Basic Elements of Financial Decision
Financial Management is the efficient and effective planning and controlling of financial resources so as to maximize profitability and ensuring liquidity for an individual is called personal finance, for government is called public finance and for profit and non-profit organization/firm is called corporate or managerial finance. Generally, it involves balancing risks and profitability.
There are three basic element of financial decision:
1. Cash flow - realizable cash flow
2. Timing of cash flow - profit is the part of cash flow
3. Risk
Major Financial Decisions
Financial Management is the efficient and effective planning and controlling of financial resources so as to maximize profitability and ensuring liquidity for an individual is called personal finance, government is called public finance and for profit and non-profit organization/firm is called corporate or managerial finance. Generally, it involves balancing risks and profitability.
The decision function of financial management can be divided into the following 3 major areas:
Investment Decision
Investment decision is determining the total amount of assets needed by a firm hence closely tied to the allocation of funds. Investment decision involves investment of company’s capital in current and fixed asset. There are two types of investment decisions namely:
- Capital Investment decisions: It means investment in fixed asset. This investment needs large amount of money for longer term and critical to the business like - purchase of plant and machinery or factory
- Working Capital Investment decisions: It means investment in current asset. It is also called working capital. This investment is routine in nature and for short term like how much and how long to invest in inventories or receivables. The amount of working capital varies depending on the nature of company. A travel company needs a little amount of working capital whereas a manufacturing company needs huge amount of working capital.
Financing Decision
After deciding on the amount and type of assets to buy, the financial manager needs to decide on how to finance these assets that is the sources of fund. Financing decision involve find out the source of fund required to invest in business. Generally a company raise fund from the following three sources:
- Equity / Stock - ownership fund: It can be raise from two sources
Ø External - common stock
Ø Internal - retaining earning
- Debt: Debt can be two type
Ø Short term - less than 1 year
Ø Long term - 5/7 years
Ø Between short term and long term debt can be called medium term debt
3. Preferred stock: It is hybrid type of financing
Financing decisions for example:
- Whether to use external borrowings /debts or share capital or retained earnings
- Whether to borrow short, medium or long term
- What sort of mix – all borrowings or part debts part share capital or 100% share capital
Dividend Decision
The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. Dividend decision determines the division of earnings between payments to shareholders and retained earnings. It is the reward of the shareholders for investments made by them in the shares of the company.
The Dividend Decision, in corporate finance, is a decision made by the Board of Directors and is confirmed generally by the annual general meeting (AGM) of the shareholders. The Dividend Decision is an important part of the present day corporate world. The Dividend decision is an important one for the firm as it may influence its capital structure and stock price.
There may be three types of dividend policy
(1) Strict or Conservative dividend Policy which envisages the retention of profits on the cost of dividend pay-out. It helps in strengthening the financial position of the company;
(2) Lenient Dividend Policy which views the payment of dividend at the maximum rate possible taking in view the current earning of the company. Under such policy company retains the minimum possible earnings;
(3) Stable Dividend Policy suggests a mid-way of the above two views. Under this policy, stable or almost stable rate of dividend is maintained. Company maintains reserves in the years of prosperity and uses them in paying dividend in lean year. If company follows stable dividend policy, the market price of its shares shall be higher.
1. Stability of Earnings.
2. Age of corporation.
3. Liquidity of Funds.
4. Growth needs of the company
5. Needs for Additional Capital.
6. Trade Cycles.
7. Government Policies.
8. Taxation Policy.
9. Legal Requirements.
10. Past dividend Rates.
11. Ability to Borrow.
12. Financing Policy of the firm
13. Debt obligation
14. Profit rates
15. Attitude of the investor group
What Is a Financial Asset?
Financial asset is a claim against the income or wealth of a business firm and represented usually by certificate and issued by financial entity.
A financial asset is an intangible representation of the monetary value of a physical item. It obtains its monetary value from a contractual agreement of what it represents. While a real asset, such as land, has physical value, a financial asset is a document that has no fundamental value in itself until it is converted to cash. A financial asset can not be depreciated.
Form of financial asset - instruments
v Money
v Equity / stock - common stock & preferred stock
v Debt
v Derivatives
Common types of financial assets include certificates, bonds, stocks, and bank deposits.
Dealer verses Broker
Transformation of savings into investment is done in two ways:
- Direct method - Dealer & broker
- Indirect method - Financial intermediaries
In general, dealer is an individual or firm who purchases goods or services for resale to consumers and maintains an inventory and stands ready to buy and sell at any time. In contrast, a broker brings buyers and sellers together but does not maintain an inventory.
