How Does Corporate Finance Work?

bulram | July 18, 2012

How does corporate finance work

In order to understand how corporate finance works you have to start by understanding what corporate finance really is. Corporate finance therefore involves dealing with monetary decisions for a business enterprise. The major role of corporate finance is to capitalize on shareholder value. Corporate finance is managed in two ways and that is through making long term and short term decisions. Long term decisions may determine which projects need to be financed as well as determining when to pay shareholders. Short term decisions deal with current assets and liabilities, this involves the use of a corporate finance account to manage cash including short term borrowing and lending activities.

The use of a corporate finance account is governed by the corporate finance manager. Corporate finance mangers use a corporate finance account to maximize the value of their firm by investing its finances into projects. Finance managers thus have to do what is known as capital budgeting. In managing a firm’s capital a corporate finance manager has to estimate the financial benefits of investing in each and every project as well as predicting future cash flows.

Corporate finance managers have to be well versed in project evaluation. The value of a project is generally estimated the discount cash flow valuation. This procedure involves calculating all increases in cash flow against time for a specific project. Future cash flows are then discounted from the project so as to come up with the projects current value. The current values of projects are then summed up to come up with the net present value (NPV). NPV is then used to determine which projects can then be selected to improve a firm’s performance in business.

A firm’s finances generally come from capital that has been generated by the firm as well as capital coming from external investors. Thus as a financial manager you have to identify the capital structure that results in maximum growth of the firm. Financing projects from borrowed money creates a liability which has to be serviced. The debt is to be serviced regardless of the success of the project thus this kind of capital investment carries a high risk component. Equity financing on the other hand is different for it has a lower risk component. Although equity financing has a lower risk as regards cash flow, it however results in dilution of share ownership, control and earnings.

The role of a financial manager is to manage the long term aspects of a firm’s finances. This means perfectly timing the cash flows and also managing any potential gaps which may result in asset liability mismatches. Financial managers may also keep their firms afloat by avoiding external finance while accepting internal finance. This helps the firm avoid new equity financing which can also allow the firm to secure new debt financing at reasonably low interest rates. Corporate finance managers also use a corporate finance account according to the conditions of a given economy. This way a firm looks for cheaper types of financing depending on the market conditions.