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1. What is the importance of cost of capital in Financial Decisions? Explain.

Cost of Capital: It is the minimum rate of return which has to be earned on investments in order to satisfy the
investors of the company in the form of shares, debentures and loans. It is the weighted average cost of
various sources of finance used by a firm.

It is very important in financial decisions as it is very relevant in the spheres of taking decisions. It is also
used in calculating new projects for a company and it is made easier for the investors as the investors expect a
minimum return for providing capital to the company.

It is mainly used in:
1. Designing capital structure
2. Capital budgeting decisions
3. Defining sources of financing:
4. Evaluation of financial performance
5. Knowledge of firms expected income and inherent risks
6. Financing and Dividend Decisions

Designing capital structure:
It is an important factor in designing a balanced and optimal capital structure of a firm. While designing the
structure, the management has to keep in mind to maximize the value of the firm. The finance manager can
select the best and most economical source of finance after comparing various specific costs of different
sources of capitals and can design a sound and balanced capital structure.

Capital budgeting decisions:
In capital budgeting cost of capital is used to measure the investment proposal to choose a project which
satisfies return on investment as acceptance or any rejection of any investment depends on the cost of capital.
A proposal shall not be accepted till its rate of return is greater than the cost of capital. In various methods of
discounted cash flows of capital budgeting, cost of capital measured the financial performance and determines
acceptability of all investment proposals by discounting the cash flows.

Defining sources of financing:
There are various sources of financing a project. The finance manager can decide which source of finance to
use by comparing costs of different sources of financing. The source which bears the minimum cost of capital
would be selected. Although cost of capital is an important factor in such decisions, but equally important are
the considerations of retaining control and of avoiding risks.

Evaluation of financial performance:
Cost of capital is used to evaluate the financial performance of the capital projects. Evaluations can be done
by comparing actual profitability of the project undertaken with the actual cost of capital of funds raise to
finance the project. The performance can be determined as satisfactory if the actual profitability of the project
is more the actual cost of capital.



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Knowledge of firms expected income and inherent risks:
It helps investors determine the return or any risk involved while investing on the firm. If the cost of capital of
a firm is high, it represent the rate of income is less. It also implicates that the risk involved is higher and the
capital structure is imbalanced. Such situation leads investors expecting higher rate of return.

Financing and Dividend Decisions:
The concept of capital can be conveniently employed as a tool in making other important financial decisions.
Depending upon this basis, decisions can be taken regarding dividend policy, capitalization of profits and
selections of sources of working capital.


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2. Explain the factors determining Capital Structure.

Capital Structure:
A mixture of companys or a firms long-term liabilities, specific short-term liabilities makes capital structure.
It could be of bank notes, common equity, and preferred equity which makes up with which a business firm
finances its operation and growth. The capital structure comprises the right side of a balance sheet.
Liabilities can come in any form of bond issues or long term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is
also considered to be part of the capital structure.

Important factors determining Capital Structures are:
1. Size of a firm
2. Control
3. Financial Flexibilities
4. Operating structures
5. Company Growth Rate
6. Market Conditions
7. Profitability
8. Risk Considerations
9. Taxes
10. Assets structure
11. Regulatory Framework

Size of a firm:
There is a direct relation between the capital structure and the size of a firm or any company, larger the
company, lesser the prone to bankruptcy. The larger firms are more diversified and have easy access to the
capital market. They get higher credit ratings and pay lower rate of interest on the debt capital. They have
lesser probability of bankruptcy and lower bankruptcy costs. Therefore, larger firms tend to use more debt
capital than smaller firms.

Control:
It plays an important role in capital structure. During the designing of the structure it should be ensured that
the control of the existing shareholders over the affairs of the company is not affected. A situation, where
management has 50% voting control between the debt and the equity, if management is not in a position to
buy more stock the other option for it is to use the debt for new financing for the firm. And if funds are raised
by issuing equity shares, then the number of companys shareholders will increase and it directly affects the
control of existing shareholders. But in a situation where the firms financial position is so weak that the use
of debt may cause serious risk default then the control considerations could lead to either debt or equity.

