International Evidence on Financial Derivatives Usage - Assignment Example

Finance and economics assignment of the Table of Contents W1a 3 W1b 3 W1c 4 W1d 4 W3c 5 W3d 5 W6a 6 W6b6 W6c 7 W6d 7 W7a 8 W7b 8 W7c 9 W7d 9 References 11 W1a The five essential principles of financial management are described as follows. Principle 1 Risk return trade off- Investors would be willing to take additional risk if there are higher returns. Principle 2 Time value of money- The value of money is a constantly changing phenomenon. A dollar earned today is worth more than the same earned after a year. Principle 3 Importance of cash is higher than profits- A firm may earn high profits, but it does not necessarily signify that it earns high profits. Profits cannot be reinvested into the business if it is in the form credit. Principle 4 Financing mix- A company is required to choose a finance mix which minimizes the weighted average cost of capital. Principle 5 Minimizing financial risk- If the main purpose of an organization is to take business risk, it must try to hedge off or minimize financial risk as far as possible. Business leaders are faced with numerous challenges on a day to day basis with respect to taking financial decisions. Based upon the five principles stated above, business leaders are required to effectively identify the correct finance mix for the organization. Different types of financial mix induce different types of risks upon the business. For instance a higher proportion of debt raises the risks associated with liquidity (W. D. Rohlf & W. D. Rohlf, 1996). W1b When the real rate of interest is 5% and the rate of inflation is 3%, then the nominal rate of interest is expected to be 8%. The real rate of interest is the inflation adjusted rate of interest which is calculated as: Real rate of interest= Nominal rate – inflation rate (Keown, et al., 2011). Interest rates may increase or decrease the purchasing power of money. As a result managers consider the real and nominal rate of interests as important information for taking essential decisions relating to investment. When banks publish interest rate for the money market, then they are known as the nominal interest rate. Such interest rates are not adjusted in any manner. Mangers mainly are required to focus upon the real interest rate which computed after deducting the inflation rate from the real interest rate. Inflation reduces the purchasing power of money. A bank account may pay an interest of 8%, but due to inflation, the entire 8% cannot be used for purchasing. Hence after adjusting the rate of inflation, the net interest obtained on investment is only 5% which is known as the real interest rate. The purchasing power of firms and individuals is signified only by the real interest rate obtained from banks upon the investments made (Wachter, 2006). W1c Gross profit is the profit earned by a business after subtracting only the direct production related costs from the revenue earned. These expenses are related directly to the main goods and services which a firm produces. From the gross profit, the operating expenses are deducted to obtain the operating profit. The operating expenses are mainly the expenses related to administration, selling and general functioning of an organization, which are not related to manufacturing. These expenses are however necessary to incur so as to maintain continuity in the operations of a firm. Finally, additional items such as taxes, extraordinary incomes or losses are adjusted with the operating profit in order to obtain the net income. EBIT refers to earnings before interest and taxes. EBIT is an indicator of the net earnings of a firm from which the company can pay interest on debts and taxes. After paying interests and taxes a firm is also required to pay dividend to shareholders and retain enough profits for making reinvestments in the business. Therefore it is essential that firm earn a high level of EBIT to meet all such business needs. EBIT is therefore considered as a measure of the financial health of a company. High EBIT facilitates greater returns to shareholders (Brigham & Ehrhardt, 2013). W1d Financial managers are often faced with the dilemma of deciding whether to choose to produce a product which is although profitable for the firm and is also legal, but is not beneficial for the society. Under such ethical dilemma, financial managers are required to put aside the profit motives of the firm and take decisions on the basis of the interest of all the stakeholders of the firm. Firms operate for the benefit of the society and therefore must indulge in producing those commodities which does not harm the welfare of the society. However this does not imply that products which cause harm to the society should be manufactured at all. If only ethics are considered then all alcohol and cigarette manufacturing firms must be shut down. This is however not the case in reality. Firms which take the decision to manufacture products legally which are harmful for the society must consider doing so following some ethics. Ethics in this respect would involve informing consumers explicitly the potential harm to health (Carroll & Buchholtz, 2014). W3c Cost of financing for the bond is as follows: P= C*[1-1/ (1+r)t]/r + F*1/(1+r)t Where each factor is computed as: F= Face value= $1000. C= Coupon rate= 12% T= Time period= 10 years P= Market value= $1125 – 6% floatation cost. On the basis of the above formula, the firm is required to determine the value of ‘r’, which the cost of debt. Using Microsoft excel tools the cost of debt (r) is computed as 10%. The after tax cost of debt is computed as r*(1-30%) = 6.98%. Therefore the after tax cost of debt financing is calculated to be 6.98%. The cost of debt financing signifies the amount of interest a firm is required to pay upon its debt capital. From the calculations done, it is seen that the firm is required to pay an interest rate of 6.98% upon its debt capital (Cornett & Saunders, 2003). W3d Price maximization refers to the increase in the price of commodities and services. Maximizing price would not always signify that a firm earns higher profits, although it may increase the overall revenues earned by the firm. When a firm charges high prices, then the net revenue from sales increases. However if the manufacturing, operating and other expenses of a firm are high, then it may