Corporate Finance - Finance Explained - PDF

KARNAVAT CLASSES 1. Corporate Finance corporate finance Q.1 Explain financiee Carnorate finance deals with the raising and using of finance by a co...

KARNAVAT CLASSES 1. Corporate Finance corporate finance Q.1 Explain financiee Carnorate finance deals with the raising and using of finance by a corporation, It deals with the activities of the corporation, capital structuring and making investment decisions MEANING:DEFINITION unnn Hoagland expresses the view that "corporate finance deals primarily with the acquisition and corporation." use of capital by business The term corporate finance also includes financial planning, study of capital market, money market and share market. It also covers capital formation and foreign capital. Even financial organisations and banks play vital role in corporate financing. - The finance manager of any Corporation has to ensure that a) the firm has adequate finance. b) they are using the right sOurce of funds that have minimum cost. c) the firm utilises raised funds effectively. d) they are generating maximum returns for it's owners. The following two decisions are the basis of corporate finance. 1) Financing Decision:The business firm has access to capital market tofulfill it's financial needs. The firmn has mltiple choices of sources of financing. The firm can choose whether it wants to raise eguity capital or debt capital. Firm can even opt for bank loan, public deposits, debentures etc. to raise funds. The finance manager ensures that the firm is well capitalised i.e. they have right amount of capital and that the firm has right combination of debt and equity. 2) Investment Decision : Once the business firm has gained access to capital, the finance manager has to teke decision regarding the use of the funds in systematic manner so that it will bring maximum retun for its owners. For this, the firm has to take into consideration the cost of capital, Once they know the cost of capital, firm can deploy or use the funds in such a way that returns are more than cost of capital. Finding investments and deploying them successfuly in the business is known as investing decision. It is also called as 'capital budgeting'. Q.2 Explain Importance of Corporate Finance. In the functional management of business enterprise, importance is given to production, finance, marketing and personnel activities. Among all these activities, utmost importance is given to financial activities. The importance of corporate finance may be discussed as follows - 1. Helps in decision making : Most of the important decisions of business enterprise are determined on the basis of availability of funds. It is difficult to perform any function of business enierprise independentlywithout finance. Every decision in the business is needed to be taken keeping in view of it's impact on profitabilily. CORPORATE FINANCE  il e t a IicattC BusmeSs pansato 2elpsin Rasing Canta for pret: heee af Nrots Tanca suCO gnificant role un varioS tivities :orlE nance a s 3. Brings co-ination betaeen unit Due to catar franoa reurements for smath rning of prOdtion meetng cher denends nthe etie inanoal manacehent aete hseoenc o evey denartment Modern mansad moden tehniQues ar r u n 6. Promotes expansion and dersi fication: dern machines prdS mONe trchse for expanson acersfcaton. Corparate fnance divesifcation of a and tecnooges Therefore fnance bamas mandaton for exansn and as sudden fall in sales, loss due th 7. Managing Risk : Compan has to man0E SEVEral nsks such ompeny neats ìnancial aid to manage such nsks natura a n t ioss due strkes et berome old and outdated ov ha 8. Replace old assets : ssets suoh as niant and mhinen new assts years They have to be repaced by new Ssets. Fnance s rauirN t Durchase intst 9. Pavment of dividendand interest :Finance s needeto nay dividend to shareholders to crec tors banks, etc 10. Payment of taxes/fees : Company has to pay taxes to Govemnent such as Income ax, Goods and Servce Tax (GST) and fees to Registrar of Companies on varnous casions. Finane is needed for pay.ng these taxes and fees Explain Capital Requirements. When a business entrepreneur conceives an idea of setting up a business enterpnise, the commeroal viability of the idea is investigated. Once the entrepreneur is satistied witth the feasibility of the projt Serious steps are taken to start the project. The first and foremost step is to take decision on the amount CORPORATE FINANCE  (KARNAVAT CLASSES) task has to be performed with utmost care. capital requirement to start and run the business. This of e h a l nlan should be drafted keeping in mind present and future requirement of the businece rqurement, an entrepreneur has to take into consideratios Ths whule deciding about the volume of capital and working capital requirement. We shall now d1scuss these capital requirements capital reqnrement fixed in detail..A Fivod Capital : Fixed capital is the capital which is used for buying fixed assets which are used for a longer period of time in the business, These assets are not meant for resale In simple words fixed capital refers to capital invested for acquiring fixed assets. It stays in the business for long period almost permanently. Examples of fixed capital are - capital used for nurchasing land and building, furniture, plant and machinery etc. Such capital is required usually at the time ofestablishment of a newcompany. However, existing companies may also need such capital for their expansion and development, replacement of equipments, etc. Initial planning of fixed capital requirement is made by company's promoters. For this, they first prepare a list of fixed assets needed by the company and cost of these assets is estimated. They collect information regarding price of land, cost of construction of building, cost of plant and machinery, etc. The cost of different fixed assets is calculated and the resulting figure would be the total of fixed capital requirement of a new firm. In recent years, estimating fixed capital requirement has assumed great importance particularly because of modern industrial processes which require increased use of heavy and automated machineries. An entrepreneur obtains funds for the purchase of fixed assets from capital market. Funding can come from issue of shares, debentures, bonds or obtaining even long term loans. IFactors affecting fixed capital requirement: 1. Nature of business : Manufacturing industries and public utilities have to invest huge amount of funds to acquire fixed assets. While Trading business may not need huge investments in fixed assets. 