How Companies Make Financial Decisions

Question 1

Initial Price$100

Ending Price$125

Dividend$2

Percentage Total Return = (((Ending Price – Initial Price) + Dividend)/Initial Price)

= ((($125 – $100) + $2)/$100)

= ($27/100)*100

=27%

Dividend Yield = (Dividend/Initial Price)

= ($2/$100)*100

= 2%

Capital Gain Yield = (Ending Price – Initial Price)/Initial Price

= ($125 – $100)/$100

= 25%

Question 2

Capital Gain on Preferred Stock = 4% of $100 = $4

Return = ($120 – $100)

= $20

Returns = $4 + $20

=$24

Question 3

Expected Rate of Return = RF+β(Rm-RF)

Where,

Beta (β)1.20

Market Rate of Return (Rm)12%

Risk free rate of return (RF)5%

= 5% + 1.20 * (12% – 5%)

= 13.4%

Question 4

WACC = (We*Re)+ (Wd*Rd)*(1-T)

Where,

Re = cost of equity = 12%

Rd = cost of debt = 7%

We = weight of equity = 80%

Wd = weight of debt = 20%

Tax Rate = 30%

= (80%*12%)+(20%*7%)*(1-30%)

= 10.58%

Question 5

Cost of the plant if the company raises equity externally = Cost of new plant*(1+floatation cost)

= $125million * (1 + 10%)

= $137.5 million

How Companies Make Financial Decisions

Firms are required to make a number of financial decisions in its day to day operations. These decisions help in increasing efficiency and improving the performance of the business firm. Such decisions include decisions pertaining to increase the revenue of the firm as well as to decrease the total expenses in order to increase the net income. So the firms are required to take strategic financial decisions to overcome such problems.

Capital Budgeting Decisions

Capital budgeting refers to planning and management of long term investments of the firm. These decisions involve the decisions pertaining to the long-term investments of the business. In making such decisions the finance personals or managers identify the opportunities for making investments. These are those opportunities that have more worth than their cost of acquisition or in other words the return is higher in such opportunities as compared to the expenditure. It suggests that investment in such opportunity will generate higher inflow of cash than outflow of cash. Thus the capital budgeting technique helps in evaluation of size, risk and time of future cash flows that are important in making financial decisions.

Capital Structure Decisions

These are the decisions that are associated with the debt and equity of the firm. The business firms source capital by way of debt and equity. Issues of bonds, bank loans, etc. are the sources of debts by which business source capital. Issue of common stock is the source of equity for capital. There needs to be an appropriate ratio between the debts and capital of the firm. It is the finance manager who is required to decide about this ratio. It is to be chosen cautiously as the proportion of debt and capital will have an impact on value of the firm as well as the risk of the firm. Such decisions include the following:

How much money should the firm borrow?

This is the most important decision as it impacts the debt ratio of the business firm. Ideally the business firm should have the debts that are half of its total equity. It means the borrowed capital should not exceed fifty percent of the equity. In case if the borrowed capital is higher, it will lead to deterioration of debt to equity ratio and most of the profits of the company will be washed in making payment of interest on the debts. Thus keeping a proper ratio among debts and equity is one of the major financial decisions.

The Best Proportion of Debt and Equity

The suitable proportion of debt and equity is different among different kind of firms. So different kind of firms may have different proportion of debt and capital. For example, a manufacturing firm may be higher on debts as compared to a service providing firm as the requirement of capital is higher in case of manufacturing firm as compared to service providing firm. So it is the responsibility of the finance manager to keep the optimum ratio of debt and equity depending on the business of the firm.

Selection of Least Expensive Sources of Capital

Different sources of capital have different cost to source. The capital sourced by way of issue of common stock requires payment of dividends whereas money sourced by way of bonds and bank loans require payment of interest to bond holders and bankers. It is on the discretion of the management to pay dividend on common stock. If the management does not thinks fit to pay dividend it may not declare it. But the payment of interest is expenditure and is to be paid within time or as it falls due.

Thus, it is important for the finance managers to take right decision at right time so as to meet the financial needs of the business. The choice of the source of finance is also important as it also carries some cost to it. If the return on the capital employed are higher than the companies should opt for the borrowed capital whereas if the returns are limited then it should opt for sourcing the capital by way of issuing stocks.