Name: Kunal Salian

Roll No.: BBA015137

Subject: Corporate Finance
 Assignment-1
Corporate Finance

1. Explain in Detail Factors Influencing Financing Decision of a firm.

Ans. Financing decision is concerned with the decisions about how much funds are to be raised
from which long-term source, i.e. by means of shareholders' funds or borrowed funds.
Shareholders' funds include share capital, reserves and surplus and retained earnings, whereas,
borrowed funds include debentures, long-term loans and public deposits.

Factors affecting financing decision:

1. Cost: The cost of raising funds from different sources are different. A wise finance
manager opt for the cheapest source of finance.
2. Risk: The risk associated to each of the source is different. The source which involves
least risk should be preferred.
3. Floatation Cost: If the floatation cost, i.e. the expenses incurred in issue of debt is higher,
the source of finance becomes less attractive.
4. Cash Flow Position of the Company: A stronger cash flow position may make debt
financing more viable than funding through equity.
5. Fixed Operating Cost: If a firm is having a higher fixed operating burden like payment of
interests, premiums, salaries, rent, etc, then it should avoid financing through debt. This
is because it will further increase the interest payment burden and the firm can reach an
unfavourable position. However, if the firm has lower operating cost, then the firm can
borrow funds.
6. Control Considerations: Issue of more equity may dilute shareholders’ control over the
business. Therefore, a company afraid of a takeover bid may prefer debt to equity.
7. State of Capital Market: If the stock market is rising, then it is easy to sell equity shares.
But in a depressed capital market, the company has to opt for debt financing.
8. Return on Investment (ROI): Return on Investment means the earnings of a company on
its investments. It is an important criteria for deciding the type of funds to be sourced.

When the ROI is more than the cost of debt, (i.e. interest to be paid on debt,) borrowed
funds should be used. The reason being:

(a) Interest paid on debt is deductible from profits while calculating tax liability.
 (b) It increases the returns of the shareholders. This can be explained by following
example

9. Tax Rate: Since interest is a deductible expense, cost of debt is affected by tax rate. If the
tax rate is higher debt financing becomes more attractive.
10. Flexibility: Financing should be done in such a way, that it should be able to cater to
additional requirements of funds in future. If a company uses its debt potential in full, it
will lose flexibility to issue further debt, which might become necessary at some future
point.
11. Regulatory Frame Work: The Companies Act and SEBI guidelines must be observed
while raising funds from the public. Government has laid down certain norms for debt
equity ratio and ceilings on public deposits. Borrowings from banks and other financial
institutions, require fulfillment of certain norms. Thus, the relative ease with which their
procedures ' and norms can be met, has an impact on the choice of the source of finance.

2. Explain in detail Factors Influencing Investment Decision of a firm.

Ans. Capital investment decisions are not governed by one or two factors, because the
investment problem is not simply one of replacing old equipment by a new one, but is concerned
with replacing an existing process in a system with another process which makes the entire
system more effective. The factors influencing investment decisions of a firm are as follows:

1. Management Outlook: lf the management is progressive and has an aggressively

marketing and growth outlook, it will encourage innovation and favor capital proposals
which ensure better productivity on quality or both. In some industries where the product
being manufactured is a simple standardized one, innovation is difficult and management
would be extremely cost conscious. In contrast, in industries such as chemicals and
electronics, a firm cannot survive, if it follows a policy of ‘make-do’ with its existing
equipment. The management has to be progressive and innovation must be encouraged in
such cases.

2. Competitor’s Strategy: Competitors’ strategy regarding capital investment exerts

significant influence on the investment decision of a company. If competitors continue to
install more equipment and succeed in turning out better products, the existence of the
company not following suit would be seriously threatened. This reaction to a rival’s
policy regarding capital investment often forces decision on a company.
3. Opportunities created by technological change: Technological changes create new
equipment which may represent a major change in process, so that there emerges the
need for re-evaluation of existing capital equipment in a company. Some changes may
justify new investments. Sometimes the old equipment which has to be replaced by new
equipment as a result of technical innovation may be downgraded to some other
applications, A proper evaluation of this aspect is necessary, but is often not given due
consideration. In this connection, we may note that the cost of new equipment is a major
factor in investment decisions. However the management should think in terms of
incremental cost, not the full accounting cost of the new equipment because cost of new
equipment is partly offset by the salvage value of the replaced equipment. In such
analysis an index called the disposal ratio becomes relevant.