In the securities market, a dear stands ready to buy securities from investors wishing to sell them and sell securities to investors wishing to buy them. The price dealer is willing to pay is called bid price and the price at which dealer will sell is called ask price or offering price. The difference between the bid and ask price is called spread and it is the basic source of dealer profits. In contrast, a securities broker arranges transactions between investors matching investors wishing to buy securities with investors wishing to sell securities. The distinctive characteristic of security brokers is that they do not buy or sell securities for their own accounts.
Financial intermediary
Transformation of savings into investment is done in two ways:
- Direct method - Dealer & broker
- Indirect method - Financial intermediaries
A financial intermediary is a financial institution that connects surplus and deficit agents. It acts as the middleman between investors and firms raising funds. Financial intermediation consists of “channeling funds between surplus and deficit agents”
The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans.
Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities.
Financial intermediaries provide 3 major functions:- Maturity transformation :Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs)
- Risk transformation: Converting risky investments into relatively risk-free ones.
- Convenience denomination :Matching small deposits with large loans and large deposits with small loans
Advantages of financial intermediaries
There are 2 essential advantages from using financial intermediaries:- Cost advantage over direct lending/borrowing
- Market failure protection the conflicting needs of lenders and borrowers are reconciled, preventing market failure
Types of financial intermediaries: Financial intermediaries include -
- Banks
- Building societies
- Credit unions
- Financial advisers or brokers
- Insurance companies
- Collective investment schemes
- Pension funds
- Mutual funds
Primary market verses secondary market
Financial market is a market where financial assets are bought and sold. There are two type of financial market:
§ Money market - duration 1 year or less
§ Capital market - duration more than 1 year
In capital markets long-term securities and shares are issued and traded. Capital markets are where most of the traffic of trading occurs. Capital market are sub-divided into a. Primary Market b. Secondary Market
Primary Market
This is a part of the financial market where new securities / shares are traded for the first time. Companies and government can issue securities in this market through Initial public offerings (IPO’s), rights issue (for existing companies), and preferential issue. Its principal function is raising financial capital to support new investment in building, equipment and inventories.
Secondary Market
Secondary market is a market where securities are traded after they are initially offered in the primary market. Its chief function is to provide liquidity to security investors and it provides an avenue for converting financial instruments into cash.
The volume of trading in the secondary market is far larger than in the primary market. The secondary market does not support new investment. Nevertheless, Primary and secondary markets are closely intertwined. A rise in security price in secondary market usually leads to similar rise in prices on primary market securities and vice versa.
There are two ways for investors to get shares from the primary and secondary markets. In primary markets, securities are bought by way of public issue directly from the company. In Secondary market share are traded between two investors.
Rate of return
In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested.
Return is realizable cash flow generated by an investment over a period of time is expressed as a percentage. Formula of return is:
Pi,t-1
Example: Price of share at the beginning of period = Tk.150
Price of share at the end of period = Tk. 160
Dividend = TK. 10
Rit = (Tk.160 - Tk.150) + Tk.10 X 100
= 13.33%
Return has two components. Firstly, one may receive some money on the investment. It is called income component of investment. Secondly, the value of the asset will often change. If increase is called capital gain and loss is called capital loss.
Riskier investments must have a higher projected rate of return in order to be worthwhile. An investment with a relatively low projected rate of return generally should be low risk in order to still be worthwhile.
For example, a savings account might have a relatively low projected rate that it will return. Because the investment is safe, however, a lower rate is acceptable. Stocks typically should have a higher projected rate the money will return, since the investor takes more risk in this situation.
Time Value of Money
Time Value of Money (TVM) is an important concept in financial management. The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.
TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future. Money that you hold today is worth more because you can invest it and earn interest. For instance, you can invest your dollar for one year at a 10% annual interest rate and accumulate $1.10 at the end of the year. You can say that the future value of the dollar is $1.10 given a 10% interest rate and a one-year period. It follows that the present value of the $1.10 you expect to receive in one year is only $1.
The Time Value of Money concepts will be grouped into two areas: Future Value and Present Value. Future Value describes the process of finding what an investment today will grow to in the future. Present Value describes the process of determining what a cash flow to be received in the future is worth in today's dollars.
Compounding
Compounding is the process of calculating the future value of a present amount.
