This article is written by Mohammad Sahil Khan of Dr Ram Manohar Lohiya, National Law University, Lucknow. The article comprehensively deals with corporate financing, principles of corporate financing, and types of corporate financing. It also covers the entirety of Indian financial system which includes various types of financial institutions, financial markets, and all other financial aspects.
It has been published by Rachit Garg.
In the era of start-ups and entrepreneurship, it is important to understand the concept of corporate financing. Corporate financing deals with the capital structure of a firm or corporation. The management of the corporation involved in corporate finance has to deal with various activities from funding to making suggestions and taking actions that would increase the value of the company. Capital restructuring, making investment decisions, accounting, and dealing with the funding of sources are some of the key aspects of corporate financing.
The purpose of corporate finance is to enhance the value of a company or business through strategic planning and implementing resources efficiently. Corporate finance is instrumental in maximizing the values of shareholders which can be done through the process of short-term or long-term financial planning.
A financial system is a chain of financial institutions such as banks, stock exchanges, and insurance companies existing on a firm, national or global level. Investors, lenders, and borrowers are essential components of a financial system. These institutions exchange funds amongst themselves for financing various projects. Financial systems are extremely essential in corporate financing as they are the institutions that provide funds for financing various financial projects. A financial system is a robust system containing various rules and practices that helps in determining which project needs to be financed.
What is corporate finance
Corporate finance is the subfield of finance that deals with how corporations address funding sources, capital structuring, accounting, and investment decisions. Corporate finance is often concerned with maximizing shareholder value through long- and short-term financial planning and the implementation of various strategies. Corporate finance activities range from capital investment to tax considerations.
Corporate finance plays a major role in the functioning of a corporation or firm as they focus on the growth of a corporation by enhancing the overall value and business of the corporation. The management dealing with corporate finance takes crucial decisions in the aspects of capital allocation, investment, and organizing budgets. The management also looks into the amount of capital needed for acquiring assets. Depending upon the type of asset acquisition, management looks into whether to do financing by issuing the equity or through debt. Many times, the management follows both issuing equities as well as debt to maintain a safe balance because too much debt can increase the risk factor while diluting the equity of the corporation to a large extent can hinder the process of growth or increase the valuation of the corporation.
Elements of corporate finance
Capital budgeting is a process that assesses the viability of an investment proposal for determining the potentially profitable corporate financing projects. In order to determine capital budgeting, a bunch of financial analysts conduct a comparative analysis of the present and estimated future value of an investment proposal. After conducting a comparative analysis, the most viable investment proposal is chosen.
Capital structuring is a method by which a financial entity employs the method of structuring corporate finance. The capital structure includes equity or debt as a method for corporate financing. From an investor’s point of view, they want an optimum mix of debt and equity because it produces a balanced combination.
Working capital is associated with the capital required on a daily basis for business conduct. An adequate cash flow is maintained by an efficient financial management company which ensures liquidity in the organization.
Companies which are publicly listed are accountable to their shareholders and in order to serve them well, they give out dividends from time to time. Dividends are generated from the surplus profit of an organization. An organization can either distribute the surplus profit amongst its shareholders or it can reinvest the same amount to look for growth in business operations.
Importance of corporate finance
- Corporate financing manages financial activities by obtaining funds from the right sources.
- Corporate financing manages financial activities to maximize the return on investment.
- Corporate financing balances risk and profitability by properly structuring and budgeting the capital.
- Corporate financing is essential in determining future cash flow.
- Corporate financing strategizes to have an optimum mix of debt and equity in capital structuring.
Examples of corporate finance
Corporate financing system requires the management of interactions between investors, corporations, government, financial institutions, etc. Following are the examples of corporate financing:
- Financial modelling: It analyzes the risk and values associated with an investment option.
- IPO: Initial Public Offering is a method of raising capital by financing equity.
- Bank loan: Corporations often require loans from banks for funding their projects, banks then carry out due diligence to analyze loan costs and their repayment.
