Business Finance and Linear Programming - Essay Example

? of Learning: Business Finance Finance theorists suggest that the goal of the firm should be to maximize ownership wealth. Discuss the basis of this concept and its application to the real world The current trend in most firms to have their main goal being to maximize the ownership wealth has received much criticism especially from the economists. In their arguments, the critics have it that firm managers are mostly interested in other factors rather than attaining profits for the firm. Managers have been observed to have their interests in prestige, power, employee welfare, leisure, the larger society welfare and community well being. The maximization act in general is the one being criticized as the managers tend to be carried away by the mere feeling to satisfice and not really come up with means of maximizing or optimizing according the theories of finance. This means that the mangers go for solutions which they regard as satisfactory yet they need to seek the best solutions that are possible respecting the existing constraints. Considering the structure of most modern firms, it is almost impossible to single out the mangers true motives. Modern firms are mostly organized to operate as a corporation where shareholders happen to be the legal owners of such firms and the managers have been given the mandate to act on behalf of their shareholders. This happens if the manager is out to merely satisfy the firm’s stockholders while at the same time pursing other goals of his or her own interests that are in no manner related to attempts to try and maximize the firm’s value. A good example is charitable organizations where it is hard to tell the firm’s support makes an integral part of its value maximization in long terms. In addition, considering a case where the size of the firm in continuously increasing yet the profits are not; this can be attributed to the decision of the manager to have his motivation as being to expand the size of the business through increasing its prestige association with other lager firms or an effort to make the firm more recognized on the market place. It becomes very hard to come up with definite answers to situations like the ones mentioned above resulting to some of the financial theorists to come up with theories on firm behavior. The theories have come up with different situation in relation to the managers and maximization of the ownership wealth. They include; A firm manager may primarily try to maximize the growth or size of the firm and not its current value, the firm’s manager may try to maximize their own welfare or utility and in other cases a firm being considered as a collection of different individuals who have divergent goals rather than one common goal (Williamson 2000, p. 73) As the financial theories regarding firm try to increase the understanding on how firms behave, they don’t necessarily provide the most desired solution especially when it comes to wealth maximization considering the dynamics in the structures of different firms. However, they serve as basis for better understanding and interpretation of different behaviors witnessed in firms. Financial theorists have argued that it is the intense market competition for services and goods that usually force the firm managers to make decisions regarding value and wealth maximization. If a firm fails to come up with the right decision regarding alternatives that are most efficient which imply the need to go for maximum costs for every output level, considering the commodity market price being produced by the firm, other firms may end up outcompeting the firm thus pushing it out of existence. Competition also impacts the firm operations through the capital market. In such as case, stockholders are mainly interested in their stocks returns as well as the prices of their stock which are determined by the value of the firm, that is the expected profits current value that has been discounted. This forces the managers to maximize the profits of the firm in an effort to maximize its value which in turn forms a significant basis for common stocks returns in the long run. Managers who have their interests on other goals rather than maximizing the wealth of the shareholders are most likely to be replaced. A firm that is inefficiently being managed risks to be bought out and in such kinds of hostile takeovers, the managers are identified as to be perusing their personal interests thus had to be replaced. Other theorists have it that managerial compensation has been closely associated with the firm’s profit generation. Therefore, managers tend to have financial incentives that are strong enough to seek their firm’s profit maximization (Malone, 2004, p. 140) The theories argue that before settling at any decision as to whether to satifice or maximize the wealth of the firm, managers just like other economic entities have to analyze the benefits and costs of the decisions they are about to make. In some cases, when all the firms’ costs have been taken into consideration, manager’s decisions that may seem aimed at satisfactory performance level end up being consistent with the behavior of value maximizing. In addition, strategies that are short-lived meant to maximize the growth of the firm are in most cases observed to remain consistent with the value maximization behavior for a long time now that large firms enjoy the advantages in distribution, production and sales promotion. This means that other firm’s goal which doesn’t seem to be geared towards wealth maximization can be intimately associated to profit and value maximization. This is in such a manner that such a model of value motivation even offers an insight into the voluntary participation of the firm in charity as well as other social behavior. The managers are normally faced with several constraints in their attempt to maximize the wealth of their respective firms. Such constraints relate to technology, resources scarcity, laws, contractual obligations and government regulations. When faced with such constraints, the managers are advised to take into consideration both the long-term and short term implications of the decisions they make as well as the several external constraints which may limit the ability of the firm to accomplish its goals. 