4. Market forecast: Both short and long run market forecasts are influential factors in capital
investment decisions. In order to participate in long-run forecast for market potential
critical decisions on capital investment have to be taken.

5. Fiscal Incentives: Tax concessions either on new investment incomes or investment

allowance allowed on new investment decisions, the method for allowing depreciation
deduction allowance also influence new investment decisions.

6. Cash flow Budget: The analysis of cash-flow budget which shows the flow of funds into
and out of the company may affect capital investment decision in two ways. ‘First, the
analysis may indicate that a company may acquire necessary cash to purchase the
equipment not immediately but after say, one year, or it may show that the purchase of
capital assets now may generate the demand for major capital additions after two years
and such expenditure might clash with anticipated other expenditures which cannot be
postponed. Secondly, the cash flow budget shows the timing of cash flows for alternative
investments and thus helps management in selecting the desired investment project.

7. Non-economic factors: new equipment may make the workshop a pleasant place and
permit more socializing on the job. The effect would be reduced absenteeism and
increased productivity. It may be difficult to evaluate the benefits in monetary terms and
as such we call this as non-economic factor. Let us take one more example. Suppose the
installation of a new machine ensures greater safety in operation. It is difficult to measure
 the resulting monetary saving through avoidance of an unknown number of injuries. Even
then, these factors give tangible results and do influence investment decisions.

3. Explain in detail Factors Influencing Dividend Decision of a firm.

Ans. A firm's dividend policy is influenced by the large numbers of factors. Some factors affect
the amount of dividend and some factors affect types of dividend. The following are the some
major factors which influence the dividend policy of the firm.

1. Legal requirements
There is no legal compulsion on the part of a company to distribute dividend. However, there
certain conditions imposed by law regarding the way dividend is distributed. Basically there are
three rules relating to dividend payments. They are the net profit rule, the capital impairment rule
and insolvency rule.

2. Firm's liquidity position

Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained
earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.

3. Repayment need
A firm uses several forms of debt financing to meet its investment needs. These debt must be
repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the
dividend payment capacity reduces.

4. Expected rate of return

If a firm has relatively higher expected rate of return on the new investment, the firm prefers to
retain the earnings for reinvestment rather than distributing cash dividend.

5. Stability of earning
If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a
firm with relatively fluctuating earnings.

6. Desire of control
When the needs for additional financing arise, the management of the firm may not prefer to
issue additional common stock because of the fear of dilution in control on management.
Therefore, a firm prefers to retain more earnings to satisfy additional financing need which
reduces dividend payment capacity.

7. Access to the capital market

If a firm has easy access to capital markets in raising additional financing, it does not require
more retained earnings. So a firm's dividend payment capacity becomes high.

8. Shareholder's individual tax situation

For a closely held company, stockholders prefer relatively lower cash dividend because of higher
tax to be paid on dividend income. The stockholders in higher personal tax bracket prefer capital
gain rather than dividend gains.

4. Explain the relationship among cost of equity, dividend, price and expected growth.

Ans. The cost of equity is the return a company requires to decide if an investment meets capital
return requirements; it is often used as a capital budgeting threshold for required rate of return. A
firm's cost of equity represents the compensation the market demands in exchange for owning
the asset and bearing the risk of ownership. The traditional formulas for cost of equity (COE) are
the dividend capitalization model and the capital asset pricing model.

The cost of equity is the return that stockholders require for their investment in a company. The
traditional formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for
owning the asset and bearing the risk of ownership.This approach approximates a future dividend
stream based on the firm's dividend history and an assumed growth rate, and computes the
market capitalization rate that equates it with the current market price.