Financial Understanding of Issues - Assignment Example

Student Name: Professor: Institution: Course Code: Financial Understanding Introduction XYZ consulting firm and associates has appointed a business finance professional to provide an advisory assistance on different decisions intending to help in the establishment of business finance division. The decision making criterion is to be given in three different areas including investment decision, dividend decision and finance decision (Grossman and Livingstone, 2009). The investment decision must have a strong relationship with other decisions so that the shareholders will be able to maximize their wealth and profit. This report therefore is expected to provide detailed information that can guide XYZ to choose appropriate investment decision which is able to provide high investment returns. The investment decisions which are to be discussed include replacement decision, expansion decision and acquisition decision. Task 1 The investment decision Investment decision is a decision reached between investors and financial managers. This kind of decision is made after the evaluation of different investment project which have been proposed to be invested in (Ogilive, 2007). To draw a valid conclusion, it is important to use fundamental examination, technical analysis and gut feel which is enhanced by the use of decision tools or models. During the decision making process, the investors use portfolio theory which enables them to achieve the satisfactory returns against risks involved. In the investment decision, the investors have to choose the kind of decision to take and they include replacement, expansion and acquisition decisions for which all of them help in profit maximization (Grossman and Livingstone, 2009). In summary, investment decision is the ascertainment of where, when, how and how much initial cash outlay can be used or the amount of debt needed to achieve the business objective of profit maximization. Quantitative models used in investment decisions In the investment decision, it is effective for the financial managers and other investors to choose an investment portfolio which can produce high returns. To achieve these, investment evaluation or appraisal must be done on each project to determine its viability. The determination of viability requires the use of different quantitative models such as NPV, payback period, IRR and ARR (Ogilive, 2007). These models are used by investors to make investment decisions based on different investment projects such as independent projects which its rejection may have little or no effect on other projects. It can also invest in mutually inclusive projects which when accepted does not allow for the acceptance of any additional project to compete with the same firm. Payback Period This is a very important model which the investor can use to evaluate the investment portfolio if viable or not. It ensures that the project selected is able to recoup its investment cash outlay within a shorter period of time (IFP, 2008). It is computed by the below formula. Payback period = Initial cash outlay/ Cash flow per annum Advantages This model is very easy to use as its computation is less time consuming as it use arbitrary cutoff periods. It also does not require the investor to discount all the cash flows and therefore less technical to the decision maker. Disadvantages The weaknesses of this model include non consideration of the timing of the future of past cash flows and also assume other cash flow which comes after the payback period and finally its decision criteria is not based on economic condition of the project (Ogilive, 2007). Decision criteria To make correct investment decision based on this model, it is important to select investment portfolio with the shortest payback period since it shows that the project can take a very short time to recover its initial cash outlay. Net present value This is a model that involves discounting of all the cash flows of the investment project to determine its viability at a given discounting rate. It is computed as follows NPV = PV (Benefits) –PV (Costs which most firms consider the best approach to evaluate their new projects (IFP, 2008). To make appropriate investment decision, the alternative project that has the highest positive NPV should be selected since it is able to produce high investment returns to shareholders. Advantage This model of investment appraisal considers time of money by discounting the cash flow. It also uses all the cash flow generated by project (Ogilive, 2007). In addition, it gives direct decision criteria on whether to accept or reject a particular project. Disadvantages The use of this model creates a ranking conflict between IRR and NPV and also assumes that the cost of capital is constant overtime which is not the case. IRR This is also a discounting cash flow method which the investor can use to determine a viable investment portfolio (IFP, 2008). It is used to determine the reliability and sustainability of an investment project. To make correct decision, select an alternative project whose IRR is greater than the cost of capital. Advantages It does not assume the time value of money and also uses all the cash flow of the project to determine the sustainability value of the investment project. Disadvantages This model conforms to the rules of NPV for single projects when all the negative cash flow come after positive cash flows and sometimes operates against net present value. Otherwise, other cases the IRR may disagree with NPV. Qualitative issues that need to be considered when finalizing decisions made as a result of quantitative models. The quantitative issues that must be considered when finalizing investment decisions made as a result of quantitative model include the acceptance of the project when NPV is greater than zero and more positive that other alternative projects. In the case of IRR, accept the project when it is more than the cost of capital indicating that the project is more sustainable. How the investment decision relates to the financing decision There is a strong relationship between investment decisions and dividend and financing decisions in financial management (IFP, 2008). The investment decision is important in determining the amount of finance that the business needs to use to finance the selected investment project. For the investment project selected to achieve the goal of a firm, it must make appropriate financial decision which matches with the lifespan of the investment project so that there is no risk of borrowing again and again (Ogilive, 2007). The investment decision also ensures that the company select appropriate source of finance which can provide adequate funds to the business so that there is no cash shortage to support current asset management. The relationship is also there because it is important to select or to make investment decision when the investor has already known the available source of finance to use that suits the business project. The dividend decision There is also a relationship between investment decision and dividend decision. The investors have an expectation to get high dividend per annum and therefore they have to make investment decision that can ensure that they achieve their expectation of maximizing their wealth. For the investors to increase their dividend it is important for the financial manager to take up a decision such as replacement decision which can increase the production capacity of the firm and in the end the company makes a huge profit margin (IFP, 2008). This will increase dividend payout ratio which has a positive impact on the earnings of shareholders. The expansion decision and acquisition decisions also play the same role as they ensure that there is increase in revenue. Short analysis of one article from a business magazine about the investment decision It is important for any business organization to make investment decision. In this decision there is need for special attention which the financial manager and the investors are required to have. Influence Growth The investment decision goes into the future of the business and it requires a long term commitment to experience positive company growth (GTG, 2008). Investment decisions are always long term which ensures there is increase in the capital assets which improve the company performance. The investment decision is also based on three decisions including replacement, acquisition and expansion decision of which all are meant to increase the production capacity. Risk Investment decisions also bear some risks to the business. This is because investment decision involves the commitment of funds in a long term project which alter the risk complexity of the business organization (IFP, 2008). When the use of an investment decision is able to increase the average gains but influences a fluctuation in the earnings it makes the company to become more risky than before and therefore it shapes the character of an organization. Funding The implementation of investment decision always requires the use of high investment funds which ensure that the firm must plan properly to achieve this objective. It therefore makes the company to make a critical decision on the choice of finance that