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Chapter 1: Introduction to Corporate Finance

1 Introduction to Corporate Finance

SR. NO. PARTICULARS BOARD EXAM

1. What is corporate finance and state two decisions which
are basis of corporate finance. (T)
2. What are the different aspects covered by corporate
finance? What decisions does a finance manager of a
corporation have to deal with?
3. Discuss the importance of corporate finance. (T)
4. What are the different steps an entrepreneur has to take
before starting a business?
5. Explain the concept of fixed capital.
6. State any four factors affecting fixed capital Oct’21, Feb’ 18
requirement. (T)
7. Explain the concept of working capital.
8. Discuss the factors determining working capital
requirement. (T)
9. Define capital structure and state its components. (T) Feb’ 20, Mar’ 16,
Oct’ 15
10. Distinguish between:
11. Chapter Assessment

INTRODUCTION
Finance is the life blood of any business organisation. The term ‘finance’ is related to
money and management of money. Success of any business organisation depends upon
the efficiency with which it is able to generate and use funds. Corporate finance deals
with the aspect of arrangement of finance and its proper utilisation. It has two main
aspects, viz. financing decisions and investing decisions. Financing decisions relate to
capital structure while investment decisions relate to capital budgeting.
A company has to estimate its capital requirements in order to draft an appropriate
financial plan. It has to take into consideration its fixed capital as well as working
capital requirements. This chapter explains basic concepts associated with corporate
finance.

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Q.1. Answer the following

1. What is corporate finance and state two decisions which are basis of corporate
T
finance.
Ans: Corporate finance is that part of finance which deals with raising and using of funds
by a corporation. It involves financing the activities of corporation, capital structuring
and making various investment decisions.
According to Henry Hoagland, “Corporate finance deals primarily with the acquisition
and use of capital by business corporation.’’
The decisions that are basis of corporate finance are as follows:
1) FINANCING DECISION
i. Financing decision relates to deciding the source of finance. A firm has
multiple choices of sources of finance.
ii. A firm has access to capital market to fulfil its financing requirements.
iii. The firm can choose whether it wants to raise equity capital or debt capital.
iv. It can even raise funds through bank loans, public deposits, debentures etc.
v. The finance manager ensures that the firm is well capitalised i.e. the firm
has required amount of capital as well as the right combination of equity and
debt.
2) INVESTMENT DECISION
i. After the firm has received the necessary finance, the finance manager has
to take decisions regarding the usage of funds in a systematic manner so
that it results in the maximum returns to the firm.
ii. In order to achieve this, the firm has to know the cost of capital.
iii. Once the cost of capital is known, a firm has to use the funds in such a
manner that the returns from investment are more than the cost of capital.
iv. Finding investments which ensure successful usage of funds is known as
investing decision. It is also known as ‘Capital budgeting’.

FOR YOUR UNDERSTANDING

Capital budgeting is a very important aspect of any business. The business has to
identify the projects which are worth investing money. If a business gets its capital
investments wrong, it can end up with a non-functioning business. Over-investment as
well as under-investment may have adverse impact on a business.

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Chapter 1: Introduction to Corporate Finance

Financing decisions Investment decisions

1. Relates to capital structure 1. Relates to capital budgeting
2. Decisions related to sources of finance 2. Decisions related to successful
3. Option of owned capital and borrowed usage of funds
capital. 3. Important to calculate cost of capital
4. Sources of finance: 4. Returns from investment should be
Owned capital: Share capital, free reserves more than cost of capital
and surplus
Borrowed capital: Debentures, bank loans
and loans from financial institutions

2. What are the different aspects covered by corporate finance? What decisions does a
finance manager of a corporation have to deal with?
Ans: Corporate finance refers to the generation and usage of funds by a corporation.
The success of any business depends upon the efficient generation and usage of
funds. The financial organisations and banks play a vital role in corporate financing.
1) DIFFERENT ASPECTS COVERED BY CORPORATE FINANCE
Corporate finance includes various aspects like:
i. Financial planning
ii. Study of capital market and money market
iii. Capital formation and foreign capital
2) FUNCTIONS OF FINANCE MANAGER
The finance manager of any corporation has to make sure that:
i. The firm has adequate finance.
ii. The firm is using funds from the right source at the minimum cost.
iii. The firm invests those funds in an effective manner.
iv. The firm is generating maximum returns for its owners.