not be possible for a firm to earn high profits even though the revenues have risen. As the operating and manufacturing expenses rise, firms incur lower profits even if the level of revenue is high. It is generally observed that prices fluctuate according to the level of operating expenses. High prices are generally not suitable for increasing demand for products as consumers are not willing to pay higher prices. While developing organizational strategies, price is usually not considered to be of utmost importance. Mangers are seen to give higher importance to aspects such as production, promotion and product development rather than pricing. When the internal operations of a firm are run efficiently, then it becomes possible for organizations to reduce the expenses associated with cost of production and thereby increase the costs of production. When the costs of production are low, ultimate prices are also low. Hence the importance of pricing decision becomes low when the concentration is on other aspects associated with production (Shy, 2008). W6a The market value of the shares is $115 per share and the net capital requirement of the firm is $12,000,000. Hence the numbers of shares which are required to be issued are 104348 (approximately). The numbers of shares which are required to be issued are computed by dividing the net capital requirement by the market value of the shares. Raising the entire capital only through issue of shares might not be a suitable option as it may not provide adequate leverage. Alternatively the firm may consider raising the finance acquiring debt. However the debt proportion should not be higher than the amount of capital raised through equity as a higher debt proportion induces the risk of lack of liquidity and is generally considered unfavorable. However the capital decision of the firm depends upon factors such as the cost of debt and the cost of equity. If the cost of debt is significantly high then it is advisable that the firm opts to have a higher proportion of equity and a lower proportion of debt (Grinblatt & Titman, 2002). W6b Cash- Yes, When sales increase, the net profits of the firm rise, assuming that the costs of operations are fixed. As a result cash balances rise. Marketable securities- No, Marketable securities are not associated with the amount of revenue from sales. Whether a firm invests in marketable securities depends upon the level of interests and the rate of inflation existing in the economy. Accounts payable- Yes, when the sales revenue of a company rises, a firm incurs higher revenue due to which it is feasible for the organization to pay off its creditors. Hence the accounts payables are seen to reduce due to the increase in sales revenue. Notes payable- Yes, since higher sales revenue leads to increase in the financial strength of a firm, it is possible for the firm to pay off notes payable on time and reduce the net liabilities. Plant and equipment- No, whether a firm invests in fixed assets or not depends upon the strategic decision taken by the management. Inventories- No, an increased sale may lead to the sales of all or majority portion of the stock of the firm. As a result the firm incurs very less or no closing stock in its balance sheet at the end of the period (Brigham & Ehrhardt, 2013). W6c Under alternative A, the cost of financing of the firm would be described as follows: Principle amount= $150,000 Total interest at 15%= $22500 Discounted interest rate at 15%= $19565 Therefore net payment to be made is $150,000 + $19565 = $169565 Additionally the firm maintains a compensating balance with the bank of 16% of the principle amount with is $24,000. The firm will not be able to withdraw $24,000, so it will be held as a locked up deposit. So the net cost of financing would be $169565 + $24,000 = $193565. Under alternative B, the cost of financing would be $163,000 as stated by the dealer. Therefore alternative B poses as a better method as the ultimate amount payable by the firm is lower (Brigham & Houston, 2011). W6d The recent global financial crisis which had risen from the subprime crisis has induced alertness and more strictness into financial firms in terms of providing credit. Before the crisis period had begun, firms were seen to allot housing loans to individuals at cheaper rates. Much attention was not paid regarding checking the background of the individuals before providing loans. Since the prices of the houses were continuously rising, investing in housing property seemed like a profitable bet. However borrowers of the housing loan soon realized that they could afford the investments as the prices of houses began plummeting and the rates on housing loan were the same. Many borrowers began to default the loans, which ultimately led to a liquidity crisis. Economist and financial experts had realized that faulty credit decisions and lack of forecasting had caused the subprime liquidity crisis. Financial investors are now keener upon checking the background of the borrowers and ensuring that the loans can be realized on time. It is essential to maintain loans as good so as to trade them and earn profits. Credit rating activities therefore requires to be done more effectively. Financial regulators must also be more cautious while fixing prices for homes so as prevent over investments in the sector as it may lead to a mortgage crisis (Eichengreen, et al., 2012). W7a It is essential that a firm has a good management system as compared to other factors. An efficient management system enables a firm to convert its weaknesses or threats into opportunities and strengths in the long run. An efficient management facilitates suitable allocation of resources, minimizing wastage and increasing the size of the organization. On the other hand if a firm considers that a good product is more important, it may not reap benefits for the organization for a very long period. A product is determined to be good or bad based upon the consumers, their interest and tastes. Changing tastes and preference may cause a product to lose its popularity and hence render lower revenues for the organization. Under such circumstances, with the help of an efficient management team, a firm can innovate and develop new products or upgrade existing products to earn higher revenues. Therefore an efficient management is a long term advantage for an organization, while