Key Financial Management Concepts - Coursework Example

Running Head:   Financial Management Concepts Introduction Financial management entails matching our expenditure with income, procuring a loan in the event of a shortage in funds and investing our savings for the sake of a better future. This management is also vital for organizations since money is necessary in hiring of people as well as purchasing equipment and materials without which it cannot realize profits. There are four key concepts in financial management and they include the nature and goal of financial decisions, the time value of money, the concept of risk and return, and the evaluation of a firm. This paper explores each of these concepts in detail and shows their importance in the daily operations of an organization. Nature and Goal of Financial Decisions Financial management thus entails managing the finance for the day-to-day running of a particular firm. It includes the obtaining of money for the organization, use of the money in the company’s assets and their efficient management and generation of surplus money as well as its distribution. Owing to the various hindrances in conducting these activities, financial decisions are necessary to meet adequately the goals of the organizations (Keown, et al., 2007). Bannerjee states that financial decisions take a three-tiered design that comprises investment decisions, financing decisions and dividend decisions. Investment decisions entail the identification of assets in which the company can invest its resources. These assets could take the form of land and buildings or computers, which are tangible assets or long-lived assets. In order to achieve the effective running of these assets as well as the goal of the firm, investment should occur in short term or current assets like an inventory as well as cash balance. For long-lived assets, the decision-making involved is a capital budgeting or capital expenditure decision. For current assets, the decision-making is working capital management. The risk element for capital expenditure decisions is high since they involve a longer time and a larger amount of money. Risk in this case refers to the probability of the actual outcome being different from the targeted outcome. Financing decisions entail finding out how to finance the investments, the source of finance as well as the possible outcomes of choosing such sources. Choices could include the use of financial markets to raise capital through the giving of securities to investors. Dividend decisions involve determining how to distribute company profits. This entails deciding how much to pay to the shareholders and how much to keep for future projects. These three decisions albeit different, are interrelated and serve to complement one another (Bannerjee, 2008). Time Value of Money Kennon writes that one of the basic principles of finance is that one dollar currently is more valuable than one dollar in the future. One reason is the fact that one dollar will not be able to buy many goods in the future owing to inflation. Secondly, one can invest the dollar at hand and gain returns through dividends, interest or capital gains. According to him, the best financial advice is to have a thorough understanding of the principle of time value of money. To prosper financially, it is important to realize the great value of every single dollar one acquires. The dollar is like a seed sown through investing or eaten through spending. A twenty-dollar bill for instance, can buy a meal or put into a tax-free retirement account. Failure to invest this money may have serious implications in terms of a loss in returns as exemplified in the time value formula below. FV = pmt (1+i)n Where: FV = Future Value Pmt = Payment I = Rate of return you expect to earn N = Number of years If one is thirty years old and due for retirement at sixty-five years old, it means that the twenty dollar can compound for a period of thirty-five years. In the formula, the thirty-five years represent ‘n’ and the ‘i’ represents the rate of return. The ‘pmt’ stands for the amount for investment. The formula will thus be FV = $20 (1+.10)35. The total of this adds up to 562$. Time value of money is vital to the management of a firm’s finances. Cash inflows and cash outflows resulting from investments and financial engagements occur at different times and timing these flows is very important (Banerjee, 2008). According to Brigham and Houston, time value analysis is also known as discounted cash flow analysis. Time value is necessary for financial managers since it has a great impact on stock prices. This analysis helps to determine when to set up schedules as well as when to purchase new equipment. This process occurs by use of a timeline that assists analysts to visualize the intricacies surrounding a particular problem and hence provide the necessary solutions. To solve time value problems, one should first try to understand them graphically to be able to represent them on a time line. Unlike the future value of cash that involves compounding, the present value refers to today’s value of a future cash flow or a set of cash flows. The theory of risk vs. return posits that if an investment is riskier, the more likely it will yield higher returns. Similarly, the safer an investment is, the more likely it will yield lower returns. This theory manifests the truth it states through government-insured deposits, treasury bills and bonds. These provide lower rates of return compared to corporate bonds and equities. Despite this evidence, people opt for lower risk investments all the same. Lower risk investments are necessary when an investor does not have much time to invest. The investor may have acquired large profits in the course