3. Discuss the importance of corporate finance. T

Ans: In any business enterprise, the important functional areas are production,
finance, marketing and personnel activities. Out of these, financial activities
are given the utmost importance. The importance of corporate finance is as
follows:

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SMART CODE 4H 3P B M R

1) HELPS IN DECISION MAKING

i. Availability of funds is an important factor that influences major business decisions.
ii. It is difficult to perform any function of business enterprise without finance.
iii. Every decision in the business needs to be taken by considering its impact on
profitability.
iv. Out of various alternatives available to the business, the management is
required to select the best one that ensures maximum profitability.
v. Business organisation undertakes a project only if it is financially viable.
vi. Thus, corporate finance plays a very important role in the decision-making process.

FOR YOUR UNDERSTANDING

Financially viable: It means the capability of a project/ idea/ business to generate

sufficient income so as to meet the expenses.

2) HELPS IN RAISING CAPITAL FOR A PROJECT

A business firm needs finance to start a new venture. There are various sources
for a business firm to raise funds like issue of shares, debentures, bonds or even
taking loans from the banks.
3) HELPS IN RESEARCH AND DEVELOPMENT
i. Research and Development play a crucial role in growth and expansion of
business. Detailed technical work is essential for the execution of projects.
ii. Research and Development is a lengthy process. Therefore, funds have to be made
available throughout the research work. It necessitates continuous financial support.
iii. Also, a company may need to improve its old product or develop a new
product in order to attract customers.
iv. In order to do this, company has to conduct survey, market analysis etc.
which again requires financial support.
4) HELPS IN SMOOTH RUNNING OF BUSINESS
A smooth flow of corporate finance ensures that the:
i. Salaries of employees are paid on time.
ii. Loans are cleared on time.
iii. Raw materials are purchased as per requirement.
iv. Sales promotion of existing products is carried out smoothly.
v. New products are launched effectively.

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5) PROMOTES EXPANSION AND DIVERSIFICATION

i. Modern machines and modern techniques are required for the expansion and
diversification of a business.
ii. Corporate finance ensures that the funds are available to purchase modern
machines and techniques.
iii. Hence, finance becomes mandatory for the expansion and diversification of a company.
6) PAYMENT OF DIVIDEND AND INTEREST
Finance is required to pay dividend to shareholders and interest to creditors, banks etc.
7) PAYMENT OF TAXES AND FEES
A company has to pay various taxes and fees to the government like income tax,
Goods and Services Tax (GST), fees to Registrar of Companies etc. on various
occasions. Finance is needed to pay these taxes and fees.
8) BRINGS CO-ORDINATION BETWEEN VARIOUS ACTIVITIES
i. Corporate finance plays a very significant role in control and co-ordination
of various business activities.
ii. E.g.: if finance department does not provide adequate funds for the purchase of
raw materials and to meet other day-to-day financial requirements that ensure
smooth running of production department, it will affect the production activities.
As a result, the sales may suffer which in turn will adversely affect the income
and profits of the business.
iii. Thus, efficiency of every department in a business organisation depends
upon the effective financial management.
9) MANAGING RISK
A company has to manage several financial risks such as loss due to sudden fall in
sales, loss due to natural calamity, loss due to strikes etc. In order to manage
these risks, a company needs financial aid.
10) REPLACE OLD ASSETS
The assets of a company like plant and machinery become old and outdated over
the years. The company needs to replace them with new assets. Finance is
required for the purchase of new assets.