- Refinancing and renegotiating debts and payments: Owing to the change in circumstances in the market, corporations need to strategically anlyze and change the terms of loans or other payment agreements.
- Dividend distribution: A company offers dividend to its shareholders on the basis of its dividend policy which might be fixed or variable.
Principles of corporate finance
This principle focuses on finding the right investment option by carrying out a financial feasibility study to determine revenues, future costs, and estimated profits. The investment is carried out by assessing the risk and return. An investment proposal is evaluated based on a hurdle rate which acts as a benchmark to determine the return analysis of an investment. A financial analyst goes over an array of investment alternatives to find the most profitable business venture. To conclude, financial analysts conduct a comparative analysis of the present and future value of an investment. The risk-to-reward ratio is observed whether they align with the goals of an organization’s business. The risk-to-reward ratio is a measure to calculate whether the risk associated with the investment of capital is worth it or not.
For an investment to be successful, the invested project should yield a greater return than the minimum acceptable hurdle rate. The hurdle rate serves as an indicator to determine the risk prospects of an investment. If an investment is supposed to be risky, it ought to have a significant hurdle rate. In cases of a risky project, the financing should be a mix of both equity and debt. Cash flows generated and their timing in the due course of business determines the return on the invested project.
The financing principle is essential in determining the method of financing to optimize the value of an investment. There are three ways of financing investment, issuing debt, equity, or a mix of both. It is a very critical course of action because too much debt can lead to a high risk of defaulting while on the other hand if too many stockholdings are diluted, it would curb the maximization of the profit.
The diversification of the investment method depends on various factors such as a short-term goal or long-term goal, cost of financing, business structure, access to the equity market, and interest rates. The finances should be carried out in such a manner that it crosses the acceptable hurdle rate.
Dividends and return of capital
When the business of a firm grows and it comes to a state where the cash flows generated by the business exceed the acceptable hurdle rate, corporate finance has a role to determine whether the excess fund should be distributed to the shareholders or should be reinvested in the business to expand the business.
Reinvesting the returns obtained is an ideal way because, in such a situation, the firm need not dilute its equity, nor do they need to take a debt that would increase its risk factor. At the same time, it is also pertinent to appease the shareholders by rewarding them with dividends. If corporate financiers believe that the rate of return is enough for the expansion of the firm’s business, they then direct firms to reinvest the funds to aim for expansion.
Types of corporate financing
There are two chief types of corporate financing that come into play in the process of investing in a firm.
Equity financing is one of the most preferred methods of financing a firm’s business. Most firms nowadays prefer offering equity in exchange for obtaining finances. Angel investing is a type of equity financing, wherein; the shareholders of a firm dilute their shareholdings to get finances for their firm’s business. The equity of a company is divided into two types of stocks, that are:
Common stock represents the ownership of shareholders in a corporation. The common stockholders of a corporation are entrusted with the responsibility of electing the board of directors and voting on various corporate policies. Common stock ownership is beneficial for the long term as it yields a higher rate of returns over some time. With rewards, there are also risks associated with common stock ownership because, in cases of liquidation, common stockholders receive their due only after all the preferred shareholders, and bondholders are paid their amount.
In common stock, shareholders have great power in deciding the fortune of the company, or rather they are the ones deciding the fate of the company by carrying out various operations. Preferred stockholders receive a significant amount of dividends in comparison to the common stockholders. Preferred stockholders receive dividends on a monthly or quarterly basis.
The dividends are set up according to a benchmark interest rate, similar to the London InterBank Offered Rate (an interest rate at which various global banks lend to each other in the international interbank market for short-term loans). Although preferred shareholders enjoy a better dividend yield, they are kept out of some of the important strategic conversations. Voting rights are not available to the preferred shareholders, still, people opt for preferred stock because it provides stability in future cash flow as it includes fixed dividends and equity from time to time.
