In simple terms, corporate finance is the study of the sources of funding, capital structure, and working capital management of corporations. As a company’s in-house legal counsel, it is helpful to understand the key tenets of corporate finance in order to appropriately advise the company on important business and legal decisions.
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Corporate finance centers around how companies make two fundamental decisions—the decision of whether or not to invest and the decision of which sources of funds to utilize.
Deciding Whether to Invest
Companies are regularly faced with decisions about whether or not to invest in particular projects. Such projects may include initiatives to expand into new geographic markets, purchase new equipment or property, build a new manufacturing plant, and acquire another company.
The decision generally hinges upon whether the investment will materially increase the value of the company. A project will often be considered a good investment if it satisfies two criteria:
- The expected internal rate of return (IRR) is greater than the applicable cost of capital
- The net present value (NPV) is greater than zero
Estimating Cash Flows
Projected cash flows over a period of time are needed in order to perform the IRR analysis and NPV analysis. The forecast of cash flows for the project being evaluated should include all the cash flows directly related to the initial investment in the project as well as ongoing expenses. It should exclude sunk costs, or costs that have already been incurred.
Internal Rate of Return (IRR) Analysis
A project is considered a good investment if the IRR is greater than the applicable cost of capital. The cost of capital represents the minimum rate of return on the project that the company must earn before it generates value. A higher risk project correlates with a higher cost of capital.
The IRR is a discount rate based on the time-weighted cash flows. It is an annualized compounded rate of return. The calculation can be made using Microsoft Excel’s built-in IRR or XIRR functions. The difference between these functions is that Excel’s IRR function assumes all cash flows are spaced exactly one period apart whereas Excel’s XIRR function allows the timing of the cash flows to be manually specified.
Net Present Value (NPV) Analysis
The net present value represents the sum of all the cash flows for a project, discounted at the applicable cost of capital or return rate. The NPV can be calculated manually or by using Microsoft Excel’s NPV function. A project with a NPV greater than zero is considered value accretive. When a project’s IRR is exactly equal to its cost of capital, then the project’s NPV will be equal to zero.
Sources of Funds: Debt
Companies can use equity or debt financing to fund its projects. There are two broad categories of equity securities—common stock and preferred stock. Equity and debt financing each come with their own unique sets of advantages and disadvantages.
A company can raise debt from one or more investors in order to fund its business needs. The debt raised can be secured or unsecured. Secured debt is backed by the company’s assets, meaning the lenders have collateral in the event that the borrower cannot repay the loan.
One of the major advantages of debt financing is that it is a cheaper form of capital than equity. This is partly attributable to the fact that debt has a more senior position in a company’s capital structure. This has important implications in an event of bankruptcy, where the debt investors will be repaid for the amounts that they are owed before the equity investors.
Debt also comes with important tax advantages over equity. The interest expenses on a company’s debt are tax deductible, reducing the overall amount of taxes that the company must pay. In contrast, dividend payments to equity holders are generally not tax deductible.
Unlike equity, debt can also be raised from private markets. As a result, debt offerings have lower disclosure burdens as compared to public filings made with the Securities and Exchange Commission (SEC) for securities like common stock.
While debt comes with many advantages, there are also important disadvantages to consider. Taking on leverage can increase a company’s chances of bankruptcy. Furthermore, the obligation to make regular cash interest payments on the debt owed can constrain a company’s ability to use cash for other corporate purposes. Additionally, the loan agreement may contain covenants that force the company to comply with certain financial ratios or restrict the company’s ability to take on additional debt.
Sources of Funds: Common Stock
Common stock represents a costlier and riskier form of funding for investors. In a bankruptcy scenario, the common equity holders are only paid back after the claims of the debtholders have been paid. In many cases, the common stock becomes worthless if the company enters bankruptcy.
Common stock often comes with voting rights, allowing investors to have some limited control over key corporate decisions such as the composition of the board of directors. Some companies only maintain one class of voting stock while others may have a dual class structure that provides certain shares with enhancing voting rights.
Sources of Funds: Preferred Stock
While preferred stock is technically a type of equity, it is considered a hybrid security because it has both debt-like and equity-like features. Preferred stock is considered riskier than debt but less risky than common stock. This is because preferred stock sits in between debt and common equity in the priority of payout in a bankruptcy scenario.
Similar to the interest on a bond, preferred stock has a fixed dividend. However, unlike interest expense, the dividend is not tax deductible. Preferred stock tends to have a less liquid trading market, which may deter companies from issuing it.