Understanding the concepts - Essay Example

? UNDERSTANDING THE CONCEPTS Imagine you are a small business owner. Determine the financial ratios that are important to the business. Compare your ratios with those that are important to a manager of a larger corporation. Ans: For a small business owner, the following ratios are important to him and he will compare these ratios with that of ratios of larger corporation in the following manner-Current ratio = current assets/current liabilities. This ratio will be compared between the two firms to check the liquidity position or short term solvency of firm. The ideal current ratio is 2:1. Debt equity ratio = long term debt/shareholders fund. It will be compared to check the claim of outsiders and owners in assets of firm which reflects the financial soundness of firm. The ideal ratio is 2:1. Inventory turnover ratio = cost of goods sold/ average inventory. It will be compared between firms to check the efficiency in inventory management. High inventory turnover ratio indicates sound inventory management. Return on capital employed = (profit before interest and tax/average capital employed)*100. It will be compared to check how much return the firms are earning in respect of the gross resources been deployed in the firm (Bull, 2007). 2. Explain the advantages and disadvantages of debt financing and why an organization would choose to issue stocks rather than bonds to generate funds. Ans. The primary advantage of debt financing is its allowing the founders to retain control and ownership of company. In contrast to equity financing, it enables the entrepreneurs to make key strategic decisions and to reinvest and keep more company profits. It also provides small business owners the greater degree of financial freedom than equity financing. Debt obligations are limited to the period of loan repayment after which no further claim can be made by the lender on the business. The main disadvantage of debt financing is its requiring the small business to make monthly payments of interest and principal regularly. Most lenders provide severe penalties for missed or late payments including charging of late fees, calling early the due loans and collateral possession. Failure to pay on loan can affect adversely the credit rating of small business and its ability of obtaining future financing. Also it will be difficult to obtain loans for unproven businesses since lenders seek security for their funds (Creamer, et al., 1960). An advantage of stock over bond are-One of the major advantage of stock is its unlimited potential. There is no ceiling on investment in buying stocks. The stock price can double, triple or may get multiplied. Stocks tend to have better performance over bonds in case of long term investment. Money may be lost in some years for wide fluctuation in stock market but it will give better return to investors in long term. Trading with stocks facilitate transaction. 3. Discuss how financial returns are related to risk. Ans. Gain or loss from investment is derived from the relation between financial risk and return. If an investor invests in securities having low risk then it will have a small return. If the risk factor associated with security is high then investor could have the potential to earn high returns. The balance between highest possible return and lowest possible risk is given by the risk/return trade-off. A standard deviation indicates higher risk with higher possible return. 4. Describe the concept of beta and how it is used. Ans. Beta can be defined as the measure of volatility or systematic risk of portfolio or security as compared to market as a whole. It is the tendency of return on a security in respond to market swings. Beta is used in capital asset pricing model (CAPM) which calculates expected return of an asset on the basis of its beta value and expected market returns using regression analysis. Beta is otherwise known as beta coefficient. Beta equals to one indicates movement of security’s price with market movement. Beta less than one indicate security will be less volatile than market. Beta greater than one indicates security price to be more volatile than market offering possibility of high rate of risk and return (Ryu, 2011). 5. Contrast systematic and unsystematic risk Ans. Systematic risk refers to risk occurred due to the influence of external factors to an organization. It is macro in nature affecting large number of organizations operating in same domain. Systematic risks are interest rate risk, market risk and inflationary or purchasing power risk. Unsystematic risk on the other hand refers to risk occurred on account of internal factors prevailing within the organization. It is macro in nature affecting a particular organization only. 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. Ans. While searching options to invest money, the considerable point is how to achieve maximum utility. For this, the net present value (NPV) needs to be calculated to get the return on investment. After winning $ 1 million, it’s better to make diversified investment portfolio to diversify the risk. Firstly, storing the money in saving deposit will facilitate to earn interest payments. Putting money in savings account involves less risk. Second investment instrument can be certificate of deposit which is a debt instrument sold by bank to depositors paying annual interest of given amount and paying back the original purchase price at maturity. Thirdly, putting money in mutual funds allows holding diversified portfolios by pooling resources facilitating lower transaction costs while purchasing large block of stocks and bonds. This investment can be risky. Investment in stock market and business projects can be another option which is quite risky as future can’t be predicted. Though a business investment is riskier but could be profitable. Decision need to be taken to become an equity holder or debt holder. Sudden rise in profits will not benefit debt holders because of their fixed payments. The investment strategy will differ from risk lover to risk averter. The diversified portfolio investment can be made with $1million in this manner - Saving deposit- $400000, Certificate of deposit-$250000, Mutual fund-$200000, Stock market-$75000 and Business project-$75000 (McMillan, 2002, p.90). References Creamer, D., Dobrovolsky, S., Borenstein,I., and Bernstein, M. (1960). Debt and Equity Financing. Retrieved from: http://www.nber.org/chapters/c1393. McMillan, L. (2002). Options As a Strategic Investment, ed.4. New York: New York Institute of Finance. Ryu, A. (2011 ). Beta Estimation Using High Frequency Data*. Retrieved from: https://econ.duke.edu/uploads/assets/Ryu.pdf. Bull, R. (2007). Financial Ratios: How To Use Financial Ratios To Maximise Value And Success For Your Business. London: CIMA Publishing.   Thursday June 25, 2009   Thursday June 25, 2009 Read More