Creativity in Business Finance - Essay Example

Creativity in Business Finance Introduction “Creativity” has been defined as “the tendency to generate or recognize ideas, alternatives, or possibilities that may be useful in solving problems, communication with others, and entertaining ourselves and others.” (Franken, 2001, p. 396) Something that is creative is understood not only to be novel or interesting, but should also possess value in a manner that has not been previously extant, or at least has not been commonly recognized. (Weisberg, 1993, p. 4) This essay aims to explore the ways and means by which creativity is used in the field of business finance. Creativity is applicable in all endeavors, even in the pragmatic world of business. The field of business finance addresses the sourcing, allocation, and investment of a firm’s funds in a way that is most advantageous to the firm. A firm is said to gain advantage if, in the allocation of its financial resources, it maximizes its income while minimizing expenses, and thus generates the optimum amount of profit at an acceptable level of risk. Creativity is employed in business finance when the financial or fund manager skilfully balances the elements affecting risk and return in order to attain the firm’s financial objective. Financial creativity in business operations In the operation of a business, financial creativity is used to adjust a firm’s liquidity position. When a firm is awash in cash and other liquid assets, it is a good sign that the business would be capable of meeting its near-term obligations. However, too much liquidity could mean that the firm is not maximizing its earning potential and, thus, is missing out on opportunities to realize revenue. On the other hand, if the firm commits its funds so as to deplete its liquidity, it runs the risk of not being able to comply with its short-term requirements, incurring penalties and other unnecessary costs in the process. For instance, the firm may decide to lease a piece of machinery – which merely commits to a short-term obligation – instead of buying it outright, in order to avoid committing its funds long-term in a large capital outlay, although in the long run this may come up to be more costly than the outright purchase. The financial manager should be creative enough to strike a balance between cost savings and maintaining a liquid position. Creativity in business finance is also used to determine the appropriate degree of financial leverage a firm could utilize to its advantage. Leverage refers to the mix of debt and equity in the firm’s capital structure. Capital debt can enhance a firm’s earning capacity because it is associated with a lower cost. Many start-up entrepreneurs had relied on borrowed funds to enhance their initial capacity to generate business volume. However, too much debt creates a constraint upon the business in the form of periodic interest payments, as well as the obligation to repay the principal on the day the debt matures. Finding the right level of debt to enhance the business earnings sufficiently to cover debt constraints is a matter of creative application. Creativity is also resorted to in prioritizing projects and choosing among alternative undertakings that promise to yield returns in the long-term. For example, a company may consider between creating generic products that yield quick returns but low profit margins, or cutting-edge products with a high R&D component that may begin earning for the company only after years of development, and yet successfully command such high profit margins because of their high marketability. This is the case with the pharmaceutical wonder, Viagra (Sildenafil Citrate), as well as Gardasil (Quadrivalent Human Papillomavirus Recombinant Vaccine), a new vaccine against cervical cancer. (RxList, 2009) Years of research and development went into these products, but their value was highly prized by an eager and expectant market. Finally, one activity where creativity is maximized is in the valuation of assets and whole companies, especially for the purpose of merger or acquisition. A merger/acquisition (M/A) is necessarily a sale or exchange, meaning that the company or asset being purchased or exchanged must be properly valued to determine the fair price. There are many different methods of valuation that may be undertaken for the purpose of M/A. These include assessing the target or merging companies’ book value, economic value, replacement value, and break-up value. (Gitman, 2008) The book value is the accounting value, that is, the net amount of the company’s total assets less total liabilities; the per-share value is arrived at by dividing this net amount by the number of common shares. As conveyed by its definition, the book value of a company is a straightforward valuation method based on historical transaction costs. (Downes & Goodman, 1995) However, seldom is the book value made the basis of an M/A transaction, because it seldom captures the true value of the firm as a going concern. (Buffet, 2008) The M/A is successfully undertaken only if the resultant post-M/A firm attains a true value greater than sum of the two separate firms (Brigham and House, 2004). Creativity in Financial Engineering Capital and money markets have developed to such a degree as to require a sophisticated level of creativity. Thus emerged the field of financial engineering which involves three types of activities: securities innovation, innovative financial processes, and creative solutions to corporate finance problems. Securities innovation is the design and creation of financial contracts that match varying levels of risks with expected returns. For the most part, it deals with packaging consumer-type financing applications, because consumer finance caters to a broad continuum of needs and preferences. These include “new types of bank accounts, new forms of mutual funds, new types of life insurance products, and new forms of residential mortgages”. (Finnerty, 1988, 15) This is the type of financial innovation that deals directly with the customer and tries to match their needs with creatively designed products. For instance, some types of bank accounts could allow the customer to retrieve his money (such as a payroll account) anytime, because the customer’s need for the account is merely as a conduit or channel to pass money through. On the other hand, there are some bank accounts that will guarantee the depositor a higher rate of interest income, on the condition that their money has a minimum lock-up period in the account during which time they could not withdraw it. These are designed for clients who wish to invest their money and watch it grow with a higher yield. There are some customers who are finance-savvy and who don’t mind assuming greater risk in exchange for a higher return. For them, relatively high-risk stock investments and equity-based securities are ideal rather than the low-risk, low-return bank deposits. Then there are customers who are so risk averse they don’t mind a low return as long as their money is safe – for them, high grade investment bonds provide the needed security. Finally, for the customers who desire a combination of both safety and moderately