The General Principles of Financial Management - Essay Example

?Question People invest money in something to earn capital gain out of it. Capital gain can be in terms of profits, dividends, increase in share value, increase in the value of the firm and this goes on as you move on from monetary gains to non-monetary gains like goodwill etc. Therefore people have a major misconception that firms only aim is to maximize its profit. Managers and employees are not only concerned about the increasing the profit margins on products but are also concerned about increase the overall worth of an organization. This doesn’t mean that profit maximization is the least most concern. Profit maximization is the main aim for which the whole organization put in efforts too but it not the only goal of the firm as discussed above. The change in the value of firm can be measured by the change in Earnings/Share which shows the per share return to investors. (Gitman, 2006) Managers and their co-workers can not only depend on the main aim of an organization which is to maximize its profits. It is because of the timing of the cash received is important as the t soon as it is received is better because of the concept of time value of money. Owners receive cash in form of dividend and hence higher EPS doesn’t necessarily mean that there will be an increase in dividends as managers may increase their own bonuses instead. Maximizing profit might result in more risky investments made and hence increasing the beta of the firm so profit maximization is not the only main goal of firm. (Gitman, 2006) Question#2: Total risk of any firm can be bifurcated into two categories: a) Diversifiable risk b) Non-diversifiable risk The diversifiable risk is one that can be diversified by taking some crude actions and making sure that firm doesn’t loose anything as a whole. This is a kind of risk that is just specific to a firm such as fire at a warehouse. This type of risk can be diversified if special precautionary measures are taken and hence it is in control of the firm to reduce such kind of risk. The chances of fire at workplace can be reduced by placing special notifications at flammable spots in the factory and other working areas. Therefore, this kind of risk is usually referred to as firm-specific-risk or nonsystematic risk. The non-diversifiable risk is the one that is out of firms own control and affects all firms in the industry with the same effect on each of them. This kind of risk is non avoidable and hence no contingency planning can help any firm in this case. The example of this kind of risk is when government increases the tax rate of the firms, they all have to bear it and none can take any step to avoid such an alteration in law. Therefore these kinds of risks are known as market risk or unsystematic risk as well. Therefore it is said that if you can’t do anything about something you just bear with it and hence nonsystematic risk is usually considered to be irrelevant while making long-term decisions. (Niehaus, 1999) Question#3: Weighted marginal cost of capital is the cost of borrowing/financing next extra dollar. The graph that portrays the cost of capital of a firm can be used to identify WMCC. The graph shows the discount rate that is applicable at each point or dollar of financing that is required. Marginal cost of capital is the rate that the firm will pay in return to its financings achieved through a particular source. WMCC is weighted average cost of all the financings done by the firm through several sources like debt, preferred stock, common stock, debentures, loans etc. each financing activity has different cost attached to it like common stock bear high cost then debentures or bonds because the holders of common stock have the right to vote for the selection of board of directors and also bear a risk of not attaining anything in terms of dividends if the business make loss in any year. Bonds on the other hand have a fixed rate of interest that is to be paid to the bond holders at the end of every year regardless of the fact that business made any profit or not. Therefore as long as the internal rate of return of any firm is higher then its marginal rate of return the projects are accepted. (Shim & Siegel, 1991) The calculation of WMCC is based on assumptions which are usually not that static in reality like inflation rate, interest rate, exchange rate etc and hence it is not always right to believe that WMCC always give the precise value of marginal cost of capital. It is just gives you an estimate. (Shim & Siegel, 1991) Question#4: Source: (Van & Wachowicz, 2005) Firms operating cycle is the time difference since we receive the cash of our sales and the time we promised to pay our creditors (time of purchase). It is like the whole supply chain comes in as we purchase raw material and then process it and then sell the resulted product in the market. The time lapse between all these activities is called the firms operating cycle. Firms operating cycle is equivalent to inventory turnover in days plus the receivable turnover in days. The importance of operating cycle comes when firm is deciding upon its procurement of current assets and are forecasting them for future activities. Until the cash comes back in firm can’t just make purchases of current assets. The shorter the operating cycle the lesser the requirement of current assets. (Van & Wachowicz, 2005) The cash cycle is the time when the actual payments and receipts are made. Operating cycle deals in transfer of goods and is just promises of cash payments whereas cash cycle is actual cash transfers. Cash cycle as portrayed in the diagram is equivalent to operating cycle operating cycle less payment turnover in days. Cash cycle is crucial as the main thing that firm is concerned about is not the product they sell but the cash they receive in turn of that sale as it can be used for further advancements in the business. Owners are more concerned about the cash cycle as they want their sales to turn into cash as quickly as possible because early receipts are better then late ones. (Van & Wachowicz, 2005) References Gitman, L. J. (2006). Principles Of Managerial Finance. Pearson Education. Niehaus, H. (1999). Risk Management & Insurance. McGraw-Hill. Shim, J. K., & Siegel, J. G. (1991). Financial Management. Barron's Educational Seriies. Van, J. C., & Wachowicz, J. M. (2005). Fundamentals of financial management . Pearson Education. Read More