Financial Management Approach - Assignment Example

Problem Solving Name Institution Problem Solving Question 1 Financial Management approach is an evolution that includes traditional and modern approaches. The traditional approach comprises of financial management initial stages conducted from the 1920s to 1950s. The approach involved past experiences used in the traditionally accepted means. The primary concern of the method was fundraising for the enterprises. The enterprises procured funds through external bodies like lending institutions and other financial instruments (Brigham, 2016). The modern approach entails conceptual and reasoned structure when making a financial decision. The method focuses on both acquisition and allocation of finances. The significance of the approach is allocating the funds wisely to the various uses (Wiley, 2008). Question 2 Cash flow is the up-to-date format required to report the cash inflows and outflows under Generally Accepted Accounting Principles (GAAP).The statement of cash flows can either be from investing, operating or financing activities. Enterprises cash revenue enhances cash inflows from various activities like selling goods and offering services. The outflow of cash is as a result activities that include purchasing and payment of loans. On the other hand, Fund flow is the outdated format that GAAP required from 1971 to 1987 to report the cash inflows and outflows that are in reference to the statement of the fund flow. The significance of fund flow was for the accountants to report if there were any changes in net working capital at the period of time set. Today, the fund flow can help the market analysts and the investors to track the funds flowing in and out of particular sectors of the economy. Question 3(a) Equity shares also known as ordinary shares have various advantages and disadvantages. The benefits include: Dividend: The investor has the entitlement of receiving a dividend from the enterprise as it is one of the primary sources of return. Capital Gain: The investor has the entitlement of receiving capital gain that results from share’s rise of market price. Limited liability: The shareholder liability is limited to the amount of investment made. Therefore, the investor does not bear the losses above the capital investment. Exercise control: the investor gains ownership of the company upon investing and thus gets to exercise control like the voting rights. Claim over assets and income: equity share investor acquires ownership of assets and hence enjoys a share of the company’s income. The income could be in the form of cash, dividend or reinvestment. Rights shares: when a company may require more capital for expansion, the existing investors are prioritized first to invest before inviting general investors. Bonus shares: At times a company decides to offer free shares or bonus shares to their existing shareholders mostly through dividends. Liquidity: The shares that are listed on the stock exchange have the advantages of liquidity at any time. Stock split: On splitting shares, the price of the pre-share reduces resulting in the increase of the tradability of shares in the market. Split prices enhance higher volumes of shares. Also, the number of investors increases resulting to higher liquidity (Skinner & Soltes, 2011). Disadvantages include: Dividend: The shareholders cannot decide or control the dividends they receive; instead, the company management makes that decision (Simonson, 2010). High risk: The investment of equity share is risky when comparing to other investments as there is no collateral security and the shareholders depend on the faith to the company. Market price fluctuation: there are equal chances of profit as well as losses to the equity shares due to the wide variation. Therefore, it is very hard to get guaranteed profit from the market. Limited control: In a company, equity investors are regarded as small investors hence it is hard for them to influence the decision by the use of voting rights. Residual claim: The equity shares have the rights to claim residual that is the income and the asset. The income is available to the equity investors after the stakeholders are paid (Totev, 2013). Question 3 (b) A debenture is unsecured debt instrument issued by a company or a government. Therefore, the government or the corporations issue the debentures through the reputation and creditworthiness rather than the collateral or physical assets so as to secure capital. Debentures documentation is through an indenture like other bonds (Tirole, 2010). The government issues treasury bonds and treasury bills which are risk-free debentures. The reason that T-bonds and T-bills risk-free consideration is because the government can decide either print more money or increase taxes to pay the debts. On the corporations, the debenture holder acts as the general creditor in case of bankruptcy. This becomes less likely for the full recovery when comparing to the secured creditors. Also, the interest rates on debenture are higher comparing with the secured debt due the high-risk factor (Changfeng, & Hailong, 2012). Question 4(a) Capital structure involves financing company assets through equity and debt. The mixture of using both or one of equity and debt capital is through the financial decision. The financial decision affects weighted average cost of capital (WACC) a company. WACC is the weighted average cost of debt and equity. The optimum capital structure is the ideal debt-to-equity ratio that maximizes the value of a firm. The optimum capital structure involves minimizing WACC to maximize the value and wealth of the shareholders (Lemmon & Zender, 2010). Question 4(b) Particulars Net operating system Minus interest Cost of debt Earnings available to the equity shareholders Equity Capitalization Rate Market Values of shares Market value of firm Average cost of capital Earnings/ Value of the firm EBIT/v (a) No debt 200,000 _ 200,000 10% 