Corporate Finance in 5 Minutes
Understand how big companies like Google make decisions.
Finance is not just numbers and formulas. Without it, our economy wouldn’t be able to operate.
There are 3 types of finance, public finance, personal finance, and corporate finance.
In this post, our goal is to analyze the 3 key decisions in corporate finance to help you gain a better understanding of how large companies make business decisions.
What is Corporate Finance?
Corporate finance is behind every major business decision.
“The ultimate purpose of corporate finance is to maximize the value of a business through planning and implementation of resources while balancing risk and profitability.” — Corporate Financial Institute
3 pieces of important information here:
- What’s the goal? Maximize firm value.
- How we’re doing it? By managing resources.
- What to base decisions on? Risk and profitability.
The 3 Decisions of Corporate Finance
Corporate finance is essentially based on 3 decisions: Investment, Financing, and Distribution. Every decision in corporate finance falls under these three areas.
I’ll try to explain them concisely, without formulas.
1 — The Investment Decision
What projects/opportunities should we invest our money in?
The investment decisions could be split into two parts — short-term and long-term. Short-term decisions concern working capital management, or how a firm should allocate its money to fund operations. Long-term decisions fall under capital budgeting, where firms filter out the best projects for it to invest in from many available opportunities.
But how do they do this?
They compare different projects by a set of metrics and accept or rank them based on specific criteria.
The two most used metrics are NPV and IRR, the value of the project today and the return it will generate for us.
Every firm has its own cost of capital — the “interest rate” they’re paying each year to have their funds — which is used to calculate those metrics to make decisions. And because of this, decisions among firms on the same project may differ.
Based on these criteria, the firm will select projects that are good to invest in (ie. will increase its value), and then allocate its funds between them.
2 — The Distribution Decision
How should we distribute excess cash?
Firms will get cash from operating, like from selling products to customers, and they have to decide what to do with it.
They have two options: 1) Put that money back into the company (reinvest) 2) Give it out (distribute)
So the decision comes down to, how much cash should we give out to our shareholders, and how should we do it?
They decide whether to reinvest or distribute typically by weighing how much return the owners will get in each case.
When there are great projects to invest in that give better returns than shareholders can get with the cash, the firm will keep the money and invest in those projects. Or, if personal taxes are too high and shareholders want to delay paying tax for dividends or capital gain, it might make more sense to keep the money if corporate taxes are lower.
Which distribution option should we use?
If the firm decides it will distribute some amount of cash to shareholders, it then needs to choose between several options.
You might be familiar with them — they can issue dividends in cash or stocks or buy back stocks from current shareholders.
Firms try to give shareholders as much value as possible by optimizing the decision against taxation. The challenge here is balancing the preferences of different groups of shareholders — since they don’t pay taxes the same way.
3 — The Financing Decision
Where should we get our money from?
A firm needs money, or capital, to operate, and there are multiple ways for them to get it — equity (stocks), debt, and anything in between.
This is exactly what the firm is deciding here: how much funding should we get individually from debt, equity, and other options?
This decision is the capital structure decision — the composition of a firm’s funding, or capital.
And within this composition, they will need to decide the type and specifics of each instrument to issue, but we won’t go there.
How do they decide?
Have you wondered why some companies sell bonds while others sell stocks?
Each option has its own pros and cons, so the decision really comes down to where the optimal balance is based on the firm’s unique situation.
To decide the mix of debt and equity, they weigh the benefits of debt against the costs.
To keep it simple, the main reason companies use debt is for tax benefits — the interest payments made on debt are tax deductible for the firm. And the downside of debt is that it increases the risk of the firm of going bankrupt because there is more financial burden and less future flexibility.
So the optimal structure, which companies usually try to maintain over time, is where the benefit is maximized while the risk is minimized.
And… that’s it!
This is how big companies use finance to make decisions — of what to invest in, how much to distribute, and where to get their funds.
If you’re new to corporate finance, I hope this was helpful to you. It was challenging to explain a whole course’s worth of content in 5 minutes, but I’ll keep working on making things clear and interesting in the future.
Also, unpopular opinion, finance is so interesting, don’t let anyone tell you otherwise.
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