Financial flexibilities:
It is firm's ability to raise capital in bad times. companies typically have no problem raising capital when sales
are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising
capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times,
not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a
company has.
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Operating structures:
It is also another factor affecting capital structure. The use of fixed cost in production process also affects the
capital structure. A firm with less operating structures can imply financial leverage in better way. The high
operating leverage; use of higher proportion of fixed cost in the total cost over a period of time; can magnify
the variability in future earnings. There is negative relation between operating leverage and debt level in
capital structure. Higher the operating leverage, the greater the chance of business failure and the greater will
be the weight of bankruptcy costs on enterprise financing decisions.

Company Growth Rate:
It plays a very important role in capital structure decisions. The company or firm with a faster growing rate
mostly depends upon the external capital as the floatation money exceeds. The conflict that arises with this
method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is
usually not appropriate. It is also possible that the firms replying on external capital may often face greater
uncertainty due to which may reduce the willingness to use debt.

Market Conditions:
Market conditions can have a significant impact on a company's capital-structure condition. If the market is
struggling / investors are limiting companies' access to capital because of market concerns, the interest rate to
borrow may be higher than a company would want to pay. This situation may be prudent for a company to
wait until market conditions return to a more normal state before the company tries to access funds for the
plant.

Profitability:
As the firms with high rates of return on investment do not use high debt but they use relatively little debt.
Higher rates of return on investment make them able to finance with internally generated funds.

Risk Considerations:
There are two types of risks in business:
(i) Operating Risk or Business Risk:
(ii) Financial Risk:

Operating Risk or Business Risk:
This refers to the risk of inability to discharge permanent operating costs (e.g., rent of the building,
payment of salary, insurance instalment, etc)

Financial Risk:
This refers to the risk of inability to pay fixed financial payments (e.g., payment of interest, preference
dividend, return of the debt capital, etc.) as promised by the company.
The total risk of business depends on both these types of risks. If the operating risk in business is less, the
financial risk can be faced which means that more debt capital can be utilised. On the contrary, if the
operating risk is high, the financial risk likely occurring after the greater use of debt capital should be
avoided.


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Taxes:
Debt payments are tax deductible. The rate of tax affects the cost of debt. If the rate of tax is high, the cost of
debt decreases. The reason is the deduction of interest on the debt capital from the profits considering it a part
of expenses and a saving in taxes. As such, if a company's tax rate is high, using debt as a means of financing
a project is attractive because the tax deductibility of the debt payments protects some income from taxes.

Assets structure:
It affects capital structure. There are two types of assets.
1. General purpose assets and
2. Special purpose assets

The sources of financing to be used are affected to several ways by maturity structure of the assets to be used
by the firm. if a firm has a relatively longer term assets with assured demand of their products, the firm
attempts to use more long term debt. In contrast to this, the firms with relatively grater investment in
receivables and inventory rather than fixed assets rely heavily on short-term financing.

Regulatory Framework:
Capital structure is also influenced by government regulations. For instance, banking companies can raise
funds by issuing share capital alone, not any other kind of security. Similarly, it is compulsory for other
companies to maintain a given debt-equity ratio while raising funds.
Different ideal debt-equity ratios such as 2:1; 4:1; 6:1 have been determined for different industries. The
public issue of shares and debentures has to be made under SEBI guidelines.


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3. What is financial Forecasting? Explain.

Financial forecasting is simply a financial plan or a budget for a business. It is a key component in
determining future operations, problems, and opportunities. It is an estimate of two essential future financial
outcomes for a business:
1. Projected Income
2. Projected Expenses

They are usually prepared by financial analyst. Forecasting is used by people like investors to make more
informed choices about what to buy and when. It is the best guess of what will happen to a business over a
period of time.

Predicting financial future is not an easy task especially for a startup company or who do not have a trading
history. It replicates how the firm thinks about and prepare for the future. The forecasting provides the means
for a firm to express its goals and priorities and to ensure that they are internally consistent. It also helps the
firm in identifying the assets requirements and needs for external financing

It is very critical for a business plan; especially it is for the purpose of getting loans or getting an investor on
board for a business. Business owners use financial forecast as a prove of the business, that it will generate
the desired profit and when it will actually start to make the profit.

All the companies and the firms have related goals to Capital Structure, Dividend Policy and Working Capital
Management. Forecasting financial structure allows determining if its forecasted sales growth rate is in
consistent with it desired Capital Structure and Dividend Policy.
The forecast should be monitored and update on a regular basis.