Debt financing is a method of financing in which funds are raised by obtaining loans from financial institutions or by issuing bonds. Debt financing involves paying off regular interest payments and eventually the entire principal is paid back after the loan tenure. The firm benefits by using debt financing because the ownership of the corporation is not diluted and as a result, the ownership of the company remains intact. Debt financing is generally used when the company requires a large sum of money, the corporation’s owner attaches some of the firm’s assets, and based on the values of assets, the loan is given to the corporation.
However, while taking up a loan the corporation always ensures that a threshold level is maintained while taking up the loan so that the risk of defaulting is covered and the corporation carries out its smooth functioning.
Indian financial system : an overview
A financial system is a system for the exchange of funds among a set of institutions like stock markets, banks, and insurance companies. A financial system is a chain of institutions that exchange funds among each other to finance a project, lead an investment, or pursue a return on financial assets. The financial system is instrumental in setting up rules and practices for borrowers and lenders who decide on the kind of projects to be financed, who would finance the investment projects and the terms regarding such investments.
The financial market is a system involving borrowers, lenders, and investors, wherein, there is an exchange of an economic commodity and the goods are traded in the form of cash, credit, or equity. In the financial market, derivative instruments are traded which are essential contracts determined based on the performance of an underlying asset. The financial system can be organized through a market economy, central planning, or a combination of both. The financial system functions at both national and international levels, it is governed by rules which determine the usage of funds for various investment purposes and the eligibility of the participants.
Examples of Indian financial systems
- Public banks,
- Commercial banks,
- Central banks,
- Cooperative banks,
- State-managed cooperative banks,
- State-managed land development banks.
Non-banking financial institutions
- Finance and loan companies,
- Mutual funds,
- Insurance companies.
Components of the Indian financial market
Financial institutions work in the arena of providing monetary help to corporations and individuals by depositing money, investing money, or managing money. Investment firms, banks, insurance companies, trusts, and brokerage ventures fall under the ambit of financial institutions. Financial institutions are an integral part of developing or maintaining a healthy economy. These institutions are administered by the administrative authority of a nation by placing certain regulations on these institutions.
Financial institutions also provide consulting services to consumers regarding any particular investment. Financial instruments are classified into three categories based on their nature of activities.
Regulatory and promotional institutions
All the four structures of the financial system are regulated by various financial regulatory authorities such as the Ministry of Finance, Reserve Bank of India (RBI), Insurance Regulatory and Development Authority (IRDA), Securities and Exchange Board of India (SEBI), the Company Law Board, etc.
RBI and the Securities and Exchange Board of India (SEBI) are the two major regulatory and promotional institutions governing all the financial systems. SEBI and RBI have the authority to supervise, monitor, legislate, and control the entire financial system.
Banking institutions are responsible for mobilizing people’s savings. Banking institutions establish an efficient mechanism for enabling the smooth exchange of goods and services. Banking institutions are further categorized into three types:
Commercial banks are institutions that accept deposits and provide loans and other financial services, these financial institutions operate to seek profit. Apart from offering financial services, commercial banks also provide administrative services by making business advances, encouraging saving deposits, offering various fundamental investment schemes, cash management, schemes on bond investment, etc. Commercial banks are further divided into four types:
Public sector banks
Banks whose majority stake (more than 50% share) is held by the Government of India are referred to as public sector banks. State Bank of India, Punjab National Bank, and Bank of Baroda are some examples of public sector banks. The public sector holds 90% of the banking business in India and overall, 27 banks fall under the category of the public sector.
Private sector banks
As the name suggests, the equity of private sector banks is held by the private shareholders. Owing to the liberalization in 1994, we are living in an era where private sector banks constitute a huge chunk of commercial banking. Private sector banks are registered as companies with limited liability. These banks deal with the management of the wealth of high-income groups. Private sector banks provide services in the form of tax advisory, financial brokerage, and assets management.
Foreign banks are those which are registered and headquartered in foreign countries but operate their branches in India. As per RBI recognition, 46 foreign banks are operating in India. Citibank, Hong Kong, Shanghai Banking Corporation, and Bank of Tokyo are some of the prominent names in the foreign bank category of financial institutions.