high returns but do not have the expertise, there are the professionally managed mutual funds which they can invest in. The second branch of financial engineering concerns the design of new processes that reduce the cost of conducting financial transactions. These kinds of innovations are brought about by a combination of legislative and regulatory changes, as well as technological advancements and developments. For instance, if there were a law that required stock brokerages to increase their minimum capital requirements or pay a higher rate of tax, compliance with this would increase the cost of transactions in stocks which, in turn, would force the brokerage to increase the commissions they charge their customers. On the other hand, technological developments such as electronic security trading would greatly speed up transactions and improve their reliability. This has the effect of reducing processing cost for every transaction, and may possibly lower commissions that are charged to clients. The third branch of financial engineering covers corporate financing problems that include innovative strategies in cash management, debt management, and different forms of asset-based financing. These are the types of financial instruments that are designed to meet the needs of large corporate clients that, like the individual investor, desire to balance risk and return. It is in this area where the most daring and advanced type of creativity is undertaken in the field of finance. Highly innovative financial experts have come up with forms of financial derivatives such as the put and call options, the forward contracts, futures, mortgage-backed securities, credit default swaps, collateralized debt securities, accounts receivable securities, and so forth. These are called financial derivatives, because they derive their value from an underlying asset. A stock option, for instance, is the right to buy or sell shares of stock in the future at a certain price (known as the strike price), through payment of an amount (known as the option price) to secure that right. This is a hedging technique that protects the buyer of the option from unexpected price changes in the future, and the value of the option price depends upon the value of the underlying asset, which in this case is the stock. (Reilly & Brown, 2006) Credit derivatives have opened a wide door of opportunities for financial institutions because, according to Blythe Masters of J.P. Morgan, “In bypassing barriers between different classes, maturities, rating categories, debt seniority levels and so on, credit derivatives are creating enormous opportunities to exploit and profit from associated discontinuities in the pricing of credit risk”. (J.P. Morgan, 2008) Creativity employed for the wrong reasons Since the Enron scandal, the concept of “creative accounting” has become the focus of regulators because of the particular mischief they could cause an unwary public. Creative accounting conflicts with the basic aim of public accountability, which is “to provide consistent and comparable financial information to users.” (Shah, 1998) Unfortunately, greedy business interests prompt the creative manipulation of accounts to provide a misleading picture of a firm’s value for the purpose of pecuniary gain. Furthermore, some financial securities are sometimes misrepresented such that their defects are not seen until a crisis develops. This is what has happened in the present crisis, which is rooted in the mismanagement of mortgage-backed securities and collateralized debt obligations. (Philips, 2008) Financial instruments represent intangible rights that are difficult to evaluate. Physically, one financial security looks the same as any other, because they are all contained in pieces of paper that could not be distinguished from one another. Although the government seeks to regulate financial institutions in order to protect the ordinary investor, the banks and financial institutions have been able to devise contracts that circumvent these regulations. For instance, the credit default swaps (CDS) were intentionally designed to bypass the government’s regulation for the bank or lending institution to maintain a minimum reserve of capital to service the loans they issue. These banks, however, were more interested in lending out more money instead of keeping them as reserves, in order to generate more interest income. They thus came up with the CDS to pass the risk of the loans on to another company who acts as insurer. They were thus free to lend out more money which should have been held in reserve. (Brown, 2008) Conclusion This writer did not begin as a finance major from the start, but rather with mathematics as field of specialization. The innate love of math has led to the realization that mathematics can be used as an invaluable tool in the field of finance, coupled with the hope for a better future. In this essay, both good and bad creative elements were examined, and it is apparent that too many lives are destroyed by financial creativity ill employed. As a potential financial analyst or manager, this writer aspires to promote fairness, truth and ethics in the financial management of a business, or in dealings in the financial markets. It is my hope that not only will I be an instrument of analyzing financial fair valuation, but of instilling fairness and moral value into the world of business finance. Wordcount = 2,000 (excluding title) References Brigham, E F & House, J F 2004 Fundamentals of Financial Management, Tenth Edition. Thomson South-Western, Cincinnati, Ohio Brown, E 2008 “Credit Default Swaps: Evolving Financial Meltdown and Derivative Disaster Du Jour,” Global Research. http://www.globalresearch.ca/index.php?context=va&aid=8634 (accessed 30 August 2009) Buffet, M & Clark, D 2008 Warren Buffet and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage. Scribner, New York Finnerty, J D 1988. Financial Engineering in Corporate Finance: An Overview. The Journal of the Financial Management Association, Winter, Vol. 17 Issue 4, p14-33 Franken, R E 2001 Human Motivation, 5th ed. Wadsworth Publishing Gitman, L J 2008 Principles of Managerial Finance. Harper & Row, New York J. P Morgan New York. The J. P. Morgan Guide to Credit Derivatives. 2008. http://www.investinginbonds.com/assets/files/Intro_to_Credit_Derivatives.pdf. (accessed 31 August 2009) Philips, M 2008 “The Monster That Ate Wall Street,” Newsweek 6 Oct 2008. http://www.newsweek.com/id/161199 (accessed 31 August 2009) Reilly, F K & Brown, K C 2006 Investment Analysis and Portfolio Management, 8th ed. Thomson-Southwestern RxList 2009 “Gardasil (Quadrivalent Human Papillomavirus Recombinant Vaccine)” The Internet Drug Index, http://www.rxlist.com/viagra-drug.htm (accessed 31 August 2009) RxList 2009 “Viagra (Sildenafil Citrate)” The Internet Drug Index, http://www.rxlist.com/viagra-drug.htm (accessed 31 August 2009) Shah, A K 1998 “Exploring the influences and constraints on creative accounting in the United Kingdom” The European Accounting Review, vol 7 issue 1 pp. 83-104. Taylor, S L 2003. Our Creative Soul. Essence, April, Vol. 33 Issue 12, p9 Weisberg, R W 1993 Creativity: Beyond the Myth of Genius. W.H. Freeman & Company Read More