Corporate finance is based on two fundamental rules. All tools and techniques of corporate finance are mere ways and means of implementing these rules. These rules can be found at the beginning of any and every corporate finance text book. One of these rules relates to the concept of return while the other relates to the concept of risk. We have described both these rules in this article. They are as follows:
Rule #1: Money today is worth more than money tomorrow
The fundamental rule of corporate finance is that the timing of cash flows is of paramount importance. Also, we want the timing of the cash flows to be as soon as possible. The sooner we get the cash, the better it is for our company. Every dollar that the company has in cash today is better than the same dollar in cash tomorrow because of the following reasons:
- Inflation: Inflation eats into the purchasing power of the company’s funds constantly with the passage of time. Thus if the company had the same nominal amount of money today or a year from now, they would be able to purchase more goods and services with the money that they have today as compared to the same amount of money a year later. Thus, to offset the effect of inflation, companies must conduct their business in a manner that they ensure that cash is received as soon as possible.
- Opportunity Cost: Also, every dollar that the company is not receiving has an opportunity cost of capital. Let’s say the company’s debtors owe it $100 and they pay $100 the next year. The nominal value of the money that they have paid is $100 however the real value is less. This is because had the debtors paid immediately, the company would have cash immediately on hand. They could then invest this cash in risk free securities and could have earned a year’s interest on the same. By accepting the same $100 a year later, the company has in effect loaned out $100 to its debtors and that too interest free!
Rule #2: Risk free money is worth more than risky money
Corporate finance involves exchanging between present and future streams of cash flows. Companies may come across different projects which offer different future cash flows. However, it is important to realize that all cash flows are not equally likely to materialize in the future. Some cash flows may be almost certain like investing in treasury bonds while others may be highly uncertain like projected returns from stock market investments. Hence, the second rule states that the company must adjust each of these cash flows for their risk before making any comparisons and selections. The following factors must be considered:
- Return of Capital: Some projects are extremely risky. Here, the company is concerned about whether or not the money they are investing will be recovered. A higher rate of return must be demanded from such projects to offset the likelihood of losing their entire capital that the investors face.
- Return on Capital: In other cases the cash flow may be a little less uncertain. In these cases, companies must consider the low risk before making their decision.
The bottom line is that before making a choice, all projects have to be made comparable. This is done by adjusting for cash flow that will be received in different time periods as well as adjusting for the different amounts of risks that are involved in different projects.
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FAQs
� The Financing Principle: Choose a financing mix (debt and equity) that maximizes the value of the investments made and match the financing to nature of the assets being financed. � The Dividend Principle: If there are not enough investments that earn the hurdle rate, return the cash to the owners of the business.
What is the fundamental concept of corporate finance? ›
The fundamental concepts of time value of money, cost of capital, and cash flows are integral to corporate finance, assisting businesses in evaluating investments, financial decision-making, and maintaining healthy financial operations.
What are the general principles of corporate finance? ›
Let's first understand that the Fundamentals of Corporate Finance revolve around three cardinal principles: The Investment Principle, The Financing Principle, and The Dividend Principle.
What are the two major functions of corporate finance? ›
The main areas of corporate finance are capital budgeting (e.g., for investing in company projects), capital financing (deciding how to fund projects/operations), and working capital management (managing assets and liabilities to operate efficiently).
What are the two key aspects of the financial planning process? ›
Two key aspects of financial planning are cash planning and profit planning. Cash planning involves the preparation of the cash budget and profit planning involves preparation of pro forma statements. To make cash budget and pro forma statements for a firm, accounting knowledge is needed.
What are the three fundamental decisions in financial management? ›
When it comes to managing finances, there are three distinct aspects of decision-making or types of decisions that a company will take. These include an Investment Decision, Financing Decision, and Dividend Decision.
Which of the following is not a fundamental concept in corporate finance? ›
Answer: DOUBLE ENTRY BOOK KEEPING is not a fundamental concept in corporate finance.
What is the fundamental element of corporate governance? ›
One of the fundamental objectives of corporate governance is for companies to develop more transparent business practices, meaning a rigidly structured framework through which to trace all such activity efficiently. Corporate governance encompasses a business's accountability to each of its stakeholder groups.
What are the five basic corporate finance functions? ›
The five basic corporate functions are financing (or capital raising), capital budgeting, financial management, corporate governance, and risk management. These functions are all related, for example, a company needs financing to fund its capital budgeting choices.
What is corporate principles business? ›
The Definition
Corporate principles are distinct from mission, vision, and value statements. They guide decision-making, especially during crucible moments, and help companies explain their choices to key stakeholders.
The purpose of the finance function
There are two main purposes of the finance function: to provide the financial information that other business functions require to operate effectively and efficiently. to support business planning and decision-making.
What is the role of corporate financial management? ›
Corporate financial management is a way to ensure that people receive a good return on their investment. This is done through proper investment planning and management of all the money in order to be able to get a suitable profit in the future.
Is corporate finance hard to learn? ›
Finance degrees are generally considered to be challenging. In a program like this, students gain exposure to new concepts, from financial lingo to mathematical problems, so there can be a learning curve.
What is the principle of financial decisions? ›
The concept of the time value of money is a basic principle of finance. It states that a certain amount of money today is worth more than the same amount in the future due to its earning potential. By understanding this principle, you can make informed investment decisions and assess the value of future cash flows.
Which principle guides in making investment decisions? ›
6 key investment principles for long-term investors
- Leverage the power of compound interest.
- Use dollar-cost averaging.
- Invest for the long term.
- Take your risk tolerance level into account.
- Benefit from diversification and strategic asset allocation.
- Review and rebalance your portfolio regularly.
Information gathering (such as life goals, assets, liabilities, cash inflows and outflows, investment preferences) and analysis. Plan development (aligning resources to short- and long-term goals) Plan implementation. Plan monitoring, periodic review, and adjustment.
What is the first principles approach to finance? ›
First Principles is a framework for getting to know the fundamental “Why's” behind a given business. Once understood, an Investor is in a much better position to consider the many other important factors (the “What's”) which can affect an investment's performance.
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The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on 