2. Explain and critically evaluate linear programming as a means of solving multi period capital rationing problems. In market situations where the availability of capital is limited to more than one occasion and thus the selection of any project or any decision made cannot not be reached at through ranking such projects or decisions in accordance to PI, the market situation will be termed as multi-period rationing. Capita constraints are normally imposed in more than one occasion in an effort to restrict the acceptance of NPV projects positivity. Several problems come up in such cases which need to be solved in order to understand the market situation. One of the most common methods of solving multi-period rationing problems is linear programming (LP) which is normally employed to optimize such problems that have linear constraints and objective functions. It is evident that multi-period capita rationing problems cannot be solved through the use of PIs as PIs approach only deals in a single limiting factor like one shortage period. When dealing with problems on multi-period rationing, several limiting factors come up, that is, several shortage periods thus the working method to be applied in such a case is linear programming technique. In a given multi-period rationing problem, linear programming can be applied in two different ways depending on the objective behind the solution. The objectives to solve a multi-period rationing problem can either be; 1. To attain a maximum of the total NPV coming from the investment directed in the current project 2. To have the present cash flow value maximized that are available for the dividends (Gneezy, 2005, p. 390). The above mentioned techniques normally result in similar project solutions Linear programming technique is normally applied in capital rationing in cases where the firm’s objectives is to be maximized or minimized while at the same time the constraints that may limit the actions of the firm happen to be linear functions with respect to the involved decision variables. The initial step to deal with such a situation is to model the problem presented to be in a linear programming form. This can be easily achieved through the identification of the variables of controllable decision and through defining the maximization or minimization objectives and having them presented as a linear function of the variables of controllable decision. After successfully completing the above tasks, the next step is coming up with the definitions of the constraints and having them expressed as linear equations or alternatively as decision variables inequalities. In achieving the above, two assumptions are normally made and they include; 1. The value decision of the decision variables are regarded as being divisible and 2. The constant coefficients used are assumed to be known and are deterministic. In case the two named assumptions prove not to be valid, stochastic and inter programming can be used in place of the linear programming approach (Antle & Epppen, 2000, p. 170). Some of the open problems in multi-period capita rationing include; Finding out if linear programming confess to a polynomial algorithm in the real cost of computation model? Finding out if linear programming takes after strong polynomial algorithm? If linear programming is a strong polynomial algorithm able to reach a strictly complementary solution If linear programming weakly or strongly admits to polynomial pivot algorithm that may in some cases be simplex pivot algorithm such as arrangement method or criss-cross Finding out if the polynomial diameter inference is true for polyhedral graphs If linear programming takes on weakly or strongly polynomial pivot algorithm simplex Finding out if linear diameter speculates right for polyhedral graphs (Evans and Moser 2001, p. 550) Looking at the linear programming graphical approach, it involves two variables only and in situation where the variables exceed two then simplex methods can be used. When an organization has two projects, graphical methods can be used in choosing the one that fits best the project. The way to go over this case is by first defining the variables or the project at hand through assigning them labels. This is followed by an important step involving the establishment of constraints such as capita availability in a specified period. The final stage of this approach is coming up with an objective function. The purpose of the objective function is to achieve investment return maximization. After the translation of the constraints and obtaining the objective function in the given equation, a graph is plotted using the identified variables, constraints and the equation in an effort to find out the feasible solution. One of the common scenarios that normally arises while using linear programming in solving multi-period capita rationing is dual price. Dual price in such a case refers to the amount that one additional scarce resource unit can increase the objective function value. It can also be considered as being the amount at which one less unit of scarce resources can reduce the objective function value (Fehr and Falk 2000,p. 125). When it comes to capital rationing, the available funds are scarce resources thus the dual value indicates the increase in the gained objective function in the case that one more dollar happens to be available or another case where the investment was done less by one dollar. The dual value amount varies and this depends on the approach used in the formulation of linear programming (Fehr and Falk 2000,p. 127); 1. PV dividends approach; this approach entails the dual values being equated to the change witnessed in the PV cash that is available to settle dividends if one less or more dollar is available. 2. NPV approach; in this method, the dual value is the same as the change observed in NPV earned if one less or more dollar is available. 3.Explain briefly what you understand by the term capital rationing and single period capital rationing in relation to capital budgeting. Explain and critically evaluate one model which a company can use to select projects under conditions of single period capital rationing Capital rationing is mostly applicable in new investments acquisition. In addition, it involves attaining investments on the basis of factors like recent capital investment performance, disposable resources amount that can be freely used in the acquisition of new asset and the anticipated asset performance. This implies that capital rationing is a strategy that is normally employed mostly by companies to invest on the basis of the company’s current circumstances that are relevant. In general terms, capital rationing is employed as a way of limiting or capping the existing budget portion that is to be used in the acquisition of a new asset. Following this process, the investor has to put into consideration the use of capital costs that are high when thinking along the lines of the acquiring act outcome of a given asset. Any company that is responsible enough is most likely to settle for strategies that are in support of the productive utilization of