4. What are the different steps an entrepreneur has to take before starting a business?
Ans: When an entrepreneur conceives a business idea, he first investigates the commercial
viability or feasibility of the project. Once he is satisfied with the feasibility of the
project, he takes serious steps to start the project. The steps taken by him are as
follows:

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1) DECIDING CAPITAL REQUIREMENT

Once the entrepreneur decides to start the project, the first and foremost step that
he has to take is to decide the amount of capital required to start and run the
business. This has to be done with utmost care.
2) DRAFTING FINANCIAL PLANS
Financial plan refers to assessment of financial requirement and arranging sources
of capital. The entrepreneur has to draft the financial plan very carefully. It should
be drafted keeping in mind the present and future requirements of the business.
While drafting the financial plan, the entrepreneur has to take into consideration
the fixed capital as well as working capital requirements of the business.

FOR YOUR UNDERSTANDING

Commercial viability: It is a process of identifying objectives of the project, recognising

opportunities and obstacles as well as analysing various alternatives available. It helps to
decide whether it is profitable to develop the business idea further.

5. Explain the concept of fixed capital.

Ans: 1) MEANING OF FIXED CAPITAL
Fixed capital is the capital which is used to purchase fixed assets of the business. In
other words, fixed capital refers to the capital invested for acquiring fixed assets.
These fixed assets are used for a longer period of time and are not meant for resale.
2) NATURE OF FIXED CAPITAL
Fixed capital stays in the business for a long period of time almost permanently.
Examples of fixed capital are capital used for purchasing assets like land and
building, furniture, plant and machinery etc.
3) TIME OF REQUIREMENT
Fixed capital is usually required at the time of establishment of a new company.
However, existing companies may also require fixed capital for their expansion and
development, replacement of equipment etc.
4) STEPS IN ESTIMATION OF FIXED CAPITAL REQUIREMENT
Initial planning of fixed capital requirement is done by the company’s promoters.
First, they prepare a list of fixed assets required by the company and then
estimate the cost of acquiring these assets. 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 thus calculated and the resulting figure
would be the total fixed capital requirement of the new firm.

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5) IMPORTANCE OF ESTIMATION
The estimation of fixed capital requirement has assumed great importance in the
recent years particularly because of the modern industrial processes which require
increased use of heavy and automated machineries.
6) SOURCES OF FUNDS FOR FIXED CAPITAL
An entrepreneur obtains funds to meet the fixed capital requirement from capital market.
Funds can come through issue of shares, debentures, bonds or long-term loans.

6. State any four factors affecting fixed capital requirement. (Oct’21, Feb’ 18) T

Ans: Fixed capital is the capital which is used to purchase fixed assets of the business. These
assets are used for a longer period of time and are not meant for resale. The factors
affecting fixed capital requirement are as follows:
1) NATURE OF BUSINESS
Nature of the business determines the fixed capital requirement. Manufacturing
industries and public utility companies have to invest huge amounts to acquire fixed
assets while trading businesses may not require huge investments in fixed assets.
2) SIZE OF BUSINESS
When a firm is set up to carry business operations on a large scale, it has higher
fixed capital requirement as most of the production processes are based on
automatic machines and equipment.
3) SCOPE OF BUSINESS
The business firms that are formed to carry on production or distribution on a
large scale would require more amount of fixed capital.
4) EXTENT OF LEASE OR RENT
If an entrepreneur decides to acquire assets on lease or on rental basis, then the
business requires lesser amount of funds for acquiring fixed assets.
5) ARRANGEMENT OF SUB-CONTRACT
If a business chooses to sub-contract some processes of production to outside
companies, then limited assets are required to carry out the production. This would
minimise the fixed capital requirement of business.

FOR YOUR UNDERSTANDING

Sub-contract: It means a business firm entering into a contract with an outsider to

perform a certain type of work. For example: a manufacturing firm may sub-contract
the task of maintaining its accounts to an outside firm.

