What is Corporate Finance? Definition, Importance, Functions

  • Post last modified:21 April 2021
  • Reading time:18 mins read
  • Post category:Corporate Finance
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What is Corporate Finance?

Corporate finance is concerned with the planning and controlling of the firm’s financial resources. It is also referred to as financial management and includes planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise.

Financial management means applying general management principles to financial resources of the enterprise. Till 1890, it was a branch of economics and as a separate discipline corporate finance has recent origin.

Corporate finance has been defined differently by different scholars. A few of the definitions are being reproduced below:-

Financial Management is an area of financial decision making harmonizing individual motives and enterprise goals.Weston and Brigam
Financial Management is that managerial activity which is concerned with the planning and controlling of the firm’s financial resourcesI.M. Pandey
The activity concerned with the planning, raising, controlling and administering of funds used in the business.Authman and Dongall

Evolution of Corporate Finance

During 1930s and 1940s, it was concerned of raising adequate funds and maintaining liquidity and sound financial structure. It is known as the ‘Traditional Approach‘ to procurement and utilization of funds required by a company. As per traditional approach corporate finance was regarded as an art and science of raising and spending of funds.

The need for most profitable allocation of capital was recognized during 1950’s. During 1960s and 1970s many scholars have introduced various analytical tools and concepts like funds flow statement, ratio analysis, cost of capital, earning per share, optimum capital structure, portfolio theory etc.

As a result, a broader concept of finance began to be used. Thus, the modern approach to finance emphasizes the proper allocation and utilization of funds in addition to their procurement.

Importance of Corporate Finance

From the above definitions, it is clear that financial management or corporate finance is that specialised activity which is responsible for obtaining and effectivety utilizing the funds for the efficient functioning of the business and, therefore, it includes financial planning, financial administration and financial control.

Following points highlights the importance of corporate finance in a firm:

For Incorporation of Company

Finance is needed for starting a company. It is needed for preparing Project Report, Memorandum of Association (MOA), Articles of Association (AOA), Prospectus, etc. It is needed for purchasing both fixed assets (land and building, machinery) and current assets (raw material and other stock etc.). It is also needed to pay wages, salaries and other expenses. In brief, we cannot start a company without finance.

For Smooth Functioning of Business

Finance is needed for conducting the business smoothly. It is needed as working capital. A company cannot function smoothly without finance

Expansion and Diversification of Business Activities

Expansion is to increase the size of the company. Diversification means to produce and sell new products which can be related or unrelated to the existing business. New machines with latest technologies and techniques are needed for expansion and diversification. Finance is needed for purchasing modern machines and modem technology. So, finance becomes mandatory for expansion and diversification of a company.

Meeting Contingencies

The Company has to meet many unforeseen events. For example sudden fall in sales, loss due to natural calamity, loss due to court case, loss due to strikes, etc. The company needs finance to meet these possibilities.

Research and Development

In today’s competitive world, a company cannot survive without continuous research and development activities. Company has to go on making changes in its old products as per the market requirements and also invent new products to sustain in the industry. Corporate Finance is needed for research and development.

Motivating Employees

Manager and employees must be continuously motivated to improve their performance. They must be given financial incentives, such as bonus, higher salaries, etc. They must also be given non-financial incentives such as transport facilities, canteen facilities etc. All this requires finance.

Government Agencies

There are many government agencies such as Income Tax authorities, Sales Tax authorities, Registrar of Companies, Excise authorities, etc. The company has to pay taxes and duties to these agencies. Finance is needed for paying these taxes and duties.

Payment to Dividend and Interest

The Company has to pay dividends to the shareholders on their shareholdings. Also, it has to pay interest to the debenture/bond holders, banks, etc. and also repay the loans and bonds amount at maturity. Finance is needed to pay dividends and interest.

Replacement of Assets

Fixed assets such as land, plant and machinery are the main assets of the company. They are used for producing goods and services. However, after some years, these assets become old and obsolete and hence need to be replaced with new assets. Finance is needed for replacement of old assets through buying new apssets.

Corporate Finance Functions

functions of corporate finance is divided into two broad categories:

  • Traditional Approach
  • Modern Approach.

The modern approach states that corporate finance covers both acquisition of funds as well as their effective allocation and utilization. The modern approach is an analytical way of looking at the financial problems of a company.

Accordingly, corporate finance in the modern approach can be broken down into following four decision or functions:-

  1. Investment decisions or Capital budgeting decisions
  2. Financing decisions or Capital structure decisions
  3. Dividend decisions or Profit allocation decision
  4. Liquidity decisions or Working capital management decision

Investment Decisions

Investment decisions are concerned with the commitment of financial resources to long- term profitable opportunities. It refers to the selection of long term assets in which the funds will be invested by a firm. These decisions include the allocation of financial resources to the contemplated activities of the firm.

Alternatively, it is also referred as capital budgeting decision and broadly involves determination of requirement of financial resources. The capital budgeting decisions provide the planning, coordination and control of the capital expenditure (long-term expenditure).