disposable funds found in a capital budget, while at the same time, it remains crucial that the company understands the benefits that can be reasonably come from owing such an asset. Now that this approach entails mostly the setting criteria which any investment opportunity has to be meet before a company entertain seriously the purchase, most business settle for it as a tool to guide them in the acquisition process. By employing the basic technique principles, a company can come up with several standards that have to be met before the purchasing on any capital. If such standards happen to be in a way that reflects the current company conditions accurately, then there are better chances that the right investments types may be put into consideration. Other significant factors that can be considered as being part of capital rationing productive approach include the company’s financial condition, both the short term and long term business goals, and daily operations proper attention. The main benefit of this strategy is that the method assists in ensuring that funds set aside for basic operations don’t get diverted so as to take advantage of the “cant fail” opportunities that help in maintaining business stability (Mukherjee, 2000, p. 10). One period capital rationing applies in cases where limits are applied on the finance availability for NPV projects that are positive for only a period of one year and the capital remains freely available in the other periods that follow. There are a number of assumptions applicable in single period rationing that have to be taken into consideration and they include; 1. When a firm fails to undertake a given project at the current period which is the capital scarcity period, the opportunity will be lost. This means that the project cannot be delayed until when the capital will be available. 2. The results of every project remains known with certainty in that the choice between different projects is unaffected by risks considerations. 3. The projects also remain divisible implying that half of the projects can be undertaken at one time half on the next project. The main approach in this case is ranking the projects in a manner that the NPV is able to be maximized with the use of the finances availability. Having the projects ranked on the basis of NPV, it is considered incorrect in this case now that NPV basis will result to the choosing of the big projects, every one of them with a high individual NPV and but which have NPV that are lower than many small projects together that have lower NPVs (Shim & Siegel 2010, p. 81). This implies that the ranking has to be made on the basis of Probability Index. The PI method has some issues associated with it. This approach remains only feasible if the selected projects are divisible. In case the projects happen to be indivisible, which is the normal case, a decision can be reached at through considering all the possible positive projects combinations absolute NPV within the limited capita constraints. This approach is less applicable when the selected approach has varying cash flow pattern (Kimmel & Donald, 2011, p. 36). This PI approach ignores the individual project absolute size. Considered as a mechanism used in controlling agency costs, it has its aims at limiting low-return projects from over-investment that take place in cases where the managers have the incentives used in controlling private information and more assets with regards to theses assets. A good real life situation is on capital allocation where a good number of firms have been observed to have their rational capital allocated either by having their rates higher than the capital costs or through having the investment budgets remain fixed. Capital rationing has been associated with several advantages including offering incentives that agents can base on in predicting higher returns for their own projects hence gaining a countervailing stand against the tendency of managers to understate the returns that are being expected thus setting simpler performance targets (Needles, 2011, p. 62). In addition, the level of mechanisms control caps the divergence between the predictions made by the managers and the reality on the ground, the pressure to come up with predictions on higher returns offering an incentive to find new opportunities for the business that have higher expected returns (Needles, 2011, p. 90). As completion often increases with the manager’s incentives, this can be considered as not being unambiguously beneficial. Some of the manager’s actions end up increasing the probability of having funds detrimental to the firm like dishonesty and sabotage. This makes competition most likely to increase such actions at the same time increase the principle benefits. In particular, the extent in which competition impacts misrepresentations witnessed in budget proposals depend on how managers’ utility for honesty offers a counterbalance against the misrepresentation of incentive. Considering the different criteria faced by mangers as mentioned above, the main decision is to undertake all investment projects that are independent and meet the standards that have been accepted. This position does not have any restrictions on the sum of capital projects that are acceptable by a company undertaken in any given period. The real situation on the ground is that most firms don’t have unlimited funds for them to invest. In this case, rather than having the capital budget size be determined by the profitable investment opportunities number, most companies settle for an upper limit while others for constraints with the regards to the amount of funds set aside for capital investments. Bibliography Antle, R and Epppen, G., 2000. Capital rational and organizational sack in capital budgets. Management Science 31 (2): 163-174 Evans, J & Moser, D., 2001. Honestly in the managerial reporting, The Accounting Review 76: 537-559 Fehr, E and Falk, A., 2000. Wage rigidity in a competitive incomplete contract market, Journal of Political Economy 107 (1): 106-134 Gneezy, U. 2005. Deception: the roles of consequences, American Economic Reviews 95: 384-94 Kimmel, P and Donald, K. (2011). Financial Accounting: Tools for Business Decision Making, John Wiley: New Jersey Malone, T., 2004. Bringing the market inside, Harvard Business Review 82 (4): 106-155 Mukherjee, T., 2000. Capital-rationing decisions if Fortune 500 firms: a survey. Financial Practice and Education: 7-15 Needles, B. (2011), Principles of Accounting, Cengage Learning: Ohio Shim, J and Siegel, G. (2010). Dictionary of Accounting Terms, Barron: New York Williamson, O., 2000. The Economic Institution of Capitalism: Firms, Markets, Relational Contracting, Free Press: New York Read More