What is Corporate Finance Theory?

Corporate finance theory is a set of principles companies can follow when making business-related decisions. Common tenets of this theory include net present value calculations, financing decisions that include debt or equity capital sources, financial ratios and cash flow management. Many companies use corporate finance theory to help find information or support business decisions with qualitative calculations. Using these calculations helps take away some of the subjectivity with business decisions by applying mathematical principles.

Net present value is one of the major tenets of corporate finance theory. This process forces managers to estimate the future cash flows from business operations or new business opportunities and discount them back to the present day’s dollar value. The discount percentage is typically the cost of capital a company must pay on borrowed funds. If the sum of the total discounted cash flows is greater than the amount paid for the new business opportunity, then the company would engage in that activity.

The sources of outside capital are another important corporate finance theory. Companies will have two options: debt and equity. Using a proper mix of these two financing options ensures the company maximizes its return from additional profit earned from business operations. Debt financing comes in the form of loans or corporate bonds issued to investors. These options are often easiest to complete, although they will carry more negativity with investors. Equity is either stock or direct investments from financial services firms. Equity is preferable because the company is not liable for repayment during bankruptcy. Corporate finance theory uses formulas like the weighted average cost of capital or capital asset pricing model to determine how much of each financing method is necessary to generate capital for new business operations.

Financial ratios are mathematical calculations that help companies determine the strength of their financial statements. Corporate finance theory requires more use from ratios that test the balance sheet than those that rely on information from the income statement. Balance sheet ratios help companies determine how much leverage is used to acquire assets used in the business. Too much leverage indicates that more profit is necessary to repay loans or investors. The ratios will also lead to cash management tools that are another feature of this theory. To properly insulate the company from risk, managers will prepare budgets that provide the company with a financial roadmap for future expenditures. Budgets are operational, capital or standard in nature and provide information for all levels within the company.