Corporate finance is the subfield of finance that deals with how corporations address funding sources, capital structuring, accounting, and investment decisions.
Corporate finance is often concerned with maximizing shareholder value through long- and short-term financial planning and the implementation of various strategies. Corporate finance activities range from capital investment to tax considerations.
- Corporate finance is concerned with how businesses fund their operations in order to maximize profits and minimize costs.
- It deals with the day-to-day operations of a business' cash flows as well as with long-term financing goals [e.g., issuing bonds].
- In addition to capital investments, corporate finance is concerned with monitoring cash flows, accounting, preparing financial statements, and taxation.
Corporate finance departments are charged with governing and overseeing their firms' financial activities and capital investment decisions. Such decisions include whether to pursue a proposed investment and whether to pay for the investment with equity, debt, or both. They also include whether shareholders should receive dividends, and if so, at what dividend yield. Additionally, the finance department manages current assets, current liabilities, and inventory control.
A company's corporate finance tasks are often overseen by its chief financial officer [CFO].
Corporate finance tasks include making capital investments and deploying a company's long-term capital. The capital investment decision process is primarily concerned with capital budgeting. Through capital budgeting, a company identifies capital expenditures, estimates future cash flows from proposed capital projects, compares planned investments with potential proceeds, and decides which projects to include in its capital budget.
Making capital investments is perhaps the most important corporate finance task that can have serious business implications. Poor capital budgeting [e.g., excessive investing or under-funded investments] can compromise a company's financial position, either because of increased financing costs or inadequate operating capacity.
Corporate financing includes the activities involved with a corporation's financing, investment, and capital budgeting decisions.
Corporate finance is also responsible for sourcing capital in the form of debt or equity. A company may borrow from commercial banks and other financial intermediaries or may issue debt securities in the capital markets through investment banks. A company may also choose to sell stocks to equity investors, especially when it needs large amounts of capital for business expansions.
Capital financing is a balancing act in terms of deciding on the relative amounts or weights between debt and equity. Having too much debt may increase default risk, and relying heavily on equity can dilute earnings and value for early investors. In the end, capital financing must provide the capital needed to implement capital investments.
Corporate finance is also tasked with short-term financial management, where the goal is to ensure that there is enough liquidity to carry out continuing operations. Short-term financial management concerns current assets and current liabilities or working capital and operating cash flows. A company must be able to meet all its current liability obligations when due. This involves having enough current liquid assets to avoid disrupting a company's operations. Short-term financial management may also involve getting additional credit lines or issuing commercial papers as liquidity backups.
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Definition
Long-term finance can be defined as any financial instrument with maturity exceeding one year [such as bank loans, bonds, leasing and other forms of debt finance], and public and private equity instruments. Maturity refers to the length of time between origination of a financial claim [loan, bond, or other financial instrument] and the final payment date, at which point the remaining principal and interest are due to be paid. Equity, which has no final repayment date of a principal, can be seen as an instrument with nonfinite maturity. The one year cut-off maturity corresponds to the definition of fixed investment in national accounts. The Group of 20, by comparison, uses a maturity of five years more adapted to investment horizons in financial markets [G-20 2013]. Depending on data availability and the focus, the report uses one of these two definitions to characterize the extent of long-term finance. Moreover, because there is no consensus on the precise definition of long-term finance, wherever possible, rather than use a specific definition of long-term finance, the report provides granular data showing as many maturity buckets and comparisons as possible.
Importance of long-term finance
Extending the maturity structure of finance is often considered to be at the core of sustainable financial development. Long-term finance contributes to faster growth, greater welfare, shared prosperity, and enduring stability in two important ways: by reducing rollover risks for borrowers, thereby lengthening the horizon of investments and improving performance, and by increasing the availability of long-term financial instruments, thereby allowing households and firms to address their life-cycle challenges [Demirgüç-Kunt and Maksimovic 1998, 1999; Caprio and Demirgüç-Kunt 1998; de la Torre, Ize, and Schmukler, 2012].
The term of the financing reflects the risk-sharing contract between providers and users of finance. Long-term finance shifts risk to the providers because they have to bear the fluctuations in the probability of default and other changing conditions in financial markets, such as interest rate risk. Often providers require a premium as part of the compensation for the higher risk this type of financing implies. On the other hand, short-term finance shifts risk to users as it forces them to roll over financing constantly.