2. Size of business : Where a business firm is set up to carry on large scale operations, its fixed capital requirements are likely to be high. It is because most of their production processes are based on automatic machines and equipments. 3. Scope of business: There are business firms which are formed to carry on production or distribution on a large scale. Such businesses would require more amount of fixed capital. 4. Extent of lease or rent :If entrepreneur decides to acquire assets on lease or on rental basis, less amount of funds for fixed assets will be needed for the business. 5. Arrangement of sub-contract : If the business wants to sub-contract some processes of production to others, limited assets are required to carry out the production. It would minimise fixed capital requirement of business. 6. Acquisition of old assets : If old equipments and plants are available at low prices, then it would reduce the need for investment in fixed assets. 7.Acquisition of assets on concessional rate : With the view to foster industrial growth at regional level, the government may provide land and building, materials at concessional rates. Plants and equipments may also be made available on instalment basis. Such CORPORATE FINANCE  XII - COM. (Secretarial Practice, facilities will reduce the requirement of fixed assets. 8, International conditions : lhis factor is very significant particularly in large organtsations carrying business on international level. For exarnple companies expecting war, may decide to invest large funds to expand fixed assets before there is shortage of materiale 9. Trend in economy : If the future of the company is anticipated to be bright, it gives green signal to business entrepreneur tocarry out all sorts of expansion of busiess firm In that case, large amount of funds are invested in fixed assets so as to reap the benefits in future. 10. Population trend : When the population is increasing at high rate, certain manufactures find this as an opportunity to expand business, For example- autornobile industry, electronie goods manufacturing industry, ready-made garments, etc. which necessitates huge arnournt of fixed capital. 11. Consumer preference : Industries providing goods and services which are in good dermand, will require large amount of fixed capital.For example -Mobile phone manufactures as well as mobile network providers. 12.Competitive factor : This factor is prime elerment in decision making regarding fized capital requirements. Ifone of the competitor's shifts to automation, the other companies in the same line of activity, will be compelled to follow that competitor. (B) Working Capital Working capital is the capital which is used to carry out the day to day business activities. After estimating fixed capital requirement of the business firm, it is necessary to estimate the anount of capital, that would be needed to ensure smooth functioning of the business firm, Abusiness firm requires funds to store adequate raw material in stock. Afirm would need capital to maintain sufficient stock of finished goods. In actual practice goods are sold out in cash or on credit., Goods sold on credit do not fetch cash immediately. Firm will have to arrange for funds tillthe amount is collected from the debtors. Cash is also required to pay overheads. Since urncertainty is always a feature of business, sorme excess cash also should be maintained to meet urnexpected expenses. Thus, abusiness firm will have to arrange capital for the following : a) For buildingup inventories b) For financing receivables c) For covering day-to-day operating expenses. The capital invested in these assets is referred to as 'Working capital". The concept of working capital is viewed differently by leading authorities. Some authorities consider working capital as equivalent to excess of current assets over current liabilities. Gerstenbergh, defines it as, "The excess of current assets over current liabilities." This approach refers to 'Net Working Capital'. Gerstenbergh does not call it as working capital. He prefer to call it as 'circulating capital". Other authorities viewed working capital equivalent to current assets. According to J. S. Mill, "The sum of current assets is working capital." This approach has broader application. It takes into consideration all current assets, of the company. It refers to 'Gross Working Capital'. CORPORATE FINANCE  KARNAVAT CLASSES requirement: Factors affecting working capital standards to measure work1ng raptal adequacy. Management has to determine There is no precise cap1talin the hght of certa1r1 asperts of business firm and economic environment with1r the size of working which the firm operates. Additional in formation: Kscial ow of wnrking capitat A bsis fien needs fusd to fnance its 2Kkng op tai neer Prorasnt stere of ths fund Inveatnrie Dzed to buy ra saterias and remaining part r keçt available to py wages ad pendtures. Tbs the working captal which was n the forrn 6 cas coveted into ietories Raw Receis abe GL2ter als are cons erted sto work nptocess and Operatess then to fin1sbed good With the sale of finished| goods they turm to accous receiv ables. presturnng the goods are sod on credt basis. Nornnly accou receivables hate maturities of CASH specific days afer billing date Collection of the recer able brings back the cycle to cash Apart of cash ay be used to pay cred itors Cycle Mow of Workíng Capital pav incorne tax 2d declare dividend and rest of st 15 Dut into crculatjon again A1. Nature of business: Firms engaged in manufacturing essential products of daily consumption would need relativey less working capital as there would be constant and sufficient cash inflow in the firm to take care of liabilities. Likewise public utility concerns have to maintain smallworking capital because of continuous flow of cash from their customers. On the contrary, if the business is dealing in luxurious products, it requires huge amount of workin9 capital, as sale of luxurious items are not frequent. Trading/merchandising firms which are concerned with distribution of goods have to carry big inventories of goods to meet customer's demand and have to extend credit facilities to attract customers. Hence they need large amount of working capital. 