of time and subjecting them to another risk is no longer a viable idea. Additionally, the investor has the opportunity to undergo a full economic cycle. Another advantage is that lower risk investments enable investors to buy at the right price. Although returns yield 1%, an investor may benefit from buying an asset at a cheaper rate than the present market prices. Through the principle of diversification, low risk investments may form part of an investor’s portfolio. Despite the relatively low yields, these assets are important inn investing (Blanchet, 2010). Concept of return and risk Choosing investments solely based on return is not sufficient. Other factors play a key role hence the need for investors top out their money in different securities. It is therefore vital to understand risk and return as well as how to measure them. Return is the gain one obtains from an investment. The return could be in terms of a realized return or even an expected return. The latter refers to a return that an investor hopes to attain in the future after a period of investment. The expected return is a return based on a prediction that may or may not arrive. The realized returns on the other hand enable an investor to approximate the cash flows such as dividends, interest, bonuses and capital gains (Gannon 2010). To measure a return, an investor considers the total gain or loss in a given duration through the evaluation of the percentage return on the amount invested. Return from an investment in equity shares occurs in the form of dividends and capital gain or loss when selling these shares. In investment, risk implies the fact that future returns from investments are not certain. Risk hence denotes the possibility that the current return may differ from the expected return. Risk is therefore a possibility in variation in return. Risky investments are thus those with more chances of variation. For example, equity shares are generally riskier than corporate bonds. This is because when corporate bonds mature, there is a fixed annual interest inflow and maturity repayment. Equity investments on the other hand do not have a fixed dividend inflow or a fixed terminal price. There is a difference between risk and uncertainty: Risk is a measurable situation whereas uncertainty is a non- quantifiable situation. There are two types of risks namely systematic risks and unsystematic risks (Fiscalmusings.com, 2010). Systematic risk is a variation in return because of factors that affect all organization. The variability in return is because of various market factors such as money supply, inflation, credit policy as well as economic recessions. These factors cause a uniform change in prices for all securities. This kind of risk is unavoidable even when diversification occurs hence is also called a non-diversifiable risk. Such a risk for example is market risk. This occurs due to fluctuations in market prices of various investments such as equity shares. The variation in market prices leads to a change in investment return. Market risk occurs due to various social, economic and political events. Market psychology also varies market price of equity shares through both the bull phases and bear phases. In the former, market prices increase while in the latter, market prices fall (Scribd.com, 2010). Interest rate risk refers to a change in return owing to a variation in interest rates. This risk occurs after a change in the market price of fixed income securities such as bonds and debentures. If the interest rate rises, market prices of various securities drop. Purchasing power or Inflation Risk refers to the likelihood of a decline in purchasing power of cash flows from an investment. This is due to the impact of inflation or deflation upon the investment. There is a relationship between the inflation risk and interest rate risk since an increase in inflation causes the interest rates to increase (Clarke, 2003). Investment entails an adjournment in present consumption. When investing, one declines the occasion to purchase some goods or services for the duration of the investment period. If, at this time, the prices of goods and services rise, the investor suffers a loss with regard to purchasing power. The inflation risk is thus due to uncertainty of purchasing power of future returns. The other type of risk is unsystematic risk. This refers to a variation in investment returns owing to factors affecting a certain firm and not the market in general. Owing to their uniqueness, the factors are also called firm- specific factors. For instance, changes in the price of crude oil have a direct bearing on profits in the petroleum companies and not other manufacturing companies such as textiles. This risk is also referred to as diversifiable risk. Business risk is a type of unsystematic risk (Scribd.com, 2010). It refers to the fluctuation in incomes of organizations because of operating conditions that the firms work in. Financial risk refers to the level of debt financing an organization uses in the capital structure. The greater the level of debt finance, the higher the level of financial risk. Moreover, various statistical measures help to identify the measure of risk regarding expected returns. The total risk of an investment therefore comprises unsystematic and systematic risk. To calculate the total risk, one should add up the diversifiable risk (unsystematic risk) with non-diversifiable risk (systematic risk) (Higgins, 2000). Valuation of the Firm Damodaran states that valuation of a firm occurs through discounting the free cash flow to the given firm at the weighted standard cost of capital. Entrenched in this assessment are the tax benefits of debt and expected additional risk related to debt. Just like in the dividend