The amount of long-term finance that is optimal for the economy as a whole is not clear. In well-functioning markets, borrowers and lenders will enter short- or long-term contracts depending on their financing needs and how they agree to share the risk involved at different maturities. What matters for the economic efficiency of the financing arrangements is that borrowers have access to financial instruments that allow them to match the time horizons of their investment opportunities with the time horizons of their financing, conditional on economic risks and volatility in the economy [for which long-term financing may provide a partial insurance mechanism]. At the same time, savers would need to be compensated for the extra risk they might take.
Where it exists, the bulk of long-term finance is provided by banks; use of equity, including private equity, is limited for firms of all sizes. As financial systems develop, the maturity of external finance also lengthens. Banks’ share of lending that is long term increases with a country’s income and the development of banking, capital markets, and institutional investors. Long-term finance for firms through issuances of equity, bonds, and syndicated loans has also grown significantly over the past decades, but only very few large firms access long-term finance through equity or bond markets. The promotion of nonbank intermediaries [pension funds and mutual funds] in developing countries such as Chile has not always guaranteed an increased demand for long-term assets [Opazo, Raddatz and Schmukler, 2015; Stewart, 2014].
Policy challenge
Attempts to actively promote long-term finance have proved both challenging and controversial. The prevalent view is that financial markets in developing economies are imperfect, resulting in a considerable scarcity of long-term finance, which impedes investment and growth. Indeed, a significant part of lending by multilateral development banks [including World Bank Group lending and guarantees] has aimed at compensating for the perceived lack of long-term credit. At the same time, research shows that weak institutions, poor contract enforcement, and macroeconomic instability naturally lead to shorter maturities on financial instruments. Indeed, these shorter maturities are an optimal response to poorly functioning institutions and property rights systems as well as to instability.
From this perspective, the policy focus should be on fixing these fundamentals, not on directly boosting the term-structure of credit. Indeed, some argue that attempts to promote long-term credit in developing economies without addressing the fundamental institutional and policy problems have often turned out to be costly for development. For example, efforts to jump-start long-term credit through development financial institutions in the 1970s and 1980s led to substantial costs for taxpayers and in extreme cases to failures [Siraj 1983; World Bank 1989]. In response, the World Bank reduced this type of long-term lending in the 1990s and the 2000s. On the other hand, well-designed private-public risk-sharing arrangements – such as Public Private Partnerships for large infrastructure projects, or credit guarantee schemes – may hold promise for mobilizing financing for long-term projects, and allow governments to mitigate political and regulatory risks and mobilize funding for private investment.
Suggested reading:
G-20 [Group of 20]. 2013. “Long-Term Investment Financing for Growth and Development: Umbrella Paper.” Found at://g20.org/wpcontent/uploads/2014/12/Long_Term_Financing_for_Growth_and_Development_February_2013_FINAL.pdf
Caprio, Gerard, and Asli Demirgüç-Kunt. 1998. “The Role of Long-Term Finance: Theory and Evidence.” World Bank Research Observer 13 [2]: 171–89.
Demirgüç-Kunt, Asli, and Vojislav Maksimovic. 1998. “Law, Finance, and Firm Growth.” Journal of Finance 53 [6]: 2107–37.
Demirgüç-Kunt, Asli, and Vojislav Maksimovic. 1999. “Institutions, Financial Markets and Firm Debt Maturity.” Journal of Financial Economics 54 [3]: 295–336.
de la Torre, Augusto, Alain Ize, and Sergio L. Schmukler. 2012. “Financial Development in Latin America and the Caribbean: The Road Ahead.” Policy Research Working Paper 2380, World Bank, Washington, DC.
Opazo, Luis, Claudio Raddatz, and Sergio Schmukler. 2015. “Institutional Investors and Long-Term Investment: Evidence from Chile.” Word Bank Economic Review 29 [2].
Siraj, Khalid. 1983. “Report of the Task Force on Portfolio Problems on Development Finance Companies." World Bank, Washington, D.C.
Stewart, Fiona. 2014. “The Use of Outcome-Based Benchmarks: Proving Incentives for Long-Term Investment by Pension Funds.” Policy Research Working Paper 6885, World Bank, Washington, DC.
World Bank. 1989. Report of the Task Force on Financial Sector Operations. Financial Sector Development Department. World Bank, Washington, DC.