2. Size Of business: The size of business also affects the requirement of working capital. Afirm with large scale operations will require more working capital. Volume of sales : This is the most important factor affecting size of working capital. The volume of sales and size of working capital are directly related with each other. If volume of sales increases, there is an increase in the amount of working capital and vice a versa. Production cycle The process of converting raw material into finished goods is called production cycle. If the period of production cycle is longer, then firm needs more amount of working capital. If manufacturing cycle is short, it requires less working capital. 5. Business cycle : When there is a boom in the economy, sales will increase. This will lead to increase in investment CORPORATE FINANCE  "XI cOM (kecretatat Pratico in stocks Ihislequres additional worktucaptal n will ate de Dunng Tecession, salex will decne and hence the ineedlot wokiny atal F Terms ot purchases and sales tt oey iberal the firm does not get cibdit fa iity for puchae but adojt then it requres more working capital ctedit sale andtome of On the other hand it ctedit terms o purchave ate favoutable requteneat willl be educed wokibu copital liberal, tthein requieiment of cash vill be less thue Credit controt: I teme of credit uales, the of cedil sale, he company to Credit controt includes the fators such as volume npreve it positlefot the In sOuot, It ia de Itcan inCrease collection pollcy, et If credit control polly problem of colleton of Ceates a cash flow. If credit policy is liberal, it capital more workbg possibility of bad debts. Therefore afin equlres The fim making cash sales requnes less wokng capital ompany 8. Growt and Expansiong fim A yroWiny fim willncrease with orowth of a The working capital Tequrement of o scale operations needs funds continuously to suppot large 9. Management atity there iy proper oomalion between producion working captal is teduced it ne requirement of all, to higher level fo workin0 on heavy iventory and distribution of goods, Afim sloking0 capital. 10. ExteHaaetors mas ndl when eqired, he need for to the and banks provide funds IT finanCial instiutions working capitel is Teduced Q.5 Capital Strciur or borrowed capital orboth capital from ditferent sources, L.e, owned captal Acompany can raise its teserves and urplus, On the of equity share capital, preference share capilal, The owned capital consists different sources are used in sources are debentures, loans, etc. A combination ol other hand, borrowed mix. capital structure. It is nothing but 'security proportion: lo decide capital sources ot fonde in desind Capital structuremeans 'mix up of various different typec of caoat tructure means, to decide upon the ratio of Definition tsness enterpris R. H. Wessel :" The long term sources of funds emptoyed between the debt and equity iecuities John Hampton : "A firm's capital structure is the telation that makes up the firm's financing of it's assets". funds, Owned funds includes share Thus capital structure is composed of owned funds and borrowed loans and capital, free reserves and surplus, whereas, borrowed funds represent debentures, Bank long term loans provided by financial institutions. Components of Capital Structure: CoRPORATE FINANCE  (KARNAVAT CLASSES) There are four basic components of capital structure. They are as follows : capitalI:It is the basic source of financing activities of business. Equity shares are Equityshare (1) shares which get dividend and repayment of capital after it is paid to preference shares. They own the company. They bear ultimate risk associated with ownership. They carry dividend at fluctuating rate depending upon the profits. Preference share capital:Preference shares carry preferential right as to payment of dividend (2) and bave priority over equity shares for return of capital when the company is liquidated. These rate. shares carry dividend at fixed It is internal source of financing. It is nothing but ploughing back of profit. (3) Retained earnings; (4) Borrowed capital: It comprises the following : B a) Debenture: it is acknowledgement of loans raised by company. Company has to pay interest at an agreed rate. b) Term loan: Term loans are provided by bank and other financial institutions. They carry fixed rate of interest. To understand the above concept, we shall consider following Balance sheet and calCulate the values: Balance sheet of ABC Company Ltd. as on 31st March, 2019 Liabilities Amount ? Assets Amount share Capital Fixed Assets 10,000 equity shares Building 4,00,000 of 10 each fully paid 1,00,000 Plant and Machinery 2,00,000 5,000 preference Current Assets shares of 100 each fully 5,00,000 Sundry Debtors 1,00,000 paid. Reserves and 50,000 Inventories 50,00O Surplus Liabilities Cash in hand 10,000 1000, 10% Debentures Cash at bank 40,000 of 100 each fully 1,00,000 paid Sundry creditors 30,00O Bills payable 20,000 8,00,000 8,00,000 Capital Structure = Equity Share Capital + Pref. Share Capital + Reserves +Debenture: =1,00,oo0 + 5,00,000 + 50,000 + 1,00,000 =7,50,000 CORPORATE FINANCE