A capital budgeting decision may be defined as the firm’s decision to invest (cash outflows) its current funds efficiently for a longterm in the anticipation of cash inflows over a series of years.

These long term assets are those assets that affect the firm’s operations beyond the one- year period. Investment decisions focussed on the desirability of investment in expansions, acquisitions, modernization & replacement and divestment activities of a business with a view to create value for its shareholders.

Investment decisions involves two important aspects (i) the evaluation of the prospective profitability of new investments, and (ii) the determination of cut-off rate against which the prospective return of a new investment could be compared.

Investment decisions have following features:

  • The exchange of certain current funds for future unexpected benefits
  • Commitment of large or huge funds
  • Irreversible or reversible at significant loss
  • Influence the firm’s growth in long term
  • Have affect on the risk of the firm

In brief, three main elements of capital budgeting or investment decisions are:

  • Long term assets and their composition
  • Risk of the firm (business risk)
  • Concept and calculation of the cost of capital

Financing Decisions

Financing decisions are concerned with financing-mix or capital structure or leverage. Once firm has decided in which assets it want to invest the next question arise from which sources these assets will be financed.

There are primarily two sources of funds available equity and debt. Suppliers of equity capital called shareholders or owner of the firm and they provide capital with no fixed and assured reward. Shareholders assume risk of getting no reward at all and therefore also called as residual equity. They have voting rights on the decision making and control the affairs of the firm.

On the other hand, Debt providers such as bondholders, debenture holders, Banks and other financial institutions (providers of loan capital) receive fixed return (in form of interest) quite independent of the performance of the firm.

Capital structure

Refers to the mix of equity and debt. The financing decision relates to the choice of the proportion of these sources to finance the investment requirements of a firm.

Since both debt and equity have different cost of capital, a fiancé manager must strive to obtain the best financing mix or the optimum capital structure (where market value of the shares is maximized).

A finance manager has to decide how much debt and equity should be raised to finance the assets of the firm. One aspect which is important for determining this mix or proportion is cost of capital of debt and equity funds.

Dividend Decisions

The third major financial decision of corporate finance is dividend decision. Dividend decisions are related to rewarding the owners of the firm, i.e. the shareholders, for investing their money in the firms.

The dividend is paid to the shareholders from the operating profits of the firm (net operating profits after taxes), after meeting all the related cost and expenses. The dividend decision should be analysed considering the financing decision of a firm.

A firm have two alternatives available for dealing the profits:

  • Profits can be distributed to the shareholders in form of dividends
  • They can be retained in the business itself also referred as retained earnings or ploughing back of profits.

Liquidity Decision

For a firm, it is very important to maintain a liquidity position to avoid insolvency. Firm’s profitability, liquidity and risk all are associated with the investment in current assets. In order to maintain a trade-off (balance) between profitability and liquidity, it is important to invest sufficient funds in current assets.

But since current assets do not earn anything for business therefore a proper calculation must be done before investing in current assets.

Current assets should properly be valued and disposed of from time to time once they become non profitable. Currents assets must be used in times of liquidity problems and times of insolvency.

Therefore, current assets management which affects a firm’s liquidity is yet another important finance function, in addition to the management of long-term assets.

Current assets should be managed efficiently for safeguarding the firm against the dangers of illiquidity and insolvency. The profitability- liquidity trade-off requires that the finance manager should develop sound technique of managing working capital. It is the dusty of the finance manager to ensure that funds would be available when needed.

Role of Finance Manager

The function performed by finance manager can be categorized under the following heads:

  • Analysing and evaluating the investment activities: The finance manager has to evaluate the investment alternatives and decide how to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible as per the objectives of the firm.

  • Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the firm. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of firm.

  • Determination of capital composition: Once the estimation of capital requirement has been made, the capital structure has to be decided. This involves debt-equity analysis. Finance manager need to decide how much debt and how much equity need to be raised from the market. The choice of method will depend on the relative merits and demerits of each source and period of financing.

  • Management of surplus: Finance manager has to decide about how to dispose the net profits of the firm. This can be done in two ways (a) dividend declaration which includes identifying the rate of dividends and other benefits like bonus and (b) retained profits – The volume has to be decided which will depend upon expansion, innovation, and diversification plans of the company.

  • Management of cash: Finance manager has to make decisions with regards to cash management. A firm require cash for various purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of inventory, purchase of raw materials, etc.

  • Financial control: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances of the firm. This can be done through many techniques like ratio analysis, financial statement analysis, financial forecasting, cost, volume and profit control (CVP), etc.

  • Understanding Capital Markets: As we know that share of a public company are traded on stock exchanges and there is a continuous sale and purchase of securities. Hence, a clear understanding of capital market is an important function or role of a financial manager. When securities are traded on stock market there involves a huge amount of risk involved.

    Therefore a financial manger understands and calculates the risk involved in this trading of shares and bonds. The practices of a financial manager directly impact the operation in capital market and therefore a clear understanding is must for efficiently discharging its duties.

    In the globalized environment, financial markets are integrated and knowledge of domestic capital market is not enough therefore, a finance manager needs to be aware about the functioning of world capital markets.

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