Chapter- 1 Introduction to Corporate Finance

 Chapter - 1 

Introduction to Corporate Finance

Chapter : 1 Introduction to Corporate Finance

Chapter: 2 Source of Corporate Finance

Chapter: 3 Issue of Shares

Chapter: 4 Issue of Debentures

Chapter: 5 Deposits

Chapter: 6 Correspondence with Members

Chapter: 7 Correspondence with Debenture holders

Chapter: 8 Correspondence with Depositors

Chapter : 9 Depository and Interests

Chapter : 10 Dividend and Interest 

Chapter: 11 Financial Markets

Chapter: 12 Stock Exchange

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Q.1 A) Select the correct answer from the options given below and rewrite the statements.

1. .................. is related to money and money management.
    a) Production b) Marketing c) Finance

Ans: c) Finance

2. Finance is the management of ................. affairs of the company.
    a) monetary b) marketing c) production

Ans: a) monetary

3. Corporation finance deals with the acquisition and use of ................. by business corporation.        a) goods b) capital c) land

Ans: b) capital

4. Company has to pay ................. to government.    

    a) taxes b) dividend c) interest

Ans:  a) taxes

5. ................. refers to any kind of fixed assets.

    a) Authorised capital b) Issued capital c) Fixed capital

Ans: c) Fixed Capital

6. ................. refers to the excess of current assets over current liabilities.

    a) Working capital b) Paid-up capital c) Subscribed capital

Ans:  a) Working capital

7. Manufacturing industries have to invest ................. amount of funds to acquire fixed assets.

    a) huge    b) less      c) minimal

Ans: a) huge

8. When the population is increasing at high rate, certain manufacturers find this as an opportunity to ................. business. 

    a) close    b) expand      c) contract

Ans: b) expand

9. The sum of all ................. is gross working capital.

    a) expenses    b) current assets      c) current liabilities

Ans: b) current assets

10. ................. means mix up of various sources of funds in desired proportion.

    a) Capital budgeting b) Capital structure c) Capital goods

Ans: b) Capital Structure 

B) Match the pairs:

Group ‘A’	Group ‘B’
a) Capital budgeting	1) Sum of current assets
b) Fixed Capital	2) Deals with acquisition and use of capital
c) Working Capital	3) Fixed liabilities
d) Capital structure	4) Sum of current liabilities.
e) Corporate finance	5) Fixed assets
	6) Investment decision
	7) Financing decision
	8) Deals with acquisition and use of assets.
	9) Mix up of various sources of funds
	10) Product mix

Ans:

Group ‘A’	Group ‘B’
a) Capital budgeting	6) Investment decision
b) Fixed Capital	5) Fixed assets
c) Working Capital	4) Sum of current liabilities.
d) Capital structure	9) Mix up of various sources of funds
e) Corporate finance	8) Deals with acquisition and use of assets.

C) Write a word or a term or a phrase which can substitute each of the following statements.

  1. A key determinant of success of any business function.

Ans: Finance

  2. The decision of finance manager which ensures that firm is well capitalised.

Ans: Financing Decision

  3. The decision of finance manager to deploy the funds in systematic manner.

Ans: Investment Decision

  4. Capital needed to acquire fixed assets which are used for longer period of time.

Ans: Fixed Capital

  5. The sum of current assets.

Ans: Working Capital

  6. The excess of current assets over current liabilities.

Ans: Working Capital

  7. The process of converting raw material into finished goods.

Ans: Product Cycle

  8. The boom and recession cycle in the economy.

Ans: Business Cycle

  9. The ratio of different sources of funds in the total capital.

Ans: Capital Structure

  10. The internal source of financing.

Ans: Retained Earning

D) State whether the following statements are true or false.

  1. Finance is related to money and money management.

Ans: True

  2. Business firm gives green signal to the project only when it is profitable.

Ans: True

  3. Corporate finance brings co-ordination between various business activities.

Ans: True

  4. Fixed capital is also referred as circulating capital.

Ans: False

  5. Working capital stays in the business almost permanently.

Ans: False

  6. The business will require huge funds, if assets are acquired on lease basis.

Ans: False

  7. The business dealing in luxurious products will require huge amount of working capital

Ans: True    

8. A firm with large scale operations, will require more working capital.

Ans: True

  9. Liberal credit policy creates a problem of bad debts.

Ans: True

  10. Financial institutions and banks cater to the working capital requirement of business.

Ans: True

E) Find the odd one.