Compounding is the process of earning interest on a loan or other fixed-income instrument where the interest can itself earn interest. That is, interest previously calculated is included in the calculation of future interest. For example, suppose someone had the same certificate of deposit for $1000 that pays 3%, compounding each month. The interest paid is $30 in the first month (3% of $1,000), $30.90 in the second month (3% of $1,030), and so forth. In this situation, the more frequently interest is compounded, the higher the yield will be on the instrument.
Discounting
Discounting is the process of calculating the present value of a future amount. Discounting is opposite to compounding.
Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time in exchange for a charge or fee. Essentially, the party that owes money in the present purchases the right to delay the payment until some future date. The discount, or charge, is simply the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the debt
To calculate the present value of a single cash flow, it is divided by one plus the interest rate for each period of time that will pass. This is expressed mathematically as raising the divisor to the power of the number of units of time.
Consider the task to find the present value PV of $100 that will be received in 5 years. Assuming a 12% per year interest rate.
What is financial management?
Financial Management is the efficient and effective planning and controlling of financial resources so as to maximize profitability and ensuring liquidity for an individual(called personal finance), government(called public finance) and for profit and non-profit organization/firm (called corporate or managerial finance). Generally, it involves balancing risks and profitability.
The key objectives of financial management are to:
v Create wealth for the business
v Generate cash, and
v Provide an adequate return on investment
v Profit maximization
v Wealth maximization
“Financial Management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations.”- Joseph and Massie.
Finance as a discipline
A branch of economics concerned with resource allocation as well as resource management, acquisition and investment. Finance deals with matters related to money and the markets. To raise money, corporations issue and sale equity/share and debt.
The focus of Finance is on the financial management of business firms. Simply, finance is a body of facts, principles, and theories dealing with the raising and using of money by individuals, businesses, and government.
The individual's financial problem is to maximize his or her well being by appropriately using the resources available. Finance deals with how individuals divide their income between consumption - food, clothes, etc. and investment - stocks, bonds, real estate, etc. how they choose from among available investment opportunities, and how they raise money to provide for increased consumption or investment.
Firms also have the problem of allocating resources and raising money. Management must determine which investment to make and how to finance those investments. Just as the individual seeks to maximize his or her happiness, the firm seeks to maximize the wealth of its owners (stockholders).
Finance also encompasses the study of financial markets and institution, and the activities of governments, with stress on those aspects relating to the financial decisions of individuals and companies. In addition, financial institutions and governments have financial problems comparable to those of individuals and firms. The study of these problems is an important part of the field of finance
Maximization profit as a goal
Possible goals
Survive
Avoid financial distress and bankruptcy
Beat the competition
Maximize sales or market share
Minimize cost
Maximize profit
Maintain steady earning growth
Maximize return
Maximize wealth
Maximization of profits is generally regarded as the main objective of a business enterprise. Each company collects its finance by way of issue of shares to the public. Investors in shares purchase these shares in the hope of getting profits from the company as dividend. It is possible only when the company's goal is to earn maximum profits out of its available resources. If company fails to distribute higher dividend, the people will not be keen to invest their money in such firm and persons who have already invested will like to sell their stocks. On the other hand, higher profits are the barometer of its efficiency on all fronts, i.e., production, sales and management. A few replace the goal of 'maximization of profits' to 'fair profits'. 'Fair Profits' means general rate of profit earned by similar organization in a particular area.
Profit maximization alone cannot be an appropriate goal for a firm. It is not a precise and clear goal. Do we mean profit this year? If so, we should note that actions such as deferring maintenance, letting inventories run down and taking other short-run cost-cutting measures will tend to increase profit now, but these activities are not desirable in the long run.
Maximization owner’s wealth as a goal
Maximization of profits is regarded as a proper objective of the firm. It does not include the goal of maximizing the value of the stocks. Stockholders buy stock because they seek to gain financially. Good financial decisions increase the value of the stock and poor decisions decrease the value of the stock. Financial manager acts in the shareholders’ best interest by making decision that increase the value of the stock. Value of stock is represented by the market price of the ordinary share of the company over the long run which is certainly a reflection of company's investment and financing decisions. The log run means a considerably long period in order to work out a normalized market price. Therefore, the appropriate goal financial management is -
“The goal of financial management is to maximize the current value of the existing stock”
The total value of the stock in a corporation is simply equal to the value of the owners’ equity. Therefore, more precise goal of financial management is “maximizing the market value of the existing owners’ equity”. This goal of financial management does not mean that financial management should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. What it means is that the financial manager best serves the owners of the business by identifying goods and services that add value to the firm.
No comments:
Post a Comment