Ten Fundamental Concepts in Corporate Finance

1. Future cash flows must be discounted to the present

Future cash flows—whether assumed, expected, or projected—must be discounted back to today at an appropriate discount rate. This is the time value of money, and it is THE FUNDAMENTAL concept in corporate finance. Everything else follows from it.

Example: Two projects each promise $100 million. One pays it next year; the other in ten years. Treating them as equal is a category error. Capital markets don't.

2. Risk must be priced

Risk and return are inevitably linked. Higher expected returns require that greater risk be assumed. If risk is ignored, understated, or mispriced, value is almost certainly being overstated.

Example: Investors in a regulated utility are willing to accept single-digit expected returns, while investors in a startup biotech require a multiple of that—reflecting the very different risks involved.

3. Firm value comes from future cash flows discounted at a cost of capital

The value of a firm comes from discounting expected (that is, hoped-for) future cash flows at an appropriate discount rate that reflects risk. This discount rate is the firm's cost of capital, or hurdle rate. Projections are just (hopefully) educated guesses. The future is fundamentally unknowable.

Example: A company beats earnings but cuts long-term investment to do so. The stock falls anyway—because future cash flows just shrank.

4. Diversification is a very rare free lunch

Diversification can reduce risk while maintaining expected return. This Nobel prize winning insight is the foundation of modern portfolio theory.

Example: An investor can reduce portfolio risk by holding many businesses. A corporation trying to do the same thing often just creates a conglomerate discount.

5. Growth does not create value

Growth creates value only when the return on invested capital exceeds the cost of capital. The cost of capital represents what investors require to provide capital to the firm. Growth for its own sake in earnings, revenue or scale—organic or acquired—often destroys value while appearing successful on the surface.

Example: An acquisition increases revenue by 30% and earnings by 10%, yet destroys shareholder value because the price paid exceeded the discounted returns ultimately generated.

6. Cash flow matters more than accounting earnings

Accounting is an agreed set of principles, not economic reality. Earnings are not cash flow; balance sheets are historical; the decision to capitalize or expense is often arbitrary. Always follow the cash.

Example: A profitable company misses payroll because customers pay slowly while suppliers insist on Net 30. The income statement shows success; the bank account shows failure.

7. Leverage magnifies outcomes

Debt magnifies both positive and negative outcomes. Properly used, leverage can increase returns to equity. Improperly used, it accelerates failure. No firm has ever declared bankruptcy because it failed to pay a dividend.

Example: Two identical firms face a downturn. The unlevered one survives; the leveraged one restructures. The difference wasn't strategy—it was the balance sheet.

8. Liquidity is a strategic asset

Liquidity buys time, flexibility, and negotiating power. It allows firms to survive downturns, meet obligations under stress, and act opportunistically when others cannot.

Example: During a crisis, one firm uses its liquidity to make strategic investments while competitors sell assets at fire-sale prices. Liquidity set the terms of survival.

9. Options and optionality have value

Options—whether embedded in financial instruments or in strategic business decisions—can be valuable. Scary looking math and the presence of Greek letters does not make this idea inscrutable.

Example: A company delays a factory build, preserving the right—but not the obligation—to expand once demand is clearer. Waiting created value.

10. Incentives shape behavior

Incentives shape both individual and corporate behavior. Managers, traders, bankers, and salespeople respond to incentives in predictable ways. Misaligned incentives explain many corporate failures more reliably than bad strategy or bad luck.

Example: Executives paid on EPS pursue buybacks and leverage; those paid on revenue pursue acquisitions; those paid on long-term equity behave differently again.