What are the three core decisions in corporate finance?

Q: What are the three core decisions in corporate finance?

The three pillars are: (1) the investment decision—what assets or projects to invest in (capital budgeting); (2) the financing decision—how to fund those investments through debt, equity, or internal cash; and (3) the dividend decision—how much cash to return to shareholders versus reinvesting in the business. Every M&A deal, IPO, and restructuring traces back to these three.

Q: What is the Modigliani-Miller theorem and why does it matter?

Modigliani-Miller states that capital structure is irrelevant in a perfect market—the value of a firm is independent of how it's financed. In reality, frictions like taxes (interest tax shield), bankruptcy costs, and agency problems make capital structure matter. The theorem provides the theoretical baseline; real-world deviations from it explain why companies carefully optimize their debt-equity mix.

Q: How do you decide whether a company should invest in a project?

Use discounted cash flow analysis. Accept projects with positive NPV (net present value), meaning the present value of expected cash flows exceeds the investment cost. Alternatively, accept if the project's IRR (internal rate of return) exceeds the cost of capital. The discount rate should reflect project-specific risk, not just the company-wide WACC.

Q: What is the pecking order theory of capital structure?

Pecking order theory says companies prefer internal funds first (retained earnings), then debt, then equity as a last resort. This ordering reflects information asymmetry—issuing equity signals that management believes shares are overvalued, so markets react negatively. Debt is preferred over equity because it requires less disclosure and avoids diluting existing shareholders.

Corporate finance explained: capital allocation, financing, and dividend decisions. Core framework for investment banking technical interviews.

OfferGoblin·4 min read··

"The three most important words in investing are margin of safety." — Warren Buffett

Concept

Corporate finance is the study of how companies make financial decisions. It covers three core areas: investment decisions (what assets to buy), financing decisions (how to fund those assets), and dividend decisions (what to return to investors). Every M&A deal, IPO, and restructuring traces back to these three pillars.

Intuition

Corporate finance exists because capital is scarce. Every dollar a company spends has an opportunity cost—it could have been invested elsewhere or returned to shareholders. The framework forces discipline: invest only where returns exceed the cost of capital. Finance with the cheapest sources adjusted for risk. Return excess cash when you've run out of good projects. Breaking any of these rules destroys shareholder value.

Components

The Investment Decision

What It Is

Deciding which projects or assets the firm should invest in. Also called capital budgeting. The goal: accept projects that create value (positive NPV) and reject those that destroy it.

How to Evaluate It

Use discounted cash flow analysis:

NPV: Accept if NPV > 0
IRR: Accept if IRR > cost of capital
Payback Period: Simpler metric, but ignores time value of money

Key Consideration

The discount rate must reflect project-specific risk, not just company-wide WACC. A pharmaceutical company's R&D project has different risk than its manufacturing expansion.

The Financing Decision

What It Is

Determining the optimal mix of debt and equity to fund operations and investments. This is capital structure theory.

How to Think About It

Debt: Cheaper (interest is tax-deductible), but increases financial risk and bankruptcy probability
Equity: More expensive, but flexible—no mandatory payments
Trade-off Theory: Balance tax benefits of debt against distress costs
Pecking Order Theory: Companies prefer internal funds first, then debt, then equity

Key Consideration

The Modigliani-Miller theorem says capital structure is irrelevant in a perfect market. Real-world frictions—taxes, bankruptcy costs, agency problems—are why it matters.

The Dividend Decision

What It Is

Deciding how much cash to return to shareholders versus reinvesting in the business. Includes dividends, share buybacks, and special distributions.

How to Think About It

Method	Signal	Tax Efficiency	Flexibility
Regular Dividend	Commitment	Lower	Low
Share Buyback	Opportunistic	Higher	High
Special Dividend	One-time	Lower	Medium

Key Consideration

Dividend irrelevance (Miller-Modigliani) assumes perfect markets. In reality, dividends signal management confidence—cutting a dividend craters the stock price because it signals distress.

Cost of Capital

What It Is

The minimum return a company must earn to satisfy its investors. It's the hurdle rate for investment decisions.

W A CC = \frac{E}{E + D} \times r_{e} + \frac{D}{E + D} \times r_{d} \times (1 - T)

E = Market value of equity
D = Market value of debt
r_e = Cost of equity (typically from CAPM)
r_d = Cost of debt (yield on existing debt)
T = Tax rate

Key Consideration

WACC is a company-wide average. Using it for all projects implicitly assumes they have the same risk as the firm overall—often wrong.

Interview Script

Corporate finance is the study of how companies make financial decisions across three core areas: investment decisions, which is what assets to buy; financing decisions, which is how to fund those assets; and dividend decisions, which is what to return to investors. The underlying principle is that capital is scarce, so companies should only invest where returns exceed the cost of capital, finance with the cheapest risk-adjusted sources, and return excess cash when there aren't enough good projects—breaking any of these rules destroys shareholder value.

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Frequently Asked Questions

What are the three core decisions in corporate finance?

What is the Modigliani-Miller theorem and why does it matter?

How do you decide whether a company should invest in a project?

What is the pecking order theory of capital structure?