Corporate finance: Learn how big companies like Google make choices 

By Hazel Antiporta 

“Finance is not just numbers and formulas. Without it; our economy wouldn’t be able to operate”.    

Finance can be broadly categorized into three types: public, personal, and corporate finance. In this post, we’re going to dive into the world of corporate finance and take a closer look at the three critical decisions big companies make. Understanding these decisions can give you a better idea of how large companies operate and make essential business choices. So, whether you’re a business student or just someone curious about how big companies operate, this post is for you!  

What is Corporate finance?   

Corporate finance is the finance branch that deals with a corporation’s financial decisions and activities. It makes important financial decisions that help a business grow and succeed.  

“The ultimate purpose of corporate finance is to maximize the value of a business through planning and implementing resources while balancing risk and profitability.”  

— Corporate Financial Institute 

The 3 Decisions of Corporate Finance  

Corporate finance is all about making smart financial decisions for a business. These decisions can be divided into three main categories: investment, financing, and distribution.  

I’ll try to explain them concisely, without formulas.  

1 — The Investment Decision   

What projects/opportunities should we invest our money in?    

When it comes to making investment decisions, companies typically divide them into two distinct categories: short-term and long-term. Short-term decisions focus on how a company should allocate its funds to keep the day-to-day operations running smoothly. These decisions are often related to working capital management.   

On the other hand, long-term decisions fall under capital budgeting, where companies evaluate and select the most promising projects to invest in over a longer period. These decisions are often focused on growth and expansion.’    

But how do they do this?  

When companies decide which projects to invest in, they have to weigh many different factors. One of the key ways they do this is by using metrics to compare different projects and make decisions. Two of the most commonly used metrics are Net Present Value (NPV) and Internal Rate of Return (IRR). These metrics consider the project’s value today and the return it will generate for the company.  

Every company has its own cost of capital, which is essentially the “interest rate” they’re paying to have their funds. This cost of capital is used to calculate the NPV and IRR metrics, which are used to make investment decisions. Because each company’s cost of capital is different, two different companies may make different decisions about the same project.   

Ultimately, companies want to invest in projects that will increase their value and make the best use of their funds. So, based on the metrics and criteria they’ve used to evaluate projects, they will select the most promising projects and allocate funds accordingly.  

2 — The Distribution Decision  

How should we distribute excess cash?  

Companies earn money through their daily business activities, such as selling products or services to customers. They then have to decide how to use this cash, whether it be for reinvesting in the business, paying off debts, or distributing it to shareholders.    

They have two options:  

1) Put that money back into the company (reinvest)  

2) Give it out (distribute)  

 At the end of the day, the company has to figure out how much money they should give back to their shareholders and how they should do it.   

They weigh the pros and cons of different options and decide what will benefit the people who own a piece of the company. They look at how much money they can make by keeping the cash and investing it in the business or how much they can give back to the shareholders by paying dividends or buying back shares. It’s not always an easy decision, but they want to ensure they’re doing what’s best for the company’s long-term success and the shareholders’ financial well-being.  

So, the big question is, Which distribution option should we use?  

Once a company distributes some of its cash to shareholders, it has to choose from options like issuing cash dividends, stock dividends or buying back shares. The goal is to give the shareholders as much value as possible while minimizing the tax impact.   

However, it can be challenging to make everyone happy because different shareholders pay taxes differently. It’s a balancing act to determine what will work best for most shareholders.  

3 — The Financing Decision  

Where should we get our money from?  

Every business needs money to operate, whether it pays employees, buys supplies, or invests in growth. The question is, where do we get that money from? A company has a few options, like selling stocks to investors, borrowing money from banks, or combining both. The company needs to decide on the right balance of funding sources so that it’s manageable on one source.  

This is what we call the capital structure decision, which is crucial for any business. Of course, once the company has decided on the mix of funding, it also needs to decide on the specifics of each option, but that’s a conversation for another time.  

So, how do companies decide on the best mix of funding options?  

Have you ever wondered why some companies sell bonds instead of stocks or vice versa? The truth is each option has its own advantages and disadvantages, and it depends on the company’s unique situation.  

To determine the right balance of debt and equity, companies weigh the benefits of borrowing money against the costs. They look at factors like the company’s creditworthiness, the current interest rate environment, and their future growth prospects. Based on these factors, they decide how much debt and equity they should have in their capital structure.  

The main benefit of using debt for a company is the tax advantage – the interest payments on debt can be written off as a tax deduction. However, debt is also a downside; it increases the risk of bankruptcy for the company as it has more financial obligations and less flexibility for the future.  

Therefore, companies usually aim for an optimal balance between debt and equity, where the benefits outweigh the risks, and the company can maximize the returns while minimizing the risk of bankruptcy.  

So that’s the basics of corporate finance!     

Companies use finance to decide where to invest, how much to distribute, and where to get their funding. If you’re new to the subject, I hope this was helpful. It’s a lot to take in, and I’ll keep working on making it easy to understand and interesting.