Regional rural banks
Regional rural banks perform a very important feature in paving economic development in the rural part of the country. These banks were first established on October 2, 1975, and since then they have worked on their objective of developing the rural economy. State Bank of India, Syndicate Bank, Punjab National Bank, United Bank of India, and United Commercial Bank are the five commercial banks that are the drivers of regional rural banks by sponsoring them. National Bank for Agriculture and Rural Development (NABARD) regulates regional rural banks. Central Government (50% stake), state government (15% stake), and sponsor bank (35% stake) are the entities that own regional rural banks.
Like banking institutions, nonbanking financial institutions also work towards mobilizing financial resources either directly or indirectly from people. What separates banking institutions from nonbanking financial institutions is the fact that they lend funds but they do not create credit. Life Insurance Corporation of India (LIC), Guaranteed Investment Certificate (GIC), and Development Financial Institutions are some of the prominent names in the nonbanking institutions. These institutions are governed by relatively lower authorities in comparison to the banks, non banking institutions are not subjected to any regulatory prescriptions which apply to the banks.
Financial markets are the places where borrowers and lenders exchange assets like bonds, derivatives, and commodities. In financial markets, investors invest in stocks of the companies to obtain a return on the capital. When a business or a firm runs in profit, it tends to pass on a share of its profit to the investors. Financial markets allocate resources and create liquidity for businesses and entrepreneurs.
The market allows buyers and sellers to trade their financial holdings. Financial markets play a very significant role in speeding up the economic growth of the country. Financial markets speed up the process of capital formation and provide for savings flow to investment. There are two components of financial markets:
In the money market, the borrowing and lending process lasts for a short period. The money market is associated with transacting in financial instruments and funds for the short term which has a maturity period ranging from a day to a year. The money market provides a great amount of liquidity and the market is mostly dominated by banks, financial institutions, and governments.
Financial instruments traded in the money market are:
A treasury bill is a financial instrument that is essentially a promissory note issued by the Reserve Bank of India to meet short-term fund requirements. Treasury bills have high liquidity and these instruments get issued at a price less than their face value and redeemed at face value.
Certificate of deposits
Certificates of deposits are short-term instruments issued by various commercial banks and financial development institutions. Certificates of deposits are issued to individuals, and corporations during times of tight liquidity when banks have slow deposit growth and the demand for credit is quite high. Certificates of deposits are negotiable and unsecured instruments that play an important role in mobilizing money for a short interval of time.
Reserve Bank of India introduced the concept of certificate of deposits in 1989 to assist commercial banks in raising funds. The maturity period of these instruments ranges from 3 months to a year, issued in multiples of 25 lakhs and the minimum subject value is 1 crore.
Call and notice money market
The call and notice money market is short-term repayable finance used for inter-bank transactions. Call money is a system wherein, transactions of funds occur on an overnight basis. This system is primarily used to maintain the high credit rate of banks. Notice money market is used in scenarios where banks need to hold funds for a longer duration, the maturity period of the notice money market ranges from two days to fourteen days.
Commercial papers were introduced into the financial market in 1990. They are short-term debt instruments issued in the form of promissory notes by listed companies having working capital of at least 5 crores. Commercial papers are an indicator of the market interest rates at any given point in time.
The money market is instrumental in dealing with short-term funds but the capital market engages in medium and long-term funds. The capital market provides facilitation for the marketing and trading of securities. The capital market consists of borrowings from financial institutions, foreign markets, and banks for the long term and the capital is raised by issuing securities in the form of shares, debentures, and bonds. These securities are traded in a market known as the Securities market.