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6) ACQUISITION OF OLD ASSETS

If the company can acquire old equipment and plants at low prices, then it would
reduce the need for investment in fixed assets.
7) ACQUISITION OF ASSETS ON CONCESSIONAL RATE
In order to encourage industrial growth at regional level, the government may
provide land and building at concessional rates. The plant and equipment may also
be made available on instalment basis. Such facilities reduce the fixed capital
requirement of a business.
8) INTERNATIONAL CONDITIONS
International conditions play a significant role, particularly in large organisations
carrying out business on international level. E.g.: if a company is expecting war, it
may decide to invest huge amount of funds to expand fixed assets before there is
a shortage.
9) TREND IN ECONOMY
If it is expected that the business is going to be successful and has a bright future,
then the entrepreneur will carry out all sorts of business expansion. 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 increases at a high rate, it leads to increase in demand and
certain manufacturers find this as an opportunity to expand their business.
E.g.: businesses like automobile industry, electronic goods manufacturing industry,
ready-made garments, etc. This leads to increase in the amount invested in fixed assets.
11) CONSUMER PREFERENCE
Industries that provide goods and services which are in high demand would require
large amount of fixed capital. E.g.: Mobile phone manufactures as well as mobile
network providers.
12) COMPETITIVE FACTOR
Competition is a prime element in decision making regarding the fixed capital
requirement. If one of the competitors shifts to automation, then all other
companies in the same line of activity are forced to follow the competitor.

7. Explain the concept of working capital.

Ans: 1) MEANING OF WORKING CAPITAL
Working capital is the capital which is required to carry out day-to-day business
activities. After estimating fixed capital requirement, the firm needs to estimate the
amount of capital that would be needed to ensure smooth functioning of the business.

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2) ASSETS UNDER WORKING CAPITAL

The capital invested in the following assets is referred to as working capital:
i. For building up inventories of raw materials and finished goods
ii. For financing receivables and payables
iii. For covering day-to-day operating expenses
3) NEED OF WORKING CAPITAL
Working capital is needed for the following reasons:
i. A firm requires funds to store adequate raw material in stock and to
maintain sufficient stock of finished goods.
ii. Goods are sold either in cash or on credit. When goods are sold on credit, it
does not fetch cash immediately. So, a firm has to make arrangement for
funds till the amount is collected from the debtors.
iii. Funds are also required to pay for the overheads.
iv. Since uncertainty always exists in business, some cash needs to be
maintained to meet unexpected expenses.
4) NET WORKING CAPITAL
The concept of working capital is viewed differently by different leading authorities.
Some authorities consider working capital as being 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 prefers to call it as ‘circulating capital’.
5) GROSS WORKING CAPITAL
Some other authorities view working capital as being equivalent to current assets
of the company. 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’.

8. Discuss the factors determining working capital requirement. T

Ans: There are no precise standards for a business firm to measure working capital adequacy.
The management has to determine the working capital requirement based on the certain
aspects of business and economic environment within which the firm operates. The
factors determining working capital requirement are as follows:
1) NATURE OF BUSINESS
Working capital requirement depends on the nature of business.
i. Firms engaged in manufacturing essential products of daily consumption
would need a relatively lesser amount of working capital as there would be a

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constant and sufficient cash inflow to take care of liabilities.

ii. Public utility companies also have to maintain lesser amount of working
capital due to continuous flow of cash from their customers.
iii. Businesses dealing with luxurious products require huge amount of working
capital as the sale of luxurious items is not frequent.
iv. Trading or merchandising firms which are concerned with distribution of
goods have to carry big inventories of goods to meet customers’ demand.
They also have to provide credit facilities to attract customers. Hence, they
need a large amount of working capital.
2) SIZE OF BUSINESS
The size of business also affects the working capital requirement. A firm with
large scale operations would require a higher amount of working capital.
3) VOLUME OF SALES
The volume of sales is the most important factor affecting the size of working
capital. The volume of sales and the size of working capital are directly related to
each other. If the volume of sales increases, the amount of working capital
required also increases and vice versa.
4) PRODUCTION CYCLE
Production cycle refers to the process of converting raw materials into finished goods.
If a firm has longer production cycle, it requires more amount of working capital. If a
firm has shorter production cycle, it requires lesser working capital.
5) BUSINESS CYCLE
During a boom in the economy, there is an increase in the sales leading to rise in the
investments in stocks. Thus, businesses require additional working capital. During
recession, the sales decline and hence, the need for working capital also declines.

