Business Knowledge

The Three Pillars of Corporate Finance: A Manager's Guide

Kieran F. Noonan
Corporate Finance Financial Management Investment Capital Structure

Summary

Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, and the actions that managers take to increase the value of the firm to the shareholders. At its core, it’s about answering three fundamental questions: What should we invest in? How should we pay for it? And what should we do with the profits? These correspond to the three pillars of corporate finance: the investment (or capital budgeting) decision, the financing (or capital structure) decision, and the dividend decision.

The Concept in Plain English

Think of running a business like managing a household budget, but on a much larger scale.

  1. The Investment Decision: You need to decide what big-ticket items to buy. Should you renovate the kitchen, or buy a new car? You can’t do both. You need to figure out which purchase will add more value to your family’s life in the long run. For a company, this is like deciding whether to build a new factory or acquire a smaller competitor.
  2. The Financing Decision: How are you going to pay for the new kitchen or car? Will you use your savings (equity), or will you take out a loan from the bank (debt)? For a company, this is about deciding whether to issue new stock (equity) or take on more debt to fund its investments.
  3. The Dividend Decision: At the end of the year, if you have extra money left over, what do you do with it? Do you pay yourself a special bonus (a dividend), or do you reinvest that money into more home improvements (retained earnings)? For a company, this is the choice between returning profits to shareholders or reinvesting them back into the business for future growth.

Every major financial choice a company makes falls into one of these three buckets.

The Three Core Decisions of Corporate Finance

1. The Investment (Capital Budgeting) Decision

This is the most important of the three decisions. It’s about deciding which projects or assets a company should invest its scarce capital in. The goal is to select investments that will generate a return greater than the cost of the capital used to finance them.

2. The Financing (Capital Structure) Decision

Once a company has decided what to invest in, it must decide how to pay for it. This involves finding the optimal mix of debt and equity financing.

  • Key Question: What is the right mix of debt and equity for our firm?
  • Key Concepts:
    • Cost of Debt: The interest a company pays on its borrowings.
    • Cost of Equity: The return shareholders require for investing in the company.
    • Weighted Average Cost of Capital (WACC): The average cost of all the capital a company uses. The goal is to minimize the WACC.
  • The Trade-off: Debt is usually cheaper than equity and offers a tax shield (interest payments are tax-deductible), but it also increases financial risk (the risk of bankruptcy if you can’t make your payments).

3. The Dividend Decision

This decision is about what to do with the profits that the company generates. The company has two main choices:

  • Retain the Earnings: Reinvest the profits back into the business to fund future growth.
  • Pay Dividends: Distribute the profits directly to shareholders. (A share buyback is another way to return cash to shareholders).
  • Key Question: How much of our profits should we return to shareholders, and how much should we reinvest?
  • The Trade-off: Returning cash to shareholders makes them happy today. However, reinvesting that cash into high-return projects could create even more value for them tomorrow. The right choice depends on the availability of profitable investment opportunities.

How the Three Decisions Interconnect

These three decisions are not made in isolation; they are deeply interconnected.

  • The investment decision determines how much capital the company needs.
  • The financing decision determines the cost of that capital (the WACC), which is then used as the hurdle rate to evaluate new investments.
  • The dividend decision is what’s left over. If a company has many profitable investment opportunities, it will likely retain more earnings and pay lower dividends.

Risks and Limitations

  • Model vs. Reality: The frameworks (like WACC and NPV) rely on assumptions and forecasts about the future, which are always uncertain.
  • Market Imperfections: Theories often assume perfect markets, but in reality, taxes, bankruptcy costs, and information asymmetry complicate decisions.
  • Managerial Biases: Managers can be overly optimistic about investment projects or too risk-averse about using debt, leading to suboptimal decisions.
  • Valuation: The tools of corporate finance are central to valuing a company.
  • Working Capital Management: While corporate finance focuses on long-term decisions, working capital management deals with the short-term financing of a company’s operations.
  • Mergers & Acquisitions (M&A): An M&A transaction is a major investment decision that involves all three pillars of corporate finance.