Understanding the Concepts
1. Imagine you are a small business owner. Explain how you will apply the concept of NPV / payback rule to make a good financial decision.
Any business has its main objective as the maximization of profits. It is noteworthy that investments mean putting some money in a certain venture with the hope of getting a return on investments. In order to ascertain the profitability of an investment, the expected returns have to be aligned with the inflation. This gives the true value of the returns. Net Present Value (NPV) refers to a discounted technique considers the time value of money. It is founded on the fact that the value of cash flow at varied times will always be different. In this case, the estimated cash flow for any venture undertaken by a business must be converted to the present value. NPV may be defined as the variation between the net cash outlay and the total present value (Peterson and Fabozzi, 2002). It marks the variation between the present value of the cash inflows and the cash outflows. A small business would use the technique to determine the reliability of the future cash inflows that a project or investment will yield. It essentially compares the present value of the dollar to the future value of the same dollar while considering returns and inflation. Any project with a positive NPV would be accepted (Peterson and Fabozzi, 2002). In this case, the higher the NPV, the higher the returns in the future and, therefore, the viability of the project.2. Explain the advantages and disadvantages of debt financing and why an organization would choose to issue stocks rather than bonds to generate funds.
Debt financing refers to the funding of expenditure and investments using money borrowed from outside sources. The borrowing rests on the condition that the principal amount will be repaid at a certain time with a predetermined interest. It may also be defined as borrowing funds from external sources so as to make new investments or run a business. The borrower would get a certain lumpsum amount upfront and agree to repay it in installments with a predetermined interest. In essence, debt financing is long term in nature (Peterson and Fabozzi, 2002).
Debt financing comes with a number of advantages. It is noteworthy that the borrower would retain the control and ownership of the business. This is because the creditor has no monetary interest in the business apart from the principle amount and the predetermined interest. In addition, the owner would retain the business profits without sharing them with the creditor (Peterson and Fabozzi, 2002). Moreover, the borrower has a limited obligation since once he has repaid the principal amount and the accrued interest, he would be freed of all obligations. This does not undermine the fact that the borrower would be entitled to all the tax advantages pertaining to a tax deduction for the amount borrowed. It is noteworthy that repaid amount is calculated beforehand in which case, it is easy to undertake future planning since it does not depend with fluctuating market conditions.
Debt financing also incorporates some cons. It is noteworthy that the debtor has to repay the loan whether the business makes a profit or not. In addition, the fixed interest cost may heighten the break-even point of the company. Moreover, the debt repayment is a fixed obligation irrespective of the performance of the business. This increases the probability that the business will be rendered insolvent, especially in hard financial periods. As much as the creditor may not be concerned with the business operations, he may impose some conditions which may limit the expansion of the business.
Stocks are comparable to debt financing while bonds are comparable to equity financing. Equity financing is essentially a complete opposite of debt financing. It is noteworthy that many organizations prefer to issue stocks rather than bonds as it comes with all the advantages of debt financing (Peterson and Fabozzi, 2002).
3. Discuss how financial returns are related to risk.
Any company makes investment with the hope of gaining returns from the investment. However, every investment involves risks since the venture may yield profits or a loss. Financial risk refers to the uncertainty that surrounds return on an investment. In essence, refers to the risk that investors bear as a result of financing the instruments that the company may use to raise money. For example, shareholders inequity financing bear the risk that the share value may go down. In business, there are expectations that high risk levels come with high financial returns. It is noteworthy that this does not have to be the case. High financial risks just come with the possibility of high financial returns. Conversely, low risks are associated with low potential returns.
4. Describe the concept of beta and how it is used.
Beta refers to a historic measure of the systematic risk or volatility of stocks, as well as how its relationship with the market as a whole. In essence, it offers an individual with a guideline on how stocks would typically move based on the market data that have been collected and analyzed. When the stock has a beta of 1, the stock volatility is less than that of the market. A beta that is higher than 1 means that the stock is likely to have a higher volatility than the market. When the beta of a certain stock is 1.5, it implies that if the market rises by 10 percent, the stock would rise by 15 percent if the historical information is anything to go by. In case the market drops by 2 percent, the stock is likely to lose 3 percent if the historical information is anything to go by (Peterson and Fabozzi, 2002). It is noteworthy that beta is a historical measure, in which case there are instances when it will have volatility that is lower or higher than expected.
5. Contrast systematic and unsystematic risk.
Any investment comes with certain risks from varied sources. Systematic risks refer to those risks emanating from factors affecting the entire market. These include changes in the investment policies, taxation clauses, foreign investment policy, socio-economic parameters and threats to global security among others. In essence, investors cannot mitigate or control systematic risks except on an exceedingly small extent. Unsystematic risks result from factors pertaining to a certain industry or company. These include product category, labor unions, pricing, research and development, marketing strategies among others. Evidently, investors can control or mitigate the unsystematic risks via portfolio diversification. The company can also avoid the risk and, therefore, the market would not compensate for the risk (Peterson and Fabozzi, 2002).
6. Imagine your manufacturing corporation has just won a patent lawsuit. After attorney and other fees, your corporation will have about $1 million. Explain how you plan to invest the money in order to diversify the risk and receive a good return. Support your decisions with concepts learned in this course.
The importance of diversification in any organization cannot be gainsaid. A company’s ability to diversify may be hampered by financial constraints. In essence, diversification strategies are undertaken in order to expand a company’s operations by adding products, markets, stages of production, as well as services to the existing business. This allows the company to engage in lines of business that vary with the current operations. In a manufacturing concern, varied diversification strategies may be incorporated. However, the best diversification strategy in the manufacturing corporation is concentric diversification where the company would add related markets and products. The strategy aims at giving the company a strategic fit, in which case it will have achieved synergy. Synergy refers to the capacity of varied components of an organization to have increased effectiveness than the individual parts would have independently. In essence, synergy would be achieved by blending the company with complementary financial, marketing, management or operating efforts (Harrison, 1999).
The manufacturing company should combine the operating units so as to improve the overall efficiency, thereby achieving operational strategic fit. Alternatively, the duplicate research and development and equipment would be eliminated through blending various units thereby improving the overall efficiency. Operation synergy may also be achieved through bulk-ordering in order to optimize on quantity discounts. In addition, efficiency would be improved through diversification into areas that can utilize by-products of existing operations.
St. John, C., and J. Harrison, (1999) “Manufacturing-Based Relatedness, Synergy, and Coordination.” Strategic Management Journal 20
Pamela Parrish Peterson, Frank J. Fabozzi, (2002). Capital budgeting: theory and practice. New York: John Wiley and Sons.
(Peterson and Fabozzi, 2002)