FOR YOUR UNDERSTANDING

Boom and recession: These are the phases of economic cycle. During boom, there is an
increase in the commercial activities while during recession; there is a decrease in
demand, savings, production and prices, i.e. general decline in economic activity.

6) TERMS OF PURCHASES AND SALES

If the firm does not get credit facility for purchases but if it provides easy
(liberal) credit facility on sales, then it would require more working capital.
However, if the firm gets favourable terms of credit for purchases and terms of
credit sales are less liberal, then lesser working capital would be required.

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7) CREDIT CONTROL
Credit control policies include factors such as volume of credit sales, the terms of
credit sales, the collection policy, etc. If a company has a sound credit control policy,
then it would have an improved cash flow and hence, may require lesser working
capital. If the credit control policy of the firm is liberal, it may create problem of
fund collection and increase the possibility of bad debts. Such firm requires more
working capital. The firm making cash sales would require less working capital.
8) GROWTH AND EXPANSION
The working capital requirement increases with the growth of the firm. A growing
company needs funds continuously in order to support its large scale operations.
9) MANAGEMENT ABILITY
A firm would require lesser working capital if there is proper co-ordination between
production and distribution of goods. If a firm stocks large amount of inventory,
then it requires a higher amount of 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.

Factors affecting requirement Factors affecting requirement

of fixed capital of working capital
Based on business Based on business
1. Nature of business 1. Nature of business
2. Size of business 2. Size of business
3. Scope of business 3. Volume of sales
Based on acquisition of assets 4. Production cycle
4. Extent of lease or rent Based on credit policy
5. Arrangement of sub-contract 5. Terms of purchases and sales
6. Acquisition of old assets 6. Credit control
7. Acquisition of assets on concessional rate Based on firm’s ability
Based on external factors 7. Growth and expansion
8. International conditions 8. Management ability
9. Trend in economy Based on external environment
10. Population trend 9. Business cycle
11. Consumer preference 10. External factors
12. Competitive factor

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9. Define capital structure and state its components. (Feb’ 20, Mar’ 16, Oct’ 15) T

Ans: 1) Capital structure refers to ‘mix up of various sources of funds in desired

proportion’. To decide capital structure means to decide upon the ratio of different
types of capital.
2) A combination of different sources is used in capital structure. It is nothing but
‘security mix.’
3) The capital structure is composed of owned funds and borrowed funds.
4) Owned funds include share capital, free reserves and surplus while borrowed funds
include debentures, bank loans and long-term loans provided by financial
institutions.
5) R. H. Wessel defines capital structure as “the long-term sources of funds employed
in a business enterprise”.
6) John Hampton stated that “A firm’s capital structure is the relation between the
debt and equity securities that makes up the firm’s financing of its assets”.

COMPONENTS OF CAPITAL STRUCTURE

The four basic components of capital structure are as follows:
1) EQUITY SHARE CAPITAL
Equity shares are the basic source of financing business activities. Equity shares
get dividend and repayment of capital after it is paid to preference shares. Equity
shareholders are the owners of the company. They bear ultimate risk associated
with ownership. The rate of dividend given to equity shareholders fluctuates
depending upon the profits earned.
2) PREFERENCE SHARE CAPITAL
Preferences shares are those shares that carry preferential right as to payment of
dividend and have priority over equity shares for repayment of capital on liquidation
of the company. Preference shares are paid dividend at a fixed rate.
3) RETAINED EARNINGS
It is ploughing back of profits made by the company. It is an internal source of financing.

FOR YOUR UNDERSTANDING

Ploughing back of profits means a part of the profits made by the company is retained
and reinvested in the business itself.

4) BORROWED CAPITAL
It consists of the following:

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i. Debenture: It is an acknowledgment of loans raised by the company.

