2: Business Financing and the Capital Structure - Assignment Example

Explain the process of financial planning used to estimate asset investment requirements for a corporation. Explain the concept of working capitalmanagement. Identify and briefly describe several financial instruments that are used as marketable securities to park excess cash. The process of financial planning for asset investment requirements is referred to as the capital budgeting process. First step in the process is to determine the possible investment alternatives that would address the need of the business.

After identifying the likely options, the corresponding costs (purchase and installation) and the possible income streams into the future should be estimated, taking note of the years during which they are expected to materialize. With this information, the payback period may be estimated for a rough expectation of when the investment would break even. Other methods will necessitate the estimation of the cost of money which would serve as the discount rate for time-value-of-money estimations.

On the basis of this discount rate, the present values of cash inflows and cash outflows should be calculated and offset to determine the net present value, or the ratios thereof taken for the profitability index. Finally, the internal rate of return can be acquired through the hit-and-miss estimation method. Working capital management is based on maintaining appropriate levels of current assets and current liabilities, in such a way as to provide for the timely fulfillment of short-term debt obligations and operating expenses without holding excessive amounts of liquidity that otherwise could be invested.

Excess cash may be invested in short term financial instruments (marketable securities) could include short-term debt instruments such as treasury bills and commercial papers, deposits and certificates of deposit, commercial papers, short-term interest rate futures and forward rate agreements. Of these, treasury bills are considered the safest because they are government securities and hold minimal risk. Commercial papers are debt instruments made in favour of private corporations and carry as much risk as the corporation’s ability to repay the debt.

Deposits and certificates of deposit are entered with the bank for conversion to loans, and hold as much risk as is associated with the bank’s record of performance. Interest rate future and forward rate agreements are considered speculative and would normally not be viable considerations because of their high risk. 2.Assume that you are financial advisor to a business. Describe the advice that you would give to the client for raising business capital using both debt and equity options in today’s economy.

Raising business capital should take into consideration the nature of the business, its production cycle, its initial capital outlay and the expected time within which it is expected to produce income, and the risk the investors are willing to take. Business capital can be raised either as equity or as debt. The capital structure of the firm should be estimated – that is, how much of their own funds the business owners can raise for themselves (equity) against what they wish to raise as borrowed funds (debt).

The higher the leverage or the ratio of debt to equity, the greater the risk of default the business is exposed to. The business is also committed to earn within a shorter period of time because of the need to pay periodic interest on the loan. On the other hand, relying too much on equity will be a greater burden to investors, for which they may seek to expand the shareholder base. Increasing the number of shareholders, however, dilutes the value of the shares and reduces the control of the current shareholders over the business.

The risk-return trade-off should be carefully considered by the business owners before they raise the capital for their business. 3.Explain why a business may decide to seek capital from a foreign investor indicating the risk and rewards for such a decision. Provide support for rationale. A business may seek capital from a foreign investor for a number of reasons, the most evident of which is the possible high cost of capital domestically available. A capital deficit economy may provide incentives for foreign investors for their direct investments in that country, in the form of tax incentives or liberal policies, in order to attract investments from abroad.

Furthermore, higher levels of foreign capital may be seeking greener investments in emerging markets because of the recessions taking place in their regions or countries, making foreign capital easier to access for the domestic firms than they can access domestic capital. It is also possible that venture capital (or funds for high-risk, pioneering ventures) originating from abroad is more accessible than local venture capital if there are any. In other words, economic disparities between countries may make it more profitable for foreign capital to invest in local businesses, and for local businesses to avail of foreign capital rather than domestic funds. 4.Explain the historical relationships between risk and return for common stocks versus corporate bonds.

Explain how diversification helps in risk reduction in a portfolio. Support response with actual data and concepts learned in this course. Risk and return for any financial undertaking have a direct relationship – that is, the higher the risk, the higher the return. This is true in the case of both stocks and bonds, because any investor who perceives higher than average risk in his potential investment will require the assurance (or at least likelihood) of a higher than average return to be worth his investment.

On the other hand, when risk rises most risk averse investors would avoid committing their funds, which means that the supply of available capital would fall in relation to the demand for capital. The price of capital, in terms of expected return, would therefore rise to merit the available capital ahead of other demand. Returns experienced in investing in common stocks versus investing corporate bonds usually have an inverse relationship. The reason is that when stocks are seen as risky, investments flow into bonds and raises bond rates; when the long-term prospects for bonds are seen as risky, money flows into common stocks and the prices of stocks increase.

This is evident in the following two graphs showing that the FTSE100 chart shows a reverse image of the graph for the benchmark 10-year government bond rates. FTSE 100 shows a two-year high, while the bond rates show a two-year low. This is a persistent relationship between them. From this it may be deduced that striking a balance between stocks and bonds is a sound strategy to sustainable and profitable investments. The investors must determine their individual risk profiles and their ability to sustain possible losses, so that they may judge how defensive their investment portfolios need to be.

Bonds are considered less risky, and they usually promise periodic income to the investor in the form of interest payments. On the other hand, common stocks are generally more risky than bonds, but they are of different levels of risk. Blue chips are usually resilient to losses, promise regular cash dividends, and have a steadily growing valuation. Speculative stocks on the other hand move on rumours, have low fundamental value, and seldom maintain a steady price-to-earnings ratio. Blue chips have a lower risk than speculatives, although they also have more gradual gains than speculatives (they also have smaller losses).

Therefore serious investors should allocate their portfolio partially to government bonds and blue chip stocks for safety and growth, and they may use a smaller portion for cautiously buying into growth and speculative stocks to enhance trading gains, if their risk tolerance can allow it. References: Hagin, R L 2004 Investment Management: Portfolio Diversification, Risk and Timing – Fact and Fiction. Chichester, West Sussex: John Wiley & Sons Jackson, C 2004 Active Investment Management: Finding and Harnessing Investment Skill.

Chichester, West Sussex: John Wiley & Sons Litterman, B 2004 Modern Investment Approach: An Equilibrium Approach. Hoboken, SJ: Wiley & Sons Trading economics.com, UK Department of Treasury