Question

Assume that a company in the early stages of growth has financed itself using only a very small percentage of debt in its capital structure. It pays no dividends to its shareholders. Do you expect this capital structure and dividend policy to be maintained over the life of the company as it grows and eventually matures? Clearly explain how the financing needs and of a newly established company are likely to change over time and how the appropriateness of the sources of funds changes as well.

Answer 1

The companies generally have two financing options that is debt and equity. A company at its initial stage may have to use its own fund equity to finance its asests and lower of debt to maintain the leverage of the company. With only equity financing the cost of capital of the company increases as there is no tax benefit on dividend which are paid from profits as these are paid after the taxes while in debt the company would get advantage of tax which reduces the overall cost of debt to the extend of taxes. With the debt in the capital structure of the company the cost of capital of the company is maintained. At the initial stage the company may pay lower dividend to the shareholders but as the company grows and if the company doesnt have enough investment opportunity the company will have to increase its dividend and pay to the investors.