  1. Land and Building, Plant and Machinery, Cash.

Ans: Cash

  2. Debenture Capital, Equity Share Capital, Preference Share Capital.

Ans: Debenture Capital

  3. Fixed Capital, Capital Structure, Working Capital.

Ans: Capital Structure

F) Complete the sentences.

  1. Initial planning of capital requirement is made by .......................... .

Ans: Financial Manager

  2. When there is boom in economy, sales will .......................... .

Ans: Increase

  3. The process of converting raw material into finished goods is called .......................... .

Ans: Production Cycle

  4. During recession period sales will .......................... .

Ans: Decrease

G) Select the correct option from the bracket.

Group ‘A’	Group ‘B’
a) Financing decision	1) -----------
b) ------------------	2) Longer period of time.
c) Investment decision	3) ---------------
d) ------------------	4) Circulating capital
e) Combination of various sources of funds	5) ---------------

( To have right amount of capital, Deploy funds in systematic manner, Fixed capital, Working capital, Capital structure )

Ans:

Group ‘A’	Group ‘B’
a) Financing decision	1) To have right amount of capital
b) Fixed capital	2) Longer period of time.
c) Investment decision	3) Deploy funds in systematic manner
d) Working capital	4) Circulating capital
e) Combination of various sources of funds	5) Capital structure

H) Answer in one sentence.

  1. Define corporate finance.

Ans: Henry Hoagland expresses the view that ‘‘corporate finance deals primarily with the acquisition and use of capital by business corporation.’’

  2. What is fixed capital ?

Ans: : 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.

Examples of fixed capital are - capital used for purchasing land and building, furniture, plant and machinery etc.

  3. Define working capital.

Ans: Working capital is the capital which is used to carry out the day to day business activities. 

Gerstenbergh, defines it as, ‘‘The excess of current assets over current liabilities.’’

  4. What is production cycle ?

Ans: The process of converting raw material into finished goods is called production cycle.

  5. Define capital structure.

Ans: R. H. Wessel : “ The long term sources of funds employed in a business enterprise”. 

     John Hampton : “A firm’s capital structure is the relation between the debt and equity securities that makes up the firm’s financing of it’s assets”.

I) Correct the underlined word/s and rewrite the following sentences.

  1. Finance is needed to pay dividend to debenture holders.

Ans: Finance is needed to pay interest to debenture holders.

2. When there is recession in economy sales will increase.

Ans: When there is boom in economy sales will increase.

3. Share is an acknowledgement of loan raised by company.

Ans: Debenture is an acknowledgement of loan raised by company.

4. Equity shares carry dividend at fixed rate.

Ans: Preference shares carry dividend at fixed rate.

Q.2 Explain the following terms / concepts.

  1. Financing decision

Ans: (a) The business firm has access to capital market to fulfill it’s financial needs. The firm has multiple choices of sources of financing. 

(b) The firm can choose whether it wants to raise equity capital or debt capital. Firm can even opt for bank loan, public deposits, debentures etc. to raise funds. 

(c) 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

Ans: (a) Investment decision refers to the decision taken by the finance manager has to take decision regarding the use of the funds in systematic manner so that it will bring maximum return for its owners.

(b) 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.

  3. Fixed capital

Ans: (a) 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. 

(b) It stays in the business for long period almost permanently. Examples of fixed capital are - capital used for purchasing land and building, furniture, plant and machinery etc.

  4. Working capital

Ans: (a) Working Capital refers to business firm's investment in short-term assets it is a capital which is used to carry out day to day business activities. Working capital ensures smooth functioning of the business firm.

(b) The capital invested in building up inventories, in financing receivables and payables and  covering day-to-day operating expenses are referred to as ‘Working capital’.    

Q.3 Study the following case / situation and express your opinion.

