Corporate Financial Management - Assignment Example

Financial management entails planning for the future of a person or a business enterprise to ensure a positive cash flow. It includes the administration and maintenance of financial assets. Besides, financial management covers the process of identifying and managing risks”. An organization is any entity that is given the admission by the by the state or the government of that country to perform the business activities that can bring profit to the fir and its shareholders (those activities must be within the legal framework of the government). An organization is given many rights as an entity separate from the owners of that company; this also defines the term limited liability company which means that the owners of the company bear limited liability with context to the business enterprise itself. In a limited liability, the owners of a company do not carry the burden of the liability which the company has taken; this in return makes them prone to limited liability only. Every organization has shareholders who are the main owners of that organization, but the director or the management who run the company, are separated from the ownership. This is return causes the main issue of conflict of interest and there are various methods to eliminate or reduce such conflicts of interests. The main interest of the shareholders is to receive proper return for their investment at the discretion of any possible costs and the directors want higher salaries at the discretion of the profits or the returns made by that company, hence to avoid such issues, auditors are appointed to witness the proper running of the company. The auditors audit the financial statements of the company and give their opinion about the organization’s activities. The main financial statements in any organization are; Income Statement/ Statement of Comprehensive Income Balance Sheet Cash Flow Statement Statement of Changes in Equity “A perfect market is one in which there are no arbitrage opportunities”, meaning markets in which no trader has the power to change the price of goods or services. It is difficult to have perfect markets, although monopolies are the closest example of perfect markets but the government interference does not make the perfect. The main imperfections in any market are taxes, taxes not only influence large financial decisions but it also does effect smaller household transactions as well. The main sources available to fund organizations are: -Equity financing; that is to issue shares to the general public; or - Debt financing; that is to get loans and debentures from banks or other financial institutions. Homemade leverage on the other hand Idea “that as long as individuals borrow (or lend) on the same terms as the firm, they can duplicate the affects of corporate leverage on their own. Thus, if levered firms are priced too high, rational investors will simply borrow on personal accounts to buy shares in unlevered firms”. Both the debt and the equity financing have their own positives and negative aspects, debt financing is cheaper and less risky but there is a compulsion to pay it off, equity finance on the other hand is expensive. Hence every organization decides upon the financing based on their risk appetite and the environment in which they operate. Weighted Average of Cost of Capital is the average cost of the company’s finance, weighted according to the relative size of each element compared with total capital. WACC is calculated as follows: WACC = 100% debt finance is not the optimal level; one view is that there is an optimal capital mix at which the average cost of capital, weighting according to the different forms of capital employed, is minimized. As gearing increases, the return expected by ordinary shareholders begin to rise in order to compensate them for the risk resulting from a larger share of profits going to the providers of debt. If a firm follows the pecking order theory its gearing ratio results from a set of incremental decisions without any aim of getting to a target and there may contrasting times such as good or bad depending upon the level of information available in the market. The pecking order theory on the other hand explains the reason of companies not behaving as per the static trade off theory. This theory states that companies have a preferred hierarchy when it comes to financing decisions: 1- Internally Generated Funds 2- Debt 3- New issue of equity This pecking order theory was developed to show the inconsistency between the trade off theory and the practical solution preferred by companies. Usually, companies tend to look at the issue costs, the issue costs for internally generated funds (such as Retained earnings) are lower, hence the company prefers it above all other modes of financing. Debt, on the other hand has some increased issue cost compared to internally generated funds and equity financing carries the highest level of issue costs amongst the three choices. The most successful companies are usually those which have a low level of gearing and this is a negative image of the static trade off theory. Besides this many companies rarely do take up equity financing clearly showing that financing methods are not driven by any considerations to optimal capital structure. Dividend puzzle is a concept that whenever a company pays out dividend to its shareholders, those shareholders are going to value the investments high. This view has been put down by many economists stating that investors who get dividends are the original owners of the company and they are apathetic about such issue. For any company, the amount of retained earnings has a direct effect on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as dividend. A company must restrict its self financing through retained profits because shareholders should be paid a reasonable amount as dividends that should align with their expectation, this would help keep shareholders happy and keep a good impression in the market, this may in return increase the value of the shares of that company in the market. REFERENCES Berk and DeMarzo, chapter 16.  Berk and DeMarzo, chapter 17.  La Porta, R., Lopez-de-Silanes, F., Shleifer, A., and Vishny, R.W. (2000), Agency Problems and Dividend Policies around the World, Journal of Finance, 1-33.  Financial Management, Economy Watch, Economy, Investment & Finance Reports. http://www.economywatch.com/finance/financial-management.html Frank, Murray Z., and Vidhan K. Goyal, 2003, Testing the pecking order theory of capital structure, Journal of Financial Economics 67. Market Imperfections, Ramon P. DeGennaro, Working Paper 2005-12, July 2005 http://www.frbatlanta.org/filelegacydocs/wp0512.pdf Myers, S.c. (2001), Capital Structure@, Journal of Economic Perspectives, 81-102  Myers, S.C. (1977), "Determinants of Corporate Borrowing", Journal of Financial Economics, 147-75.  Myers, S.C. (1984), "The Capital Structure Puzzle", Journal of Finance, 575-92.Miller, M.H. (1977), "Debt and Taxes", Journal of Finance, 261-75.  Perfect capital market, bizterms.net http://www.bizterms.net/term/Perfect-capital-market.html The New York times on the Web, Homemade leverage http://www.nytimes.com/library/financial/glossary/bfglosh.htm Read More