Question

4. Relation between firm life cycle and payout policy.

5. Why does the cost of capital affect firm value

Answer 1

4] A firm's payout policy changes will be related to its life cycle stages.

Startup:

When a firm is established and it starts operations, it may make nominal profits or even end up in losses in the early years. If it makes profits, the firm may start paying small amounts of dividends to give hope to the investors.

Growth:

If the first stage is successfully outlived by the firm, it may start growing, witnessing spurt in profits. During this stage the firm may increase its dividends each year, However, it will be with the aim paying sustainable dividends in the maturity stage.

Maturity:

The dividends will be constant as the firm will be facing constant performance and profits. Dividends would not be increased.

Decline/Reincarnation:

During the decline phase, the firm will be experiencing decreasing profits and will be forced to reduce dividends. It may also pay liquidating dividends if, there is no chance of revival.

But, if the firm can shift to new areas by the time the original project ends, the cycle may restart.

5] Cost of capital is the weighted average of the returns payable to the various suppliers of capital, Viz; creditors, preferred stockholders and common stockholders.

When a firm invests in projects the cash flows from the project must be able to service the suppliers of capital. It means making the following payments:

*contracted returns to creditors and preferred stockholders

*normal return to common stockholders

*return of capital to creditors, preferred stockholders and common stockholders.

Anything that is left after the above payment, will be the surplus available to common stockholders. This surplus is called NPV [Net present value].

When projects are evaluated, the cash inflows are discounted using the WACC, which in effect will amount to setting apart the return due to the suppliers of capital. When the sum total of PVs of cash inflows is more than the initial investment [which is equal to the funds supplied by the investors], the excess is the surplus in PV terms or the NPV of the project. This NPV represents the addition to shareholders' wealth if, the project is implemented.

When NPV is maximized value of the firm is increased. So the aim should be to increase the NPV. This is possible by minimizing the WACC. Thus, cost of capital will affect the firm's value.