a good product may not always be a strong point. Also it is essential to consider that without an efficient management system, it is not possible for an organization to reap the advantages obtained from a good product. Even if an organization has a good product, it is essential to promote and produce the commodity in a manner such that profits can be maximized (Shapiro & Balbirer, 2000). W7b A firm’s cash balances are affected by a number of factors. It is essential for a firm to have adequate cash balances in order to meet the day to day needs of the business and to meet continuity in the operations of the business. Holding sufficient cash in the business is essential to meet three important needs namely, transaction motive, precautionary motive and speculative motive. Transaction motive involves meeting the needs which are associated with the production and operations of the business. An increased demand may cause an organization to produce more number of products, which further raises the production expenses. If the firm has sufficient cash holdings it becomes possible to meet these needs effectively. Precautionary motive of holding cash refers to meeting financial requirement during an unprecedented event such lock outs, strikes and decreased demand of products. During such periods, a firm cannot earn adequate revenues to pay of fixed expenses such as interest and taxes. Hence if there are adequate cash reserves, it becomes possible for the firm to pay off expenses in a timely manner, even in the absence of sales revenue. Speculative motive refers to the ability of a firm to indulge in speculative transactions due to the existence of excess cash reserves (Van Horne & Wachowicz, 2008). W7c In international organizations, revenues are often affected due to fluctuations in the exchange rate. There are essentially three types of risks which international firms are exposed to which are transactional, economic and translational risks. Transaction risk arises when there are fluctuations in the rate of exchange between the settlement date and the date of the transaction. The amount receivable from foreign debtors or payable to foreign creditors depends upon the ultimate movement of the exchange rate on the settlement date. Economic risks are the risks which are associated with the fluctuations in expected future cash inflows due to changes in exchange rate. For instance if the home currency strengthens, then other foreign currencies earns more competitive advantages as the products of the home nation have become expensive. This is considered as a direct effect. An indirect effect is caused when the weakening of another foreign currency induces loss of revenue as the foreign nation’s products become cheaper. Translation risks are associated with the consolidation of financial statements (Allayannis & Ofek, 2001). Risks which are associated with exchange rate can be minimized with the help of derivative contracts such as forwards, futures, options and swaps. In a forwards contract, the underlying currency can be bought or sold at a fixed future at a predetermined rate of exchange. Hence even if the exchange rates move negatively, a firm does not have to incur much loss (Bartram, Brown & Fehle, 2009). W7d Healthcare facilities change alongside of changing standard of living. The healthcare facilities available today were not the same as they were ten years back. Research and development and scientific inventions consistently induce changes in lifestyle. A faster percentage of growth leads to better standard of living. A faster percentage of growth leads to quicker returns. As a result it is possible to invest more and earn higher revenues thereby facilitating a higher standard of living. In other words, it can be stated that the increase in the standard of living is directly associated with the rate of growth. The last decade has witnessed a higher rate of growth than before due to rapid growth in different sectors such as pharmaceutical, engineering and retailing. The growth has not caused higher economic returns but it has also revolutionized the manner in which individuals carry out day to day activities. However in order to give effect to growth it is essential that the economic conditions are sound. A failing economy cannot facilitate growth and improve the standard of living. Adequate cash flows and excess cash in the economy is essential for increasing investment in growth (Lewis, 2013). References Allayannis, G. & Ofek, E. (2001). Exchange rate exposure, hedging, and the use of foreign currency derivatives. Journal of international money and finance, 20(2), 273-296. Bartram, S. M., Brown, G. W. & Fehle, F. R. (2009). International evidence on financial derivatives usage. Financial management, 38(1), 185-206. Brigham, E. & Ehrhardt, M. (2013). Financial management: theory & practice. Connecticut: Cengage Learning. Brigham, E. & Houston, J. (2011). Fundamentals of financial management. Connecticut: Cengage Learning. Carroll, A. & Buchholtz, A. (2014). Business and society: Ethics, sustainability, and stakeholder management. Connecticut: Cengage Learning. Cornett, M. M. & Saunders, A. (2003). Financial institutions management: A risk management approach. New York: McGraw-Hill/Irwin. Eichengreen, B., Mody, A., Nedeljkovic, M. & Sarno, L. (2012). How the subprime crisis went global: Evidence from bank credit default swap spreads. Journal of International Money and Finance, 31(5), 1299-1318. Grinblatt, M. & Titman, S. (2002). Financial markets and corporate strategy. New York: McGraw-Hill/Irwin. Keown, A. J., Martin, J. D., Petty, J. W. & Scott, D. F. (2011). Financial management: Principles and applications. New Jersey: Prentice Hall. Lewis, W. A. (2013). Theory of economic growth. London: Routledge. Rohlf, W. D. & Rohlf, W. D. (1996). Introduction to economic reasoning. Boston: Addison-Wesley. Shapiro, A. C. & Balbirer, S. D. (2000). Modern corporate finance: A multidisciplinary approach to value creation. New Jersey: Prentice Hall. Shy, O. (2008). How to price: a guide to pricing techniques and yield management. New York: Cambridge University Press. Van Horne, J. C. & Wachowicz, J. M. (2008). Fundamentals of financial management. New Jersey: Pearson Education. Wachter, J. A. (2006). A consumption-based model of the term structure of interest rates. Journal of Financial economics, 79(2), 365-399. Read More