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 companys 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. Lets say the companys 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 years 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 suggests that the right financing mix for a firm is one that maximizes the value of the investments made. The dividend principle requires that cash generated in excess of good project needs be returned to the owners. These principles are the core for corporate finance.
What are the fundamental concepts 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 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 two principles guide financing decisions? ›
The basic principles of financial decisions include:
- Risk Assessment: Every financial decision carries a certain level of risk. ...
- Cost-Benefit Analysis: This principle involves weighing the projected benefits of a decision against its costs.
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.
What is the fundamental principle of finance? ›
Cash Flow. Perhaps the most basic of the finance principles, cash flow is the broad term for the net balance of money moving into and out of a business at a specific point in time. There are four types of cash flow that you should know: Operating cash flow: The net cash generated from day-to-day business activities.
What are the general principles of corporate finance? ›
The financing principle suggests that the right financing mix for a firm is one that maximizes the value of the investments made. The dividend principle requires that cash generated in excess of good project needs be returned to the owners. These principles are the core for corporate finance.
What are the two 2 basic functions of finance? ›
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 main focus of corporate finance? ›
Its primary goal is to maximize shareholder value while striking a balance between risk and profitability. It entails long- and short-term financial planning and implementing various strategies, capital investment, and tax considerations.
What are two main finance activities? ›
Financing activities include: Issuing and repurchasing equity. Borrowing and repaying short-term and long-term debt.
Principles of Corporate Finance
The three foundational pillars of corporate finance are the investment, financing, and dividend principles.
What is corporate finance theory? ›
Corporate finance theory encompasses the principles and concepts that guide financial decision-making within a corporation. It is the field that studies how businesses allocate resources and make investment decisions to maximize shareholder value.
What are the fundamentals of financial management? ›
The objective of a Financial Management is to design a method of operating the Internal Investment and financing of a firm. The two widely used approaches are Profit Maximization and Wealth maximization. Investment and financing decisions of the firm's are continuous and unavoidable.
What are the two rules of Warren Buffett? ›
Warren Buffett once said, “The first rule of an investment is don't lose [money]. And the second rule of an investment is don't forget the first rule. And that's all the rules there are.”
What is the golden rules of finance? ›
1) Debit what comes in - credit what goes out. 2) Credit the giver and Debit the Receiver. 3) Credit all income and debit all expenses.
What is the decision rule in corporate finance? ›
The NPV Investment Decision Rule is a financial principle that stipulates an investment project should only be undertaken if its Net Present Value is positive. It represents the difference between the present value of its cash inflows and the present value of its cash outflows.
What are the key concepts and 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 is the fundamental concept of finance? ›
Finance basics include developing, managing, and analysing funds and investments. It comprises projected cash flows to fund current projects via credit and debt, securities, and investments.
What is the concept of finance in corporate finance? ›
Corporate finance is a branch of finance that focuses on how corporations approach capital structuring, funding sources, investments, and accounting decisions. Its primary goal is to maximize shareholder value while striking a balance between risk and profitability.
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