200,000*100/10 Rs. 2,000,000/- 2,000,000 200,000 200,000/2,000,000*100 =10% (b) 25,000 6% debentures 200,000 1500 198,500 11% 198,500*100/11 Rs. 1,804,545/- 1,829,545 200,000 200,000/1,829,545*100 10.93% (c) 4,000,000 7% debentures 200,000 28,000 172,000 13% 172,000*100/13 Rs. 1323,077/- 1,723,077 200,000 200,000/1,723,077*100 11.61% Question 5 (a) Book Value Note that Book values on the questions preference, equity, and retained earnings have ‘0’ missing. The figures should be 100,000, 600,000 and 200,000so that the total will be 1,300,000. Sources of funds Amount Cost %(x) Weighted Cost Proportion X Cost (XW) Debt Preference shares Equity Shares Retained Earnings 400,000 100,000 600,000 200,000 5 6 15 13 20,000 6,000 90,000 26,000 ΣW = 1,300,000 ΣXW = 142,000 Kw= ΣXW/ Σ w*100 Kw= 142,000/1,300,000 * 100 = 10.92% (b) Market value Note that preference and the total should be 110,000 and 1,690,000 respectively. Sources of funds Amount Cost %(x) Weighted Cost Proportion X Cost (XW) Debt Preference shares Equity Shares Retained Earnings 380,000 110,000 900,000 300,000 5 6 15 13 19,000 6,600 135,000 39,000 ΣW = 1,690,000 ΣXW = 199,600 Kw= ΣXW/ Σ w *100 Kw= 199,600/1,690,000 * 100 = 11.81% Question 6 Difference between operating leverage and financial leverage Operating Leverage Financial Leverage The formulae for the operating leverage = Contribution/Operating Profit Operating leverage is involved with a company’s investment activities It characterizes on how to use fixed operating cost It is not affected by the tax and the interest rates. The percentage variations in sales are as a result of percentage differences in profits. A company cannot trade with equity while operating leverage. It is determined by the fixed and variable cost Involves a company’s fixed operating expenses (Artikis, 2007). The formulae for the operating leverage = Operating Profit /profit before tax It is engaged in the company’s financing activities. It characterizes the connection concerning EBIT and EPS. Its changes are as a result of tax and interest rate changes. The percentage variation in EBIT is due to the percentage differences in taxable profit. A company can trade with equity while financing leverage It is involved with the company’s operating profit. It involves a company’s operating profit (Hillier, Grinblatt, & Titman, 2011). Question 7 Firm’s profitable position: A business financial status determines the dividend decisions. The more the enterprise earns profits, the more the dividend distribution to the shareholders and vice versa. Future income uncertainty: An enterprise should retain consistent dividend policy to maintain the needs of regular income to the shareholders. Legal constraints: Some laws restrict the payments dividends. The laws include Companies Act 1956 and Income tax act 1961. Liquidity position: Liquidation enhances easy payments of firm’s dividends. An enterprise with high liquidity delivers cash dividends. Otherwise, they pay the stock dividend (Fan, Titman, & Twite, 2010). Finance sources: A firm is with sources of funding mobilizes massive finance efficiently without going for retained earnings. Enterprise growth rate: when the business enhances high growth rate, the shareholders can get more dividend. Tax policy: A company can pay more dividends when the government offers tax incentives. Conditions of Capital market: A perfect capital markets increases more dividends to shareholders (Drexler, Black & Sparks, 2015). Question 8 (a) Pay-back period = Investment/ Cash Flow Therefore; 2,000,000/400,000 = 5 years (b) Year Cash Inflows Project-X Rs. Project-Y Rs. Present Values of Rs.1 @ 10% Present Value of Net Cash Inflow Project-X Rs. Project-Y Rs. 1 2 3 4 5 Scrap Value Total Present Value Initial investment Net present value 5,000 10,000 10,000 3,000 2,000 1,000 20,000 10,000 5,000 3,000 2,000 2,000 0.909 0.826 0.751 0.683 0.621 0.621 4,545 8,260 7,510 2,049 1,242 621 24,227 20,000 4,227 18,180 8,260 3,755 2,049 1,242 1,242 34,728 30,000 4,728 Project Y is higher and hence should be selected as net present value. Question 9(a) The statement is true. This is because an annuity involves fixed interval payment in a series of fixed specified number of years. A fixed amount must be available to be an annuity. On the statement, the second set shows that it is irregular but on the other hand still institutes a sequence of the annuity. Question 9 (b) PV=-$250,000 FV=1,000,000 N=18 Future value = 1 million = 1,000,000 * (1 + 0.1)18 = 250,000 (1+i) 18 = 4 (1+i) = 1.08 I = 8.01% Reference Artikis, G. P. (2007). Capital structure. Bradford, England: Emerald. Brigham, E. F. (2016). Financial management: Theory and practice. Place of publication not identified: South-Western. Changfeng, C., & Hailong, L. (2012). Study On Debenture Bond Market Liquidity and Investor Heterogeneity [J]. Review of Investment Studies, 3, 003. Drexler, D. A., Black Jr, L. S., & Sparks III, A. G. (2015). Dividends (Vol. 1). Delaware Corporation Law and Practice. Fan, J. P., Titman, S., & Twite, G. (2010). An international comparison of capital structure and debt maturity choices. Hillier, D., Grinblatt, M., & Titman, S. (2011). Financial markets and corporate strategy (No. 2nd Eu). McGraw-Hill. Lemmon, M. L., & Zender, J. F. (2010). Debt capacity and tests of capital structure theories. Lonergan, W. (2003). The valuation of businesses, shares and other equity. Crows Nest N.S.W: Allen & Unwin. Simonson, P. F. (2010). Debenture and debenture stock holders' legal handbook: With appendix containing forms. S.l.: Gale Ecco, Making Of Mode. Skinner, D. J., & Soltes, E. (2011). What do dividends tell us about earnings quality?. Review of Accounting Studies, 16(1), 1-28. Tirole, J. (2010). The theory of corporate finance. Princeton University Press. Totev, H. (2013). The value of the securities (Bonds and shares). ASSOCIATION SCIENTIFIC AND APPLIED RESEARCH, 1, 144. Wiley Interscience (Hoboken, Estados Unidos). (2008). Financial Management. Read More