9 Principles of Corporate Finance You Need To Know

Are you interested in knowing the basics of corporate finance? Have you always wondered what goes into the day-to-day operations of a company?

Corporate finance is an interesting and complicated topic. With that said, this article will provide a few principles of corporate finance you need to know. This article will describe the difference between debt and equity financing, explain how companies acquire financing, and introduce the idea of shareholder value maximization. If you’re looking for some basics, read on to learn how these principles are applied to a business's management decisions.

 

Introduction to Corporate Finance

The principles of corporate finance are applied in every day operations of a business. In this article, we'll introduce you to seven basic concepts that you may find helpful when navigating your company's finances.

 

The Cost of Capital

The cost of capital is the return a company will pay to investors in order to raise funds. It's also known as the hurdle rate, or the return required on an investment before it's considered worthwhile. The cost of capital is found by taking into account the risk and opportunity cost of debt versus equity financing, as well as other factors that affect the decision to borrow or invest equity.

Companies need financing to grow their business. In order for a company to be able to grow its business and make profits, it must have access to capital that it can use in different ways. For example, when a company needs money, it can either rely on equity-based financing or debt-based financing.

Debt-based financing entails borrowing money from external sources (such as banks) in order to fund its operations; whereas equity-based financing relies on resources provided by owners' investment into a company's stock. In both cases, each type of financing comes with its own set of risks and incentives (e.g., interest rates).

Investors expect companies to pay back their debt or equity investments with interest over time; however, they also take into account risk within these investments and therefore charge higher interest rates for certain types of debt.

 

Lending vs. Borrowing

When a company wants to acquire capital, it can do so in two ways: lending or borrowing. Companies that want to lend money are called lenders and companies that want to borrow money are borrowers.

Lenders can offer financing at a lower rate than the market-rate interest rate. This is because their investments have more risk associated with them. On the other hand, borrowers can offer financing at a greater rate than the market-rate interest rate because they have less risk associated with their investment.

Lenders and borrowers typically differ in terms of how much risk they take on which might be why some companies choose one option over the other.

This means that loans will typically carry a higher interest rate than borrowings which makes it more expensive for companies to use loans as compared with borrowings.

 

Cost of Debt

Companies usually use debt financing for two purposes: to acquire a specific asset, or to raise capital. When companies use debt financing for the first purpose, they are required to pay interest on the loan as well as repay the loan at a certain date. For example, borrowing money from a bank might allow you to purchase an asset such as a piece of equipment. Or it could allow you to invest in inventory or other assets that will generate revenue in the future. On the other hand, in order to raise capital by issuing bonds, companies are taking a chance on receiving additional investors’ cash.

If you're looking for some basics on corporate finance, you'll want to learn about the cost of debt and equity financing.

 

Intrinsic Value

Intrinsic value is the value a company has in its own right, before any debt or equity is accounted for. The intangibility of this value is what makes it difficult to calculate and compare to other companies.

A company's intrinsic value is based on its production-based assets: its inventory, property, and human resources. These are the three different types of assets that contribute to intrinsic value. They can be seen as an investment in the company's future, which helps it become more valuable over time.

Suppose your company produces $1 million worth of products per year, costs $500,000 per year to maintain and make $100,000 annually selling them in the market. The net income from these calculations would be $200,000 per year or $2 million per decade (10 years). With this information in mind, you can see that the total intrinsic value for this business is about $10 million.

 

Valuation

A company's valuation is the amount of money that a company is worth. The value of a company's stock, or ownership in a company, can be calculated. A valuation calculation will take into account the current price of the stock (or the share price) and all future dividends that are expected to be paid out.

Value is based on multiple factors including earnings per share (EPS), return on investment (ROI), and growth rate of EPS and other measures.

 

Risk

If you're considering taking on debt, the first thing to consider is the risk involved. Companies are often required to take on debt in order to grow and expand their business. However, taking on too much debt can leave a company unable to make its payments, leading to more financial trouble.

A company's decision on whether or not it should take on debt is based primarily off of how certain the company believes it can reduce its risk. This decision will also be dependent on how long the company wants to invest in a new project before determining if it's worth it.

 

Shareholder Value

We've all been taught that the main goal of a company is to make profits. However, not all companies operate with this goal in mind. There are some companies that have been built on the principle of maximizing shareholder value. This means that their shareholders get as much as possible for their money and investors are rewarded for taking risks.

This strategy has worked well for some companies and has led to high levels of profitability. The key to maximizing shareholder value is being able to estimate what your company will be worth in the future, given its current performance, sales volume, and rate of growth.

It's important to remember that not all companies follow this strategy equally. Some choose it because it can help them avoid bankruptcy later on in life, while others do so because they want more than just profits from their business—they want long-term success as well.

So how do you calculate shareholder value? It starts with understanding your company's financial statements and gauging its industry trends over time by taking into account fluctuations in supply and demand with regard to your capital goods or services.

 

Dividends and Earnings Per Share

In corporate finance, dividends are payments made to shareholders out of the company's profits. On the other hand, earnings per share is an indicator of how much profit a stock is making during a given period.

For example, let's say Company A has $100 million in revenues and $0 in profits for a given year but pays out $10 million in dividends. That means its EPS is $1 (it earns one dollar for each share it has outstanding). By contrast, Company B has $50 million in revenues and $5 million in profits for the same year and doesn't pay any dividends. Its EPS is still only $0. In this case, Company B would be considered more profitable on a per-share basis than Company A.

This difference between dividends and earnings per share highlights the importance of considering both aspects when measuring profitability as you decide which company to invest in.

 

Asset Valuation

If you are thinking about investing in a company, it's important to know the value of its assets. Then you'll be able to calculate how much a company would cost to buy.

What are assets? Assets are physical resources (land, buildings, equipment) and intangible resources (intellectual property, goodwill) that provide value for the company.

In order for the company to perform efficiently, it needs access to these resources. The company will have different types of assets; some are more liquid than others. Liquid assets like cash can easily be converted into other forms of capital like stocks or bonds while other assets may not be as liquid as they could use more time and effort to sell them off without significantly damaging their value.

You can only compare an asset's market price with its book value; this is what the asset's intrinsic value is. This intrinsic value is calculated by taking all of the asset's liabilities and subtracting their book values from their market prices. What remains is what an asset is worth in free and fair market conditions - this is called fair market value (FMV).

Date
2022-01-10