Two Fundamental Rules of Corporate Finance

Corporate finance is based on two fundamental rules. All tools and techniques of corporate finance are mere ways and means of implementing these rules. These rules can be found at the beginning of any and every corporate finance text book. One of these rules relates to the concept of return while the other relates to the concept of risk. We have described both these rules in this article. They are as follows:

Rule #1: Money today is worth more than money tomorrow

The fundamental rule of corporate finance is that the timing of cash flows is of paramount importance. Also, we want the timing of the cash flows to be as soon as possible. The sooner we get the cash, the better it is for our company. Every dollar that the company has in cash today is better than the same dollar in cash tomorrow because of the following reasons:

  • Inflation: Inflation eats into the purchasing power of the company’s funds constantly with the passage of time. Thus if the company had the same nominal amount of money today or a year from now, they would be able to purchase more goods and services with the money that they have today as compared to the same amount of money a year later. Thus, to offset the effect of inflation, companies must conduct their business in a manner that they ensure that cash is received as soon as possible.

  • Opportunity Cost: Also, every dollar that the company is not receiving has an opportunity cost of capital. Let’s say the company’s debtors owe it $100 and they pay $100 the next year. The nominal value of the money that they have paid is $100 however the real value is less. This is because had the debtors paid immediately, the company would have cash immediately on hand. They could then invest this cash in risk free securities and could have earned a year’s interest on the same. By accepting the same $100 a year later, the company has in effect loaned out $100 to its debtors and that too interest free!

Rule #2: Risk free money is worth more than risky money

Corporate finance involves exchanging between present and future streams of cash flows. Companies may come across different projects which offer different future cash flows. However, it is important to realize that all cash flows are not equally likely to materialize in the future. Some cash flows may be almost certain like investing in treasury bonds while others may be highly uncertain like projected returns from stock market investments. Hence, the second rule states that the company must adjust each of these cash flows for their risk before making any comparisons and selections. The following factors must be considered:

  • Return of Capital: Some projects are extremely risky. Here, the company is concerned about whether or not the money they are investing will be recovered. A higher rate of return must be demanded from such projects to offset the likelihood of losing their entire capital that the investors face.

  • Return on Capital: In other cases the cash flow may be a little less uncertain. In these cases, companies must consider the low risk before making their decision.

The bottom line is that before making a choice, all projects have to be made comparable. This is done by adjusting for cash flow that will be received in different time periods as well as adjusting for the different amounts of risks that are involved in different projects.

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Corporate Finance