Corporate Finance: Goals, Functions & Stakeholders

What is Corporate Finance?

Corporate finance is the art and science of managing a company’s financial resources to maximize shareholder wealth while ensuring long-term sustainability. It involves three primary areas:

1. Capital budgeting (investment decisions)
2. Capital structure (financing decisions)
3. Working capital management (day-to-day operations)

Key Definitions

Objectives of Corporate Finance

The primary objective is shareholder wealth maximization, but it must align with:

• Legal compliance (e.g., company laws in Nepal).
• Ethical responsibilities (e.g., fair treatment of employees, customers, and creditors).
• Social responsibilities (e.g., corporate social responsibility (CSR) initiatives).

Why Shareholder Wealth Maximization?

• Market efficiency: Stock prices reflect all available information.
• Long-term sustainability: Ensures the company can grow and pay dividends.
• Risk-adjusted returns: Investors demand compensation for risk.

Functions of Corporate Finance

Corporate finance performs three critical functions:

1. Investment Decisions (Capital Budgeting)

• Deciding where to invest funds (e.g., expanding a factory, buying new machinery).
• Example: Nepal Electricity Authority (NEA) deciding whether to build a new hydroelectric plant.

flowchart TD
   A["Investment Proposal"] --> B["Evaluate Cash Flows"]
   B --> C["Calculate NPV/IRR"]
   C --> D["Assess Risk"]
   D --> E["Make Decision: Accept/Reject"]

2. Financing Decisions (Capital Structure)

• Deciding how to raise funds (e.g., loans, equity, bonds).
• Example: Ncell issuing bonds to raise capital for network expansion.

3. Dividend Decisions

• Deciding how much profit to distribute as dividends vs. reinvest.
• Example: Nepal Investment Bank declaring a 10% dividend to shareholders.

flowchart TD
   A["Net Profit"] --> B["Retained Earnings"]
   A --> C["Dividend Payout"]
   B --> D["Reinvestment"]
   C --> E["Shareholder Returns"]

Stakeholders in Corporate Finance

Corporate finance decisions impact multiple stakeholders:

The Agency Problem and Corporate Governance

What is the Agency Problem?

• Principals (shareholders) hire agents (managers) to run the business.
• Conflict arises when managers prioritize their own interests over shareholders’.

Solutions:

1. Corporate Governance: Rules and practices to ensure accountability.
   • Example: Nepal Stock Exchange (NEPSE) listing rules.
2. Incentive Alignment: Tie manager compensation to company performance.
   • Example: Nepal Investment Bank giving bonuses based on ROI.
3. Monitoring: Independent boards, audits, and shareholder voting.

In the Real World

1. Khalti (Digital Payments)

   • Capital Structure: Uses a mix of debt (bank loans) and equity (venture capital) to fund expansion.
   • Investment Decision: Allocated funds to develop Khalti Lite for low-income users.

2. Nepal Electricity Authority (NEA)

   • Working Capital Management: Manages cash flow to pay salaries and buy fuel while waiting for government subsidies.
   • Dividend Policy: Since NEA is government-owned, profits are reinvested rather than paid as dividends.

3. Daraz (E-commerce)

   • Capital Budgeting: Evaluated whether to expand warehouses in Pokhara and Biratnagar using NPV analysis.
   • Risk Management: Used hedging to protect against currency fluctuations in USD transactions.

Worked Example: Kathmandu Retail Shop’s Financing Decision

Scenario: A small retail shop in Kathmandu needs ₹5,00,000 to expand. It has two options:

1. Take a bank loan at 10% interest.
2. Issue 10,000 new shares at ₹50 each.

Option 1: Bank Loan (Debt Financing)

• Loan Amount: ₹5,00,000
• Interest Rate: 10% per annum
• Annual Interest Payment: ₹5,00,000 × 10% = ₹50,000
• No dilution of ownership, but fixed repayment obligation.

Option 2: Equity Financing

• Shares Issued: 10,000
• Price per Share: ₹50
• Total Equity Raised: ₹5,00,000
• No interest payment, but new shareholders gain ownership (10%).

Comparison Table:

Decision: The shop owner may choose a mix of both (e.g., ₹3,00,000 loan + ₹2,00,000 equity) to balance risk and control.

The Accounting Cycle in Corporate Finance

While not part of accounting, corporate finance relies on financial statements generated from the accounting cycle. Here’s how it flows:

flowchart TD
   A["1. Transactions Occur"] --> B["2. Journal Entries"]
   B --> C["3. Ledger Postings"]
   C --> D["4. Trial Balance"]
   D --> E["5. Financial Statements"]
   E --> F["6. Corporate Finance Decisions"]
   F --> G["7. Implementation & Feedback"]

Example: Journal Entry for a Loan

Example: Ledger (T-Account) for Loan

Loan A/c
Dr (₹) | Cr (₹)
--------|--------
        | 5,00,000 (Loan received)

Exam Tip

1. Define Key Terms Clearly:

   • Always start with shareholder wealth maximization as the primary goal.
   • Differentiate between capital budgeting, capital structure, and working capital.

2. Use Real-World Examples:

   • Relate theories to Nepali companies (e.g., Ncell, Khalti, NEPSE).
   • Example: "How does Daraz use capital budgeting to decide warehouse locations?"

3. Compare Financing Options:

   • Debt vs. Equity: Use tables to highlight pros/cons (as shown above).
   • Dividend Policies: Explain stable vs. residual dividend policies.

4. Agency Problem:

   • Always mention corporate governance as a solution.
   • Example: "How does NEPSE’s listing rules reduce agency conflicts?"

5. Numerical Problems:

   • Practice loan vs. equity financing comparisons.
   • Example: "A company needs ₹10,00,000. Compare taking a loan at 12% vs. issuing shares at ₹100 each."

Final Summary Table