discount model and the FCFE model, the type of the model used will depend upon projections regarding future growth. There are two conditions necessary when using this model. Foremost, the growth rate employed in the model ought to be less than or equal to the growth rate in the economy –nominal growth if the cost of capital is in nominal terms, or real growth if the cost of capital is a real cost of capital. Next, the characteristics of the firm ought to be constant with conjectures of stable growth. In particular, the reinvestment rate used to approximate free cash flows to the firm ought to be in tandem with the stable growth rate. The best way of ensuring this constancy is to derive the reinvestment rate from the stable growth rate. Damodaran also states that there is a difference between equity valuation and firm valuation. The former values only the equity stake in the business whereas the latter values the whole firm, which comprises other claimholders within the firm. One of the principles of valuation is to never mix and match cash flows and discount rates. This is because discounting cash flows to equity at the weighted average cost of capital will result in a higher biased estimate of equity whereas discounting cash flows to the firm at the cost of equity will result in a toned down biased estimate of the value of the firm. When an organization’s cash flows grow at a stable rate perpetually, the present value of those cash flows finds expression in the following formulae: Value=Expected Cash Flow Next Period/r-g Where r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate This consistent growth rate is referred to as a stable growth rate and cannot be higher than the growth rate of the economy in which the organization runs. Although companies can maintain a high growth rate for a long period, they all get to a point of stable growth eventually. After attaining the stable growth, the valuation formula helps to determine the terminal value of future cash flows. Mistakes in estimating the discount rate or mismatching cash flows and discount rates may result in grave errors in valuation. The discount rate employed should match with both the riskiness and the kind of cash flow one is discounting. In relative valuation, the value of an asset is got from the pricing of comparable assets that have undergone standardization through using a common variable such as earnings, cash flows, revenues or book value. Bayrak states that one of the steps in valuation entails an analysis in terms of historical performance. The next step is through forecasting performance by evaluating the company’s strategic position, its competitive advantages and disadvantages within the industry. This helps to foster an understanding of the company’s potential in growth as well as its ability to earn returns. The third step in valuation entails the estimation of the cost of capital and developing target market value weights. The final steps involve the calculation and interpretation of results as well as their interpretation in the decision context. Conclusion The four key concepts in financial management are necessary for the realization of profits for any investment made. These concepts also help to govern the financial spheres and operations of any given firm since they form the foundations of financial management. The nature of financial decisions serves to determine the course of a particular investment ranging from sources of funds to the distribution of company profits through dividends. The time value of money instills an investment discipline as opposed to consumption since a dollar invested has the ability to gain multiply itself through the principle of compounding or the purchase of stocks and bonds. The concept of risk and return highlights the reality that the expected outcome of investment could be different from the actual outcome owing to the interplay of extraneous factors. Valuation of a firm is also vital since this appraisal helps to determine the profitability of a given firm over the course of time. References Banerjee, B. (2008): Fundamentals of Financial Management New Delhi: PHI Learning Private Limited. Bayrak, O. (2010): Valuation Of Firms In Mergers And Acquisitions. Retrieved July 31, 2010, from fic.wharton.upenn.edu/fic/cmbt/Okan%20Bayrak.ppt Blanchet, C. (2010): Exploring the Concept of Risk and Return and Why Low Risk Investments Must Exist. Retrieved July 30, 2010, from http://ezinearticles.com/?Exploring-the-Concept-of-Risk-and-Return-and-Why-Low-Risk-Investments-Must-Exist&id=4452761 Brigham, E. & Houston, J. (2003): Fundamentals of Financial Management. Boston, MA: South-Western College Pub. Clarke, J. (2003): Modeling Interest Rate Risk. Retrieved July 31, 2010, from http://findarticles.com/p/articles/mi_m0ITW/is_3_86/ai_n14897409/ Damodaran, A. (2010): Firm Valuation: Cost Of Capital And Apv Approaches. Retrieved July 30, 2010, from www.stern.nyu.edu/~adamodar/pdfiles/ovhds/ch12.pdf Fiscalmisings.com, (2007): Concept of Risk vs. Return. Retrieved July 30, 2010, from http://www.fiscalmusings.com/2007/12/concept-of-risk-vs-return.html Gannon, J. (2010): Risk vs. Return: A Fundamental Tradeoff. Retrieved July 31, 2010, from http://www.militarymoney.com/investing/1194377284 Higgins, R. (2000): Analysis for Financial Management. New York: McGraw-Hill. Kennon, J. (2010): A Lesson in the Time Value of Money. Retrieved July 29, 2010, from http://beginnersinvest.about.com/cs/personalfinance1/a/101303a.htm Keown, et al. (2007): Foundations of Finance: The Logic and Practice of Financial Management. New Jersey: Pearson Higher Education. Scribd.com, (2010): Concept of Return and Risk. Retrieved July 30, 2010, from http://www.scribd.com/doc/25412084/Concept-of-Return-and-Risk Read More