Forecasting can be done in different methods:
1. Quantitative Methods
2. Qualitative Methods
3. Combination of both Qualitative and Quantitative

Qualitative methods are more intuitive and are based on information like:
a) Judgmental,
b) Consensus,
c) Expert, etc.

Quantitative methods use information like:
a) Trend Analysis,
b) Multiple Regressions analysis,
c) Time-Series Analysis, etc.


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Main advantages of having an effective financial forecast:
1. It helps demonstrate the financial viabilities of a new business venture. It also helps in constructing a
model of how a business might perform on certain strategies or plans are carried out.
2. It helps measure the actual financial operations of business against the forecast plan and make
required adjustments.
3. Helps take control of the cash flow and take business in the right directions.
4. It also allows to do a performance check for the business growth.
5. It helps in identifying potential risk and cash shortfalls to keep the business out of financial troubles.
6. It also assists to secure bank loans or other funding as lenders and investors requires financial
forecasting to show the capability to repay the loan back.

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4. What is a fund flow statement? Explain its uses.

Fund flow statement gives the information of funds on a particular date. The purpose of preparing a fund flow
statement is to know about from where the funds are coming and where is it being invested.
The fund flow statement also termed as Statement of Sources and Applications of Fund, Where Got and
Where Gone Out Statement, Inflow of Fund or OutFlow of Fund Statement.

It is generally prepared from the data identifiable and profit and loss account and balance sheet. It is also
prepared to analyze the reasons for the changes in the financial position of a company between two balance
sheets. In other words, Fund Flow is prepared to explain the changes in the Working Capital Position of a
company.

There are two types of inflows:
a) Long term funds
b) Funds generated by the operations

Long Term Funds:
Long term funds are the funds generated through purchases of fixed assets such as plant, machinery, land,
building, furniture, etc. Investments in these assets represent the part of the firms capital whichi s blocked on
a permanent basis or fixed basis, and is also called fixed capital.
Some of the sources are:
a. Ownership Securities
b. Creditor ship securities
c. Loan financing
d. Internal financing
e. Public deposits

Fund Generated by Operations:
It is a measure of cash generated by real estate investment, trust, etc. There is a difference between Fund from
Operations and Cash from Operations, which is a key component of the indirect method cash flow statement.

Reasons to prepare Fund Flow Statement:
There are multiple reasons for preparing fund flow statement. Some of them are listed below:
1. Financial statement doesnt provide in detail or complete information but fund flow discloses the
funds at the end of one period to the end of another period of time.
2. Another important reason to prepare fund flow statement is that income statement and balance sheet
provide useful and needed information.
3. It explains the financial consequences of business operations
4. It answers intricate questions about the source of the fund and the uses of funds.
5. It also acts as an instrument in allocating resources
6. It is also used as a test of effectiveness in use of working capital.




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Uses of Fund Flow Statement:
1. It helps its users (such as investors, creditors, bankers, govt., etc) to understand the managerial
decisions regarding the utilization of funds.
2. The quantum of working capital is revealed by the schedule of working capital changes, which is a
part of fund flow statement.
3. It is the best and the first source for judging the repaying capacity of an enterprise
4. Helps management keep a track on the surplus/shortage of fund balance.
5. The fund derived from the operation is not mentioned in the profit and loss account or in the balance
sheet, but it is separately calculated for the fund flow statement.
6. It highlights the different sources and applications or uses of funds.
7. It brings into light about financial strength and weakness of a concern.
8. It helps management to take corrective actions while deviations between two balances sheets figures.
9. It is used as an instrument by the investors for effective decisions at the time of their investment
proposals.
10. It also presents detailed information about the profitability, operational efficiency, and financial affairs
of a concern.
11. It also serves as a guide to the management to formulate its dividend policy, retention policy and
investment policy, etc.

Limitations of Fund Flow Statement:
1. It is prepared based on the information related to historic in nature. It ignores to project future
operations.
2. This statement doesnt focus on transactions involved in non-fund items.
3. It also ignores transactions involved between current account and non-current accounts.
4. It doesnt provide any additional information to the management because financial statements
rearrange and presented.

Preparation of Fund Flow Statement:
To prepare a Fund Flow Statement the following statements are required:
1. Fund from operations
2. Statement of changes in Working Capital
3. Fund Flow Statement