Explain the functions and objectives of Corporate Finance


Corporate Finance :

Corporate finance is the field of finance dealing with financial decisions that business enterprise make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value while managing the firm’s financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms. The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the short-term balance of .current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending.

Corporate finance covers every decision a firm makes that may affect its finances which can be grouped into five areas for the conceptual understanding.

1.      The first is the objective function, where we define what exactly the objective in decision making should be.

2.      The second is the investment decision, where we look at how a business should allocate of resources across competing uses.

3.      The third is the financing decision, where we examine the sources of financing and whether there is an optimal mix of financing.

4.      The fourth is the dividend decision, which relates to how much a business should reinvest back into operations and how much should be returned to the owners.

5.      Finally, there is valuation, where all of the decisions made by a firm are traced through to a final value


Functions of Corporate Finance :

1.      Acquisition of Resources : Acquisition of resource indicates fund generation at the lowest possible cost. Resource generation is possible through:

(a)   Equity : This includes proceeds received from retained earnings, stock selling, and investment returns.

(b)     Liability  : This includes warranties of products, bank loans, and payable account.

2.      Allocation of Resources : Allocation of resources is nothing but investment of funds for profit maximization. Investment can be categorized into 2 groups:

(a)     Fixed Assets – Buildings, Land, Machinery etc.

(b)     Current Assets – cash, receivable accounts, inventory, etc. Broad Functions of Corporate

Finance are :

(1)     Raising of Capital or Financing

(2)     Budgeting of Capital

(3)     Corporate Governance

(4)     Financial management

(5)     Risk Management


Objective of Decision making in corporate Finance :

1.      Long term decisions : This includes capital investment decisions like viability assessment of projects, financing it through equity and/or debt, pay dividend or reinvest the profit. Long term corporate finance decisions that are normally related to fixed assets and capital structure are known as Capital Investment Decisions. Senior management always targets to maximize the value of the firm by investing in projects having positive Net Present Value. If such opportunities are not arising then reinvestment of profits should be stalled and excess cash should be returned to shareholders in form of dividends. Thus, Capital Investment Decisions constitute 3 decisions :

(a)     Decision on Investment

(b)     Decision on Financing

(c)     Decision on Dividend

2.      Short term decisions :

These are also called working capital management decisions which try to strike a balance between current assets such as cash, inventories, etc and current liabilities i.e. a company’s debts/obligations impending for less than a year.

          Principles of Corporate Finance :

The broad principles of corporate finance are:

1.      Investment Decision

2.      Financing Decision

3.      Dividend Decision

4.      Liquidity Decision

1.      Investment Decision : The firm has limited resources that must be allocated among challenging uses. On the one hand the funds may be used to generate added capacity which in turn generates additional revenue and profits and on the other hand some investments results in lesser costs. In financial management the returns, from a proposed investment are compared to a minimum acceptable hurdle rate in order to accept or reject a project. The hurdle rate is the minimum rate of return below which no investment proposal would be accepted.

2.      Financing Decision : Another important area where financial management plays an important role is in deciding when, where, from and how to acquire funds to meet the firm’s investment needs. These aspects of financial management have acquired greater importance in recent times due to the multiple avenues from which funds can be raised. Some of the widely used instruments for raising finds are ADRs, GDRs, ECBs Equity Bonds and Debentures etc. The core issue in financing decision is to maintain the optimum capital structure of the firm that is in other words, to have a right mix of debt and equity in the firm’s capital structure. In case of pure equity firm the shareholders returns should be equal to the firm’s returns. The use of debt affects the risk and return of shareholders. In case, cost of debt is used the firm’s rate of return the shareholder’s return is going to increase and vice versa. The change in shareholders return caused by change in profit due to use of debt is called the financial deverage.

3.      Dividend Decision : Dividend decisions is the third major financial decision The share price of a firm is a function of the cash flows associated with the share. The share price at a given point of time is the present value of future cash flows associated with the holding of      share. These cash flows are dividends. The finance manager has to decide what proportion of profits has to be distributed to the shareholders. The proportion of profits distributed as dividends is called the dividend pay out ratio and the retained proportion of profits is known as retention ratio.

4.      Liquidity Decision : A firm must be able to fulfill its financial commitments at all points of time. In order to ensure this the firm should maintain sufficient amount of liquid assets. Liquidity decisions are concerned with satisfying both long and short-term financial commitments. The finance manager should try to synchronise the cash inflows with cash outflows. An investment in current assets affect the firm’s profitability and liquidity. A conflict exists between profitability and liquidity while managing current assets. In case, the firm has insufficient current assets it may default on its financial obligations. On the other hand excess funds result in foregoing of alternative investment opportunities.

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MT UVA- University, Vocational and Affiliated Education for BMS


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