then, see which variables impact the bottom line the most. This can also help you understand, when running the project, where you have to pay more attention.
What is Corporate Finance: a Summary
In this brief guide we answered the question “what is corporate finance”. In short, is the discipline of finance that deals with how to manage the money in a company: where to obtain them, and how to use them.
It may sound counter-intuitive at first, but every single project in every single organization can benefit from applying corporate finance. Your organization makes no exception, so not it is time for you to go and advocate for this wonderful discipline in your company.
