What Is Finance?
Finance is the language of business. It deals with how money is raised, spent, and managed to create value. Whether it’s an individual saving for education or a global corporation expanding operations, finance determines how funds are sourced and used efficiently.
Financial decisions are generally grouped into five main areas:
1. Corporate Finance – Managing a company’s financial activities, investments, and capital.Each of these areas is interconnected, but corporate finance sits at the core — shaping decisions that drive business success.
Corporate Finance and the Financial Manager
Corporate finance focuses on how firms make decisions about investments, financing, and daily operations to maximize shareholder value.
It aims to answer three crucial questions:
- What long-term investments should the company undertake?
- How should the company finance these investments — through debt or equity?
- How should the firm manage its daily financial activities, such as payments and collections?
These responsibilities fall under the role of financial management, which is led by executives like the Chief Financial Officer (CFO) or Vice President of Finance.
Key Roles Within Financial Management
1. Vice President (Finance):Coordinates the activities of the treasurer and controller.
Handles the firm’s cash management, credit policy, financial planning, and capital expenditures.
Oversees cost accounting, tax management, and financial reporting systems.
Together, they ensure that the organization maintains liquidity, invests wisely, and complies with financial regulations.
The Three Major Financial Decisions
Every firm must deal with three fundamental areas of decision-making:
1. Capital Budgeting
Capital budgeting is the process of identifying and evaluating long-term investment opportunities that will generate future benefits for the firm.
The goal is to invest in projects that create more value than they cost.
Financial managers use tools such as Net Present Value (NPV) and Internal Rate of Return (IRR) to evaluate investment proposals.
Example: Deciding whether to build a new factory or invest in new technology.
2. Capital Structure
This refers to the mix of debt and equity used to finance the company’s operations.
The main questions include:
- How much should the firm borrow?
- What is the ideal balance between debt and equity?
- What are the least expensive funding sources?
The optimal capital structure minimizes the cost of capital while maximizing shareholder value.
3. Working Capital Management
Working capital management focuses on short-term assets and liabilities to ensure smooth operations.
Working Capital = Current Assets – Current Liabilities
A firm must manage its cash, inventory, and receivables efficiently to avoid liquidity crises or missed opportunities.
Example: Ensuring that the company can pay suppliers while still having funds to continue operations.
Forms of Business Organization
Businesses can take different legal and structural forms, each with unique advantages and challenges.
1. Sole Proprietorship
- Owned by a single individual.
- Easiest to start and least regulated.
- The owner receives all profits but faces unlimited liability for business debts.
- The business ends when the owner retires or passes away.
2. Partnership
- Formed by two or more individuals.
- Shared profits and responsibilities.
- Partners face unlimited liability, and transferring ownership can be difficult.
3. Corporation
- A separate legal entity owned by shareholders.
- Managers run the business on behalf of owners.
- Offers limited liability — owners can lose only what they’ve invested.
- Ownership is easily transferable through stock sales.
- Has a major disadvantage: double taxation — profits are taxed at both corporate and personal levels.
The Goal of Financial Management
In a for-profit business, the primary goal of financial management is to maximize the current value per share of existing stock — in other words, to increase shareholder wealth.
Financial goals fall into two categories:
1. Profitability Goals:Aimed at increasing sales, market share, and cost control.
Focused on ensuring stability and avoiding bankruptcy.
Good decisions increase the firm’s stock value, while poor decisions decrease it.
When a firm has no publicly traded stock, the objective is to maximize the market value of owners’ equity.
Corporate Finance in Context
Corporate finance studies the relationship between business decisions and firm value.
Every financing or investment choice ultimately affects shareholder wealth.
For example, launching a new product line may boost profits — but if financed poorly, it could increase debt risk. Financial managers constantly balance risk vs reward to sustain long-term growth.
The Agency Problem and Control of the Corporation
In large corporations, there’s often a separation between ownership (stockholders) and management.
Stockholders are the principals, while managers act as agents making decisions on their behalf.
This gives rise to the Agency Problem — the potential conflict of interest between owners and managers.
Types of Agency Costs
1. Direct Costs:
- Corporate expenditures that benefit management but hurt shareholders (e.g., luxury offices).
- Monitoring expenses like audits.
2. Indirect Costs:
Lost opportunities when management avoids profitable but risky projects.Companies minimize these issues by linking managerial pay to performance through stock options, promotions, and job reputation.
The Sarbanes-Oxley Act (SOX) of 2002 further strengthened corporate accountability by requiring accurate and transparent financial reporting.
Stakeholders and Accountability
Apart from shareholders, a firm also has stakeholders — anyone affected by its operations, such as employees, customers, suppliers, and the community.
A Benefit Corporation (B-Corp) is a modern legal form that considers broader responsibilities. It must demonstrate:
- Accountability – Reporting how business actions affect society and the environment.
- Transparency – Publishing annual reports detailing public benefits achieved.
- Purpose – Providing a social or environmental benefit beyond profit.
These models reflect the growing importance of ethical finance and sustainability.
Financial Markets and the Corporation
Financial markets connect buyers and sellers of debt and equity securities, providing the capital companies need to grow.
There are two main types:
1. Primary Market
1. Where new securities are issued for the first time.2. The corporation is the seller, raising money directly.
. Transactions include:
- Public Offerings: Sale of securities to the general public (regulated by the SEC).
- Private Placements: Negotiated sales to specific investors like insurance firms or mutual funds.
2. Secondary Market
1. Where existing securities are bought and sold between investors.2. Facilitates transfer of ownership and liquidity.
3. Two kinds exist:
Dealer Markets: Over-the-counter (OTC) markets where dealers trade electronically at their own risk.
Auction Markets: Physical or virtual platforms matching buyers with sellers (like stock exchanges).These markets are crucial for price discovery and corporate fundraising.
Management Incentives
Managers have a strong incentive to act in shareholders’ interests because their compensation and reputation are tied to company performance.
1. Managerial Compensation:
- Often linked to stock value or share price.
- Managers may receive stock options, aligning their goals with shareholders.
2. Job Prospects:
- Successful managers gain promotions and recognition in the labor market.
- Poor performance can lead to dismissal by the board of directors, who represent shareholders.
This structure ensures that managers focus on long-term value creation rather than short-term gains.
Summary
- Corporate finance deals with investment, financing, and working capital decisions.
- The goal is to maximize shareholder value while maintaining financial stability.
- Forms of business include sole proprietorships, partnerships, and corporations.
- Agency problems arise from conflicts between managers and owners.
- Financial markets enable companies to raise capital through primary and secondary transactions.
- Effective financial management requires accountability, transparency, and strategic decision-making.
FAQs on Corporate Finance
1. What is corporate finance?
It’s the study of how companies raise and manage money to maximize value.
2. What are the three major decisions in finance?
Capital budgeting, capital structure, and working capital management.
3. Why do corporations face agency problems?
Because ownership and management are separate, leading to potential conflicts of interest.
4. What are primary and secondary markets?
Primary markets issue new securities; secondary markets trade existing ones.
5. What is the goal of financial management?
To maximize the current value of the company’s shares.
6. What are benefit corporations?
Firms that prioritize social and environmental goals alongside profits.
7. What is working capital?
The difference between current assets and current liabilities, showing liquidity.
8. How does the Sarbanes-Oxley Act affect corporations?
It enforces accurate reporting and greater managerial accountability.
