Understanding the Concepts - Essay Example

? Understanding the Concepts Introduction: While making financial plans for any business, it is highly necessary to understand certain concepts related to the financial topics. This is primarily because in case of business, matters of investments and returns are of serious concerned issues. Hence without understanding the different concepts of financing and their results, it would become difficult to realize and come to proper financial decisions. The present study focuses on the understanding of different concepts of finance that a small business owner would require in his/her decisions and include topics like NPV, debt financing, risk-return relationships, concept of beta, and systematic and unsystematic risk. Concept of NPV/Payback Rule: The concept of NPV or Net Present Value of a particular investment represents the difference in its market value and its actual cost. The value of NPV is determined by estimating the present value of those cash flows that shall take place in the future. The cost is then deducted from the resultant to obtain the value of the NPV. According to the payback rule, a particular cutoff is selected and if the payback period is less than that cutoff, the project proves to be good to undertake. A payback period represents the time period when the cost of the project becomes equal to the total sum of the investments made on the project (Ross, Westerfield & Jordan, 2008, p.290). Thus, these two concepts can be utilized in the business in order to determine whether the investments made on the project and the costs being incurred are on a right track to provide the owner with sufficient returns. Advantages and Disadvantages of Debt Financing and Issue of Stocks over Bonds: The first advantage of debt financing is that a business only requires repayment of the borrowed amount but it is the owners who are accrued for any rise in the firm’s value. Secondly, debt is less costly in comparison to equity and carries lesser amounts of risk. Thirdly, the availability of debt financing is more frequent and easy than equity financing. The disadvantages of debt financing lie with the fact that debts have to be cleared even if the firm has undergone any losses in its finances. Secondly, in debt financing the assets of a firm are required to be used a guarantee that limits the further borrowing of the firm. Thirdly, several restrictions might be presented by the lenders in the process of debt financing. Lastly, personal guarantee might also be required in some cases (Seidman, 2005, pp.32-33). An organization would choose to issue stocks than bonds since firstly a stock represents the share of the owners of the firm, while a bond is a debt instrument. Secondly, a stock does not have a maturity period unlike bonds that have a fixed maturity period. Thirdly, dividends are gained over stocks while bonds borne fixed rates of interests (Brown, 2011). Risk-Returns Relationship: Financial risks are considered to be any such uncertainty that might affect the positive outcomes of a firm. Such risks might be associated with the market which is external to a firm. On the other hand, internal problems might also give rise to risks. The primary relationship between financial returns and risk arise based on the fact that investors always prefer higher returns and lesser risks. Thus it can be understood in this context that if financial risks are higher in case of an investment, the investor would have expectations for higher returns. This reflects on a trade-off that exists between the risks and the returns. Such a trade-off enables determination of the added amount of return that an investor would receive if he considers a higher level of risk in his investment measure (Brigham & Houston, 2012, p.258). Thus depending on the level of risks that an investor can consider in his investment, the financial returns vary and this throws light on the relationship that exists between financial returns and risks. Beta and its Use: The concept of beta has been used for the measurement of systematic risk of any particular business. It determines the difference in the risk of a firm’s portfolio or risk prevailing in the security and the value of the risk in the market. Thus the concept of beta enables a firm to determine the amount of returns it might gain as against the market risks prevailing. It reflects on the variation that the company’s stocks risks present from the market risks. It is useful since the concept is easy to understand. Moreover, the calculation of beta is easy as well and is done by obtaining the arithmetic average of the beta values of different stocks that are included in the portfolio of the concerned firm (Smith & Smith, 2005, p.58). Thus the concept of beta can be understood to help an investor in measuring the risk of the firm’s portfolio and compare that with the market risk thus focusing on the required financial measures. Systematic and Unsystematic Risks: Financial risks can be divided into two components: systematic and unsystematic. The risk is referred to as systematic if it “affects a large number of assets, each to a greater or lesser degree” and an unsystematic risk occurs when it “specifically affects a single asset or a small group of assets” (Jaffe, et al, 2004, p.299). When risks arise due to uncertainties in general conditions in the economy, they are systematic risks. Thus the primary difference in the two risks lies in the nature of the risk and the effects that they have on the businesses. Systematic risks are those that are bound to affect all companies in some way or the other that is they are not specific to a company. Unsystematic risk is different since it is specific to a company and may or may not affect other companies. Investment Decision: In order to invest the $1million diversifying the risk, firstly the company would be required to determine the portfolio of stocks where investment would be feasible. This might be obtained through a detailed study of the market and the industry thus determining the stocks. Stocks need to be so chosen that reflect varying risks in the market. This would be beneficial since if one stock undergoes losses for some reasons, the other stocks would be able to complement and balance the losses. A detailed study on the systematic and unsystematic risks is also required to understand the factors that the corporation need to focus on. Moreover, the measurement of the market risk can be calculated through beta and hence the risk of the chosen portfolio can be compared. All these measures considered relevantly would enable to determine an optimal investment measure for the manufacturing company. Conclusion: From the study it has been understood that the understanding of the discussed financial concepts help in the investment for a firm and determine the portfolio that would be able to provide the firm with sufficient returns against the risks it undertakes. References 1) Brigham, E.F. & J. F. Houston (2012). Fundamentals of financial management, Connecticut: Cengage Learning 2) Brown, G. (2011). The Advantages of Issuing Stock Rather than Bonds, eHow, Retrieved on February 5, 2012 from: http://www.ehow.com/info_10009321_advantages-issuing-stock-rather-bonds.html 3) Jaffe, J. et al (2004). Corporate finance, India: Tata McGraw-Hill Education 4) Ross, S.A., Westerfield, R. & B.D. Jordan (2008). Fundamentals of Corporate Finance, India: Tata McGraw-Hill Education 5) Seidman, K.F. (2005). Economic development finance, London: SAGE 6) Smith, K.V. & J.A. Smith (2005). Strategies in personal finance: basic investment principles for today and tomorrow, Indiana: Purdue University Press Read More