Segments of capital market
The primary market is referred to as New Issue Market as it is a market consisting of new issues or financial claims. The primary market is involved in transacting with securities issued to the public for the first time. Since the capital market is associated with long-term (assets held for more than three years) manoeuvring of funds, the primary market allows borrowers to exchange financial securities for a longer time frame. A company may raise capital in the primary market by three methods:
When a corporation invites the public at large to become an investor in their corporation by offering them a particular stake in their venture, it is called a public issue. There are five types of public issues:
Initial public offer (IPO)
The process of an unlisted company entering into the financial market by issuing shares or convertible securities of its companies or by offering its existing shares or convertible securities for sale, the process is known as an initial public offer. Once a company is listed, its shares and convertible securities can be traded on stock exchanges.
Further public offer (FPO)
FPO is a process in which a company that is listed on the stock exchange makes a fresh offer by issuing shares or convertible securities to the public.
When shares or convertible securities are issued by the issuer to its existing shareholders on a particular date assigned by the issuer, it is referred to as a rights issue.
A composite issue is one in which an already listed company offers shares on the public-cum-rights basis and makes concurrent allotment of the shares.
An issuer makes an issue of shares to existing shareholders without any investment on their part based on the number of shares held by the shareholders on the record date, this phenomenon is known as a bonus issue. The shares are issued in a particular ratio to the number of securities held on a record date out of the company’s reserved shares.
When a company decides to offer shares to a selected group of individuals or institutions such as mutual funds, insurance companies, and banks to raise capital, it is known as a private placement. There are three kinds of private placements, those are:
i) Preferential issue
When a public listed company allots shares to a particular group of venture capitalists, individuals, and companies on a preferential basis, such an allotment of shares is known as a preferential issue.
ii) Qualified institutional placement
When qualified institutional buyers such as venture capital funds, mutual funds, insurance funds, etc are offered non-convertible securities or equity shares for selling by a listed organization to raise capital is known as Qualified Institutional Placement.
iii) Institutional placement programme
An institutional placement program is that part of Private Placement wherein, a public listed company or the promoters of the company make a follow-on offering of equity shares, where the stakes are allotted only to Qualified Institutional Buyers to purchase minimum public shareholding.
Financial instruments provide a gateway for the flow of capital to investors all around the world. Financial instruments are documents that may be real or virtual and represent a legal agreement involving any kind of monetary value. Financial instruments can be in the form of cash, a contractual right of delivering or receiving cash, or any other type of financial instrument.
Types of financial instruments:
Equity-based financial instruments
Equity-based financial instruments are those which represent ownership of an asset. Common stock, preferred stock, and convertible debentures are some of the prominent examples of an equity-based financial instrument.
Debt-based financial instruments
Debt-based financial instruments are those which represent loans made by an investor to the owner of assets. Bonds, certificated, and debentures are examples of debt-based financial instruments.
Foreign exchange Instruments
Foreign exchange is a trading platform where one currency is traded with another one. The transactions associated with foreign exchange take place in the foreign exchange market which is also known as the Forex Market. Currency futures, currency swaps, and currency options are some examples of foreign exchange instruments.
Financial services sector
An economy comprises various segments which are referred to as sectors, all the sectors cover different businesses and provide goods and services to consumers. A sector consists of various companies which offer similar kinds of services. For example, a company offering medical services comes under the healthcare sector or a company offering cellular telephone service comes under the telecommunication sector. Similarly, institutions offering financial services come under the financial services sector. Commercial banks, mutual funds, insurance companies, and non-banking financial intermediaries are some of the institutions covered under the financial services sector.
The financial services sector is focused on increasing earnings and equity market capitalization. International Monetary Fund has defined financial services as the process by which consumers or businesses acquire financial goods. Financial services companies are responsible for managing money.
Roles of financial services
- Financial services play a massive role in the economic development of a country. Financial services assist businesses or corporations by giving out loans, mortgages, etc. The loans provided by the financial services are further used by corporations to purchase assets or to invest in any other fundraising source.
- The entrepreneurial era that we are witnessing in India has been given direction by financial services institutions. Banks do not give loans to new budding entrepreneurs because of credibility issues, financial services step in to rescue the aspiring entrepreneurs by providing them loans to start their ventures. Angel investors and venture capitalists are some of the common ways for an entrepreneur to seek money for starting their entrepreneurial journey.
