Lesson 1: What’s Corporate Finance all about?

Today, We are going to take a 10,000 feet view of Corporate Finance. The primary purpose here is to develop some intuition about the internal and external factors affecting decision making in companies.

What is a company? In simple words — A company is a legal entity created for individuals to conduct business. When you think of a company being created, think of it as the birth of an artificial person. He has rights, can own land, take loans, has to pay taxes and is liable for his actions (can be sued in court).

There are primarily two main types of companies:

1. Sole proprietorship or partnership — for a business owned by one person or multiple people respectively.
   Pros: Taxes can be included in personal tax returns for the owners. (which is a considerably lower rate as compared to Corporate tax)
   Cons: Unlimited liability. Owners are directly responsible for the actions of the company and can be sued.
2. Corporation — represents a legal entity created to separate the ownership (shareholders) from control (management) of the company.
   Pros: Limited liability (very difficult to sue the owners in court)
   Cons: Taxes are higher than personal tax rates because of double taxation. The company has to pay Corporate tax on its income, and the shareholders pay taxes on the return they receive from the company.

The main goal of a company is to maximize its overall value and current stock prices (if public). The primary way in which the company achieves that is by investing in real assets.

What are Real assets? These are assets that have intrinsic worth due to their substance and properties. They can be tangible (something you can kick, like plant and machinery) or intangible (like brand name, patents and other intellectual property).

Corporations invest in real assets that contribute to generating revenue. Raising funds for these investments is referred to as financing the investments. Corporations finance their investments by selling financial assets (also known as securities).

What are Financial assets or securities? These are claims that the corporation sells on the cash flow the real assets are going to generate. Financial assets are financial instruments that have monetary value and can be traded. They are also highly liquid as compared to real assets, meaning it is considerably easy to convert them to cash rather than selling real estate or machinery.

So, now we understand that the company needs to maximize its overall value and it achieves this goal by making two principal financial decisions:

1. What investments should the corporation make? (investment decisions)
2. How should it pay for the investments? (financing decisions)

It is important to note that making the right investment decisions add way more value than making the right financing decisions. It’s usually the profitability of the corporate investments that separates winners from the pack.

When these decisions are made right, the company becomes attractive to investors. Now let’s take a step back to understand the investor’s point of view.

What would make you invest in a company? You would invest if you can receive higher returns from investing in that company as compared to what you can earn by investing in other companies or financial instruments in the market. This is a very simple yet powerful thing to keep in mind. The moment the investors feel they can earn higher returns for themselves by investing in a competitor or some other company, they will pull the plug causing the stock prices to fall.

Let us consider that the company has been successful in raising funds and has splendidly conducted business over the past year. The company has been able to generate substantial amounts of profits and now the decision that the leaders of the company need to make is: whether to reinvest the cash in the company or give it back to the investors in terms of dividends (returns on the shares). This is the classic trade-off that plagues investment decisions.

When the firm reinvests cash rather than paying it out, the shareholders forego the opportunity to invest that cash for themselves, the return they are giving up, as a result, is called the opportunity cost of the capital. If the firm’s return on investment is higher than the opportunity cost of the capital, the stock price increases, else it falls.

In conclusion, there are 5 principles you need to keep in mind:

1. Corporate finance is all about maximizing value
2. The opportunity cost of capital sets standard for investments
3. A safe dollar is worth more than a risky dollar (investors are risk-averse)
4. Smart investment decisions create more value than smart financing decisions
5. Good governance matters — to prevent conflict of personal interest of leaders of the company with that of shareholder’s interests.

That’s it for today. I hope you got some idea about how companies work and what motivates them, the main purpose was to give you the big picture before we dive deeper into more complex concepts that are absolutely crucial in understanding Corporate Finance.

I’d love to hear from you- post your comments and share the knowledge!

You got this,
Naman Doshi

Quote of the day:
“That there is no secret is the biggest secret of Wall Street and of any specialized industry. Very little in the financial world is so complex that you cannot grasp it. The fundamentals, as their name implies, are basic and relatively uncomplicated. The only factor complicating financial information is jargon, overly complex statistical analysis and complex formulas that don’t convey information any better than straight talk.” — Michael C. Thomsett