  (1) The management of ‘Maharashtra State Road Transport Corporation’, wants to determine the size of working capital.

      a. Being a public utility service provider, will it need less working capital or more ?

      b. Being a public utility service provider, will it need more Fixed Capital ?

      c. Give one example of public utility service that you come across on day-to-day basis.

Ans: a)     Being a public utility service provider, it will need less working capital.

b)   Yes. Being a public utility service provider, it will need more fixed capital.

c)     BEST Brihanmumbai Electric Supply and Transport undertaking is an example of public utility service.

  (2) A company is planning to enhance it’s production capacity and is evaluating the possibility of purchasing new machinery whose cost is ` 2 crore or has alternative of machinery available on lease basis.

      a. What type of asset is machinery ?

      b. Capital used for purchase of machinery is fixed capital or working capital ?

      c. Does the size of a business determine the fixed capital requirement ?

Ans:

a)     Machinery is a fixed asset. This is because it stays with a company for a long period of time.

b)   Capital used for the purchase of machinery is fixed capital. It is the capital that stays in the company almost permanently.

c)    Yes, the size of a business determines the fixed capital requirement. Large size business has high fixed capital requirements and vice versa.

Q.4 Distinguish between the following.

1. Fixed Capital and Working Capital.

Ans: 

Points	Fixed Capital	Working Capital
Meaning	Fixed capital refers to any kind of physical asset i.e. fixed assets.	Working capital refers to the sum of current assets.
Nature	It stays in the business almost permanently.	Working capital is circulating capital. It keeps changing.
Purpose	It is invested in fixed assets such as land, building, equipments, etc	Working capital is invested in short term assets such as cash, account receivable, inventory, etc.
Sources	Fixed capital funding can come from selling shares, debentures, bonds, long term loans, etc	Working capital can be funded with short term loans, deposits, trade credit, etc.
Objectives of Investors	Investors invest money in fixed capital hoping to make future profit	Investors invest money in working capital for getting immediate returns.
Risk	Investment in fixed capital implies more risk.	Investment in working capital is less risky

Q.5 Answer in brief.

  1. Define capital structure and state it’s components.

Ans: R. H. Wessel : “ The long term sources of funds employed in a business enterprise”. 

Components of Capital Structure : There are four basic components of capital structure. They are as follows : 

(1) Equity share capital : It is the basic source of financing activities of business. Equity shares are 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. 

(2) Preference share capital : Preference shares carry preferential right as to payment of dividend and have priority over equity shares for return of capital when the company is liquidated. These shares carry dividend at fixed rate. 

(3) Retained earnings : It is internal source of financing. It is nothing but ploughing back of profit. 

(4) Borrowed capital : It comprises the following : 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. 

  2. State any four factors affecting fixed capital requirement.

Ans: Fixed 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.

Factors 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 facilities will reduce the requirement of fixed assets. 

 8. International conditions : This factor is very significant particularly in large organisations carrying business on international level. For example : companies expecting war, may decide to invest large funds to expand fixed assets before there is shortage of materials

  3. What is corporate finance and state two decisions which are basis of corporate finance.

Ans: CORPORATE FINANCE : MEANING Corporate finance deals with the raising and using of finance by a corporation. It deals with financing the activities of the corporation, capital structuring and making investment decisions. 

 DEFINITION Henry Hoagland expresses the view that ‘‘corporate finance deals primarily with the acquisition and use of capital by business corporation.’’

The following two decisions are the basis of corporate finance. 

1) Financing Decision : The business firm has access to capital market to fulfill it’s financial needs. The firm has multiple choices of sources of financing. The firm can choose whether it wants to raise equity 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 : The finance manager has to take decision regarding the use of the funds in systematic manner so that it will bring maximum return 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. 

Q.6 Justify the following statements.

  1. The firm has multiple choices of sources of financing.

Ans: 

Justification:

(a) Finance is the life-blood of the organisation.

The business firm has access to the capital market to fulfill its financial needs.

(b) The firm has multiple choices of sources of financing. Different types of securities like shares, debentures, etc. can be issued to raise funds.

 

(c) Funds may also be borrowed from financial institutions and lenders. The finance manager must ensure that the firm is well capitalised.