- Financial services form a chain of networks wherein each branch is linked to one another either directly or indirectly. For example, a person invests his money in the stock market and gets a return, he later decides to purchase a house with the money that he received and gets his house insured. In this scenario, the individual has circulated his money in three segments (stocks, buying house, and insurance company) and thus, a chain of networks in the financial services sector is established.
- Investors have got the choice to invest their money due to a vast array of financial services. The better the services, the more would be the demand by the investors. Consequently, financial services promote healthy competition amongst the firms offering financial services which is beneficial for the business of the country as the power is in the hands of investors.
Functions of Indian financial system
The financial system is a pillar of a country’s economy and is extremely instrumental in shaping the way for the economic development of the country. Through the constant exchange of funds among the institutions, circulation is maintained across the sector and a network chain is formed of financial systems. There are certain key functions that a financial system performs:
The financial system is extremely effective in mobilizing savings which are further used for other productive purposes. The financial system obtains funds from various business firms, central government, state government, and other public sector units. The financial system mobilizes the savings by moving them into financial assets like bank deposits, post office saving deposits, bills, bonds, equities, etc.
Allocation of funds
The financial system arranges credit smoothly and efficiently. Although, indigenous bankers and money lenders have been allocating funds for a long time, their system of allocating funds is disorganized. Since the inception of the financial system, the financial sector, financial institutions, and financial markets have been completely organized. Subsequently, the allocation of funds has become an extremely smooth and easier process.
Development of trade
The financial system of the country not only benefits domestic trade but also foreign trade is being promoted by an effective financial system. To promote domestic trade, financial instruments such as bills are discounted by the financial system and when it comes to foreign trade, it is promoted by commercial banks through per shipment and post-shipment finance.
Settling commercial transactions
The financial system is responsible for settling commercial transactions. Various financial claims which arise due to the sale of goods and services are settled by the financial system. All transactions including sales of goods and services are monitored in terms of money since money is a legally recognized instrument.
The financial system has evolved over some time and has adopted instruments like credit cards, cheques, and demand drafts for settling commercial transactions. These instruments are used by the financial system because they have been legally recognized as money substitutes.
We have often come across various television commercials, wherein, life insurance, and health insurance are being advertised, these life insurance, healthcare policy, and property insurance are also covered under the financial system. By selling these insurances, the financial market protects people from risks associated with health and income.
Ease of liquidity
Liquidity simply means converting an asset to cash. The financial market provides an opportunity for investors to liquidate their investments which are in the forms of shares, bonds, and debentures. The market experiences price fluctuation daily owing to the operational forces of the market and other factors such as demand and supply.
The Indian economy is a developing economy and still has a long way to go. The financial system provides the force to push the economic development of the country. The government plays a massive role by influencing macroeconomic variables like inflation or interest rate. This allows corporations to avail of credits at a cheaper rate, which further works towards boosting the economy of the country, and as a result, the overall economic development goes significantly up.
Corporate financing is one of the most important aspects of developing an economy. Corporate financing deals with all the major issues of a corporation such as seeking funds, making investment decisions, capital structuring of the company, etc.
A financial system is a well-established institution wherein different parts of the financial system work in collaboration with each other to fund an entrepreneurial venture, help borrowers and lenders, etc. A financial system is a well-organized chain of institutions that exchange funds amongst themselves depending upon the requirements of each segment of the institution. These systems work in unison to create a chain of financial networks which proves to be beneficial in developing an economy.
Frequently asked questions
What is angel investment?
Angel investment is a phenomenon wherein an individual known as an angel investor invests in a start-up or business in exchange for equity or convertible debt.
What is the difference between the money market and capital market?
In the money market, the process of lending and borrowing lasts for a short period in comparison with the capital market.
What are the four components of a financial system?
The four components of a financial system are:
1. Financial institutions,
2. Financial markets,
3. Financial instruments, and
4. Financial services sector.
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