The first step is projecting the financial statements which include income statement and balance sheet. They are used to estimate the funds needed for investment. The second step is determining the funds needed. After projections on product sales, productions costs, marketing costs and administrative costs have been made, the finance manager draws a plan for the fund requirement with the timing. The third step is forecasting fund availability. A company generates funds from its activities. The finance manager should be able to forecast funds that can be generated internally to finance the investment. The last step is determining the deficit. The difference between fund requirement and availability of funds is what will be borrowed.
Working capital is the difference between current assets and current liabilities. Working capital management is the supervision of an entity’s current assets and its current liabilities. Working capital management entails determining and maintaining the target level of each current asset category and determining how they will be financed. Working capital management is used to minimize liquidity risk in an entity by planning acquisition and the use of liquid resources to settle short term maturing obligations when they fall due. Matching method and conservative approach are the most commonly used working capital management techniques.
Some of the financial instruments used to park excess cash by firms include; treasury bills, banker’s acceptance and commercial paper. Treasury bills are short marketable securities issued and backed the government. Their maturity period is less than 1 year. Treasury bills are usually issued a discount from their par value. Commercial papers are short-term debt instruments that are issued by corporations to finance their current assets. Commercial papers are issued at a discount that is pegged on the prevailing interest rate. Banker’s acceptance is short-marketable securities issued by corporations but guaranteed commercial banks.
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There are several factors that a business should consider before raising both debt and equity from to finance its investments and operations. The first factor is cost of the borrowed funds both implicit and explicit. Implicit costs include floatation cost and any discounts offered on the par value. The explicit cost of debt is interest while the explicit cost of equity is dividends. A firm should select an option that has a lower cost to reduce its financing costs. The second factor is tax implications. When considering tax implication, debt is a better option compared to equity. This is because interest is a tax allowable expense hence it reduces tax liability. On the contrary, dividends are not allowable for tax purposes. The third factor is risk. Debt financing increases liquidity and bankruptcy risk since payment of interest and the principle is a legal obligation that must be honoured failing which the business will be declared bankrupt. Therefore, it is important to consider the repayment terms of the loan contract. On the contrary, equity does not have any effect on the liquidity and bankruptcy risks of an entity since payment of dividend is discretional. It is also important to consider liquidity situation of the firm. A firm that is liquid enough can finance its operations and investment using short term debt since it will be in a position to repay them as and when they fall due. However, firms that have low working capital should finance their investments with long term debt or equity. Lastly, firms should consider the effect of the financing option on control of the company. Equity financing gives ordinary shareholder’s voting rights. Therefore, it dilutes the control that existing shareholders have on the company.
There are several rewards that accrue from seeking funds from international investors. The first one is that the company can raise very high amounts. Normally, investors who seek offshore investments have huge financial muscle and are capable of financing mega-projects. The second reward is that the entity will benefit from the expertise of the foreign investor In case the entity seeks to expand to the country in which the foreign investor comes from. The third reward is the finance could be cheaper compared to funds from local investors. This is because most firms will seek local investors to finance their investments hence increasing completion for funds. Increased completion often translates into high financing costs as firms compete to outdo each other. However, there are risks associated with using foreign investors. The first risk is currency risk. Fluctuations in the foreign exchange rate may result into higher financing costs. The other form of risk is legal risk. Since the foreign investor and firm come from different countries with different legal regimes. There is a possibility that one party may engage in an act that is not legally allowed in the other country resulting in law suits.
Generally, bonds have a lower risk than stock because bonds have a guaranteed income. Whereas the payment of interest on corporate bonds is obligatory, payment of dividends is discretionary. Besides, the dividends paid fluctuate depending on the firm’s financial performance. Similarly, the prevailing market price of bonds is unlikely to change significantly unless there is a substantial fall in interest rates. The price of corporate bonds can accurately be predicted using the yield to maturity model. However, the price of stock cannot easily be predicted although there are various models for valuing stock. They include; earning basis valuation, dividend basis valuation and asset based valuation. This is because stock prices respond to various factors that cannot be predicted with accuracy. For example, it is difficult to predict market sentiments or lawsuit that may damage the reputation of a firm. Therefore, bonds have a lower risk compared to stock. There is an inverse relationship between risk and return. High risk often translate to high return to compensate the investor for assuming higher risks while low risk have lower return. The interest rate on bonds tends to be closer to the risk-free rate of return since the risk they assume is almost negligible. On the other hand stock holder need to receive risk-premium over and above risk-free return in order to assume additional risk. Besides, total return is the sum of the regular cash flows received on the security plus any capital gains. Corporate bonds tend to experience very minimal price fluctuations. Therefore, the capital gains on corporate bonds are very meagre. On the contrary, stock prices are very volatile. Therefore, stock holders have a chance of making significant capital gains.
It is important to diversify by obtaining a portfolio that has both stock and corporate bonds in order to balance both risk and return. Investing in an all-bond portfolio will reduce risks to very low levels. However, the portfolio will realise very low returns. On the other hand, investing in all-stock portfolio will maximize returns. However, the investor will be assuming very high risk which may be catastrophic if the risk occurs.
Banjerjee, B. (2005). Financial Policy And Management Accounting 7Th Ed. Delhi: PHI Learning Pvt. Ltd.
Petty, J., Titman, S., Keown, A. J., Martin, J. D., Martin, P., Burrow, M., et al. (2012). Financial Management, Principles and Applications (6th edition ed.). French Forest, NSW, Australia: Pearson Education.
Prasanna, C. (2011). Financial Management. New York: Tata McGraw-Hill Education.