5 Corporate Finance - 5. Corporate Finance Explained

Key Concepts

• Capital Structure
• Cost of Capital
• Dividend Policy
• Working Capital Management
• Capital Budgeting

Capital Structure

Capital Structure refers to the mix of a company's long-term funding sources, including equity, debt, and hybrid securities. The optimal capital structure balances the cost of capital and risk to maximize the company's value. A well-structured capital mix can reduce the weighted average cost of capital (WACC) and enhance shareholder returns.

Example: A company with a capital structure of 60% equity and 40% debt might have a lower WACC compared to a company with 80% equity and 20% debt, assuming the cost of debt is lower than the cost of equity. This balance can increase the company's market value.

Cost of Capital

The Cost of Capital is the rate of return that a company must earn on its investments to satisfy its investors. It includes the cost of equity and the cost of debt, weighted according to the company's capital structure. The WACC is a critical component in evaluating investment opportunities and making financing decisions.

Example: If a company's cost of equity is 10% and its cost of debt is 5%, with a capital structure of 60% equity and 40% debt, the WACC would be (10% * 0.6) + (5% * 0.4) = 8%. This 8% represents the minimum return required on new investments.

Dividend Policy

Dividend Policy involves the decisions regarding how much profit a company will distribute to its shareholders and how frequently. A company's dividend policy can influence its stock price and investor sentiment. Policies range from high dividends (indicating stable earnings) to low or no dividends (indicating reinvestment in growth).

Example: A mature company with stable earnings might adopt a high dividend payout ratio, distributing 70% of its profits as dividends. In contrast, a growth-oriented startup might retain 100% of its earnings to fund expansion, paying no dividends.

Working Capital Management

Working Capital Management focuses on the management of a company's short-term assets and liabilities to ensure it has sufficient liquidity to meet its short-term obligations. Efficient working capital management can improve profitability and reduce the risk of insolvency. Key components include inventory management, accounts receivable, and accounts payable.

Example: A retail company might optimize its inventory levels to reduce holding costs while ensuring product availability. By managing its accounts receivable efficiently, it can accelerate cash inflows, improving its liquidity position.

Capital Budgeting

Capital Budgeting involves evaluating and selecting long-term investment projects that are expected to generate future cash flows. Key techniques include Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. Capital budgeting helps companies allocate resources to projects that maximize shareholder value.

Example: A manufacturing company is considering investing in new machinery. By calculating the NPV of the project, it can determine whether the present value of future cash inflows exceeds the initial investment cost. If the NPV is positive, the project is likely to increase shareholder value.