A company has to pay interest on debentures at an agreed rate.
ii. Term loan: These loans are provided by banks and financial institutions. Term
loans carry a fixed rate of interest.
The capital structure of a company can be explained with the help of an example of a
Balance sheet as follows:
Balance Sheet of XYZ Ltd as on 31st March, 2019
Liabilities Amount Assets Amount
(`) (`)
Share Capital Fixed Assets
20,000 equity shares of Building 5,00,000
` 10 each fully paid 2,00,000 Plant and Machinery 2,00,000
5,000 preference shares of Current Assets
` 100 each fully paid 5,00,000 Sundry debtors 1,00,000
Inventories 40,000
Cash in hand 20,000
Cash at bank 40,000
Reserves and Surplus 50,000
Liabilities
1000, 10% debentures of
` 100 each fully paid 1,00,000
Sundry creditors 30,000
Bills payable 20,000
9,00,000 9,00,000

Capital structure = Equity share capital + Preference share capital + Reserves

+ Debentures

= 2,00,000 + 5, 00,000 + 50,000 + 1, 00,000

= 8,50,000

There should be a proper balance between debt and

equity. If the company relies too much on debt, then it may increase the
risk of default while repaying loans. If the company depends too heavily on
equity, it would reduce its earnings to the original investors.

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Components of capital structure

Owned capital Borrowed capital

Equity share Preference share Retained

Debentures Term loans
capital capital earnings

Q.2. Distinguish between: (T)

1. Fixed capital and Working capital

(Mar’ 22, Feb’ 20, July 17, Mar’ 17, July 16, Mar’ 15, Oct’ 14)
Ans:
Fixed capital Working capital
1) Meaning
Fixed capital refers to any kind of physical Working capital refers to excess of current
asset i.e. fixed assets. assets over current liabilities.
2) Nature
Fixed capital stays in the business almost Working capital is circulating capital. It keeps
permanently. changing.
3) Purpose
Fixed capital is used for financing fixed Working capital is used for financing
assets such as land, building, equipment, short-term assets such as cash, account
etc. receivable, inventory, etc.
4) Sources
Fixed capital funding can come from Working capital can be funded with
issuing shares, debentures, bonds, taking short-term loans, deposits, trade credit, etc.
long-term loans, etc.
5) Objectives of investors
Investors invest money in fixed capital Investors invest money in working capital for
hoping to make future profit. getting immediate returns.
6) Risk
Investment in fixed capital involves more risk. Investment in working capital is less risky.

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Chapter 1: Introduction to Corporate Finance

CHAPTER ASSESSMENT

Time: 1 hour Marks: 25 marks

Q.1. A) Select the correct answer from the options and rewrite the statements. [2]
1. Manufacturing industries have to invest _______ amount of funds to acquire
fixed assets.
a. huge b. less c. minimal

2. A firm keeping _______ requires higher levels of working capital.

a. low inventory b. higher inventory c. no inventory

B) Write a word or a phrase or a term which can substitute each one of the
following. [2]
1. Capital needed to acquire fixed assets which are used for longer period of
time.
2. The internal source of financing.

C) State whether the following statements are true or false. [2]

1. Corporate finance deals with only acquisition of finance of a company.
2. Capital for financing receivables comes under working capital.

D) Answer in one sentence. [2]

1. Define corporate finance.
2. Define working capital.

Q.2. Explain the following terms/concepts. (Any 1 out of 2) [2]

1. Investment decision
2. Capital Structure

Q.3. Study the following case/situation and express your opinion. [3]
1. Mukesh Traders is a trading firm dealing in essential goods. They have to maintain
huge stock of inventories and provide credit facilities to its customers.
i. Will it need less or more working capital?
ii. Will it need more fixed capital?
iii. If they were dealing in luxurious products will they require comparatively more
or less working capital?

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Std. XII: Secretarial Practice

Q.4. Justify the following statements. (Any 1 out of 2) [4]

1. Research and Development requires continuous financial support.
2. There are various factors affecting the requirement of working capital.

Q.5. Answer the following. (Any 1 out of 2) [8]

1. What are the factors affecting requirement of fixed capital?
2. Define capital structure and state its components.

Scan the given Q. R. Code in Quill - The Padhai App

to view the answers of the Chapter Assessment.

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