(d) Thus, it is rightly justified that the firm has multiple choice of sources of financing.

  2. There are various factors affecting the requirement of fixed capital.

Justification:

There are various factors affecting the requirement of fixed capital. Some of them are as follows:

 a) Nature of Business: The nature of business plays a vital role in determining fixed capital requirements.

For instance, a manufacturing company needs more fixed capital as compared to a trading company. This is because the trading company does not need a plant, machinery, etc.

 

(b) Size of business: The companies which are operating at large scale require more fixed capital as they need more machinery and other assets.

Whereas, small scale business needless amount of fixed capital. Hence, the size of the firm, either in terms of its assets or sales, affects the need for fixed capital.

 

(c) Scope of business: The scope of business is the maximum extent up to within which a business can act or perform its business activities. 

If the scope of business is vast, it needs higher fixed capital. For instance, a company involved in multiple activities like manufacturing processing, and assembling usually needs a substantial amount of fixed capital. Similarly, if the scope of business is limited, then it requires less fixed capital.

For instance, if a company does only assembling activities, it needs a fewer amount of fixed capital.

 

(d) The extent of lease or rent: If companies can arrange financial and leasing facilities easily then they require less fixed capital as they can acquire assets on easy instalments instead of paying a huge amount at one time.

 

(e) Choice of Technique: Those manufacturing enterprises which make use of modern and automatic machines need a large amount of fixed capital.

  3. Fixed capital stays in the business almost permanently.

Justification:

Fixed capital refers to capital invested in fixed assets. Fixed Capital is invested in long term assets such as land, building, equipment, etc.

Investor invests money in fixed capital to make a future profit. It is permanent capital.

Fixed capital is usually required at the time of the establishment of the company.

However, existing companies may also need such capital for their: Expansion and development, Replacement of equipment, etc.
Thus, it is rightly justified that, fixed capital stays in the business almost permanently as it is invested in fixed assets.

  4. Capital structure is composed of owned funds and borrowed funds.

Justification:

Capital structure constitutes two words i.e. capital and structure. 'Capital' refers to the investment of funds in the business while 'structure' means the arrangement of different components in proper proportion.

Thus, capital structure means 'mix-up of various sources of funds in desired proportion'. A company can raise its capital from different sources i.e. owned capital or borrowed capital or both.

The owned capital consists of equity share capital, preference share capital, reserves, and surplus. On the other hand, borrowed capital are debentures, loans, etc. The proportion of different sources are used in the capital structure.

Thus, it is rightly justified that, capital structure is composed of owned funds and borrowed funds.

  5. There are various factors affecting the requirement of working capital.

Justification:

 

There are various factors affecting the requirement of working capital. Some of them are as follows:

 

(a) Nature of business: The requirement of working capital depends on the nature of business. The nature of business is usually of two types:

• Manufacturing Business and • Trading Business.

- In the case of a manufacturing business, it takes a lot of time in converting raw material into finished goods. Therefore, more working capital is required.

- On the contrary, in the case of trading business, the goods are sold immediately after purchasing, or sometimes the sale is affected even before the purchase itself. Therefore, less working capital is required.

 

(b) Size of Business: There is a direct link between working capital and the size of the business.

In other words, more working capital is required in the case of a big organization. Whereas, less working capital is required in the case of a small organization.

 

(c) Business cycle: The need for working capital is affected by various stages of the business.

For instance:

During the boom period, the demand for a product increases, and sales also increase. Thus, more working capital is required.

During the depression period, the demand declines and it affects both the production and sales of goods. Thus, less working capital is required.

 

(d) Production cycle: Production cycle means the time involved in converting raw material into a finished product. When the period of the production cycle is more, more working capital will be needed.

On the contrary, when the period of the production cycle is less, less working capital will be needed.

(e) Volume of Cycle: This is the most important factor affecting the size of working capital. The volume of sale and the size of working capital are directly related to each other. For instance, if the volume of sales is more, there is an increase in the amount of working capital. But if the volume of sales is less, there is a decrease in the amount of working capital.

Q.7 Answer the following questions.

  1. Discuss the importance of corporate finance.

Ans: Ans: CORPORATE FINANCE : MEANING Corporate finance deals with the raising and using of finance by a corporation. It deals with financing the activities of the corporation, capital structuring and making investment decisions. 

 DEFINITION Henry Hoagland expresses the view that ‘‘corporate finance deals primarily with the acquisition and use of capital by business corporation.’’

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 enterprise independently without finance. Every decision in the business is needed to be taken keeping in view of it’s impact on profitability. There may be number of alternatives but the management is required to select the best one which will enhance profitability. Business organisation can give green signal to the project only when it is financially viable. Thus corporate finance plays significant role in decision making process. 

2. Helps in Raising Capital for a project : Whenever a business firm wants to start a new venture, it needs to raise capital. Business firm can raise funds by issuing shares, debentures, bonds or even by taking loans from the banks. 

3. Helps in Research and Development : Research and Development must be undertaken for the growth and expansion of business. Detailed technical work is essential for the execution of projects. Research and Development is lengthy process and therefore funds have to be made available through out the research work. This would require continuous financial support. Many a times, Company has to upgrade its old product or develop new product to attract the consumers. For this company has to conduct survey, market analysis, etc. which again requires financial support. 

4. Helps in smooth running of business firm : A smooth flow of corporate finance is needed so that salaries of employees are paid on time, loans are cleared on time, raw material is purchased whenever required, sales promotion of existing products is carried out smoothly and new products can be launched effectively 

5. Brings co-ordination between various activities : Corporate finance plays significant role in control and co-ordination of all activities in an organisation. For e.g. Production will suffer, if finance department does not provide adequate finance for the purchase of raw materials and meeting other day-to-day financial requirements for smooth running of production unit. Due to this, sales will also suffer and consequently the income of concern as well as rate of profit will be affected. Thus efficiency of every department depends upon the effective financial management. 

6. Promotes expansion and diversification : Modern machines and modern techniques are required for expansion and diversification. Corporate finance provides money to purchase modern machines and technologies. Therefore finance becomes mandatory for expansion and diversification of a company. 

7. Managing Risk : Company has to manage several risks, such as sudden fall in sales, loss due to natural calamity, loss due to strikes, etc. Company needs financial aid to manage such risks. 

8. Replace old assets : Assets such as plant and machinery become old and outdated over the years. They have to be replaced by new assets. Finance is required to purchase new assets. 

9. Payment of dividend and interest : Finance is needed to pay dividend to shareholders, interest to creditors, banks, etc. 10. Payment of taxes/fees : Company has to pay taxes to Government such as Income Tax, Goods and Service Tax (GST) and fees to Registrar of Companies on various occasions. Finance is needed for paying these taxes and fees.

  2. Discuss the factors determining working capital requirement.

Ans: Factors affecting working capital requirement : 

1. Nature of business : Firms engaged in manufacturing essential products of daily consumption would need relatively 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 small working capital because of continuous flow of cash from their customers.

2. Size of business : The size of business also affects the requirement of working capital. A firm with large scale operations will require more working capital.

3. 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. 

4. 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 in stocks. This requires additional working capital. During recession, sales will decline and hence the need of working capital will also decline. 

6. Terms of purchases and sales : If the firm does not get credit facility for purchases but adopts liberal credit policy for its sales, then it requires more working capital. On the other hand if credit terms of purchases are favourable and terms of credits sales are less liberal, then requirement of cash will be less. Thus working capital requirement will be reduced. 

7. Credit control : Credit control includes the factors such as volume of credit sales, the terms of credit sales, the collection policy, etc. If credit control policy is sound, it is possible for the company to improve it’s cash flow. If credit policy is liberal, it creates a problem of collection of funds. It can increase possibility of bad debts. Therefore a firm requires more working capital. The firm making cash sales requires less working capital. 

8. Growth and Expansion : The working capital requirement of a firm will increase with growth of a firm. A growing company needs funds continuously to support large scale operations. 

9. Management ability : The requirement of working capital is reduced if there is proper co-ordination between production and distribution of goods. A firm stocking on heavy inventory calls for higher level for working capital. 

10. External factors : If financial institutions and banks provide funds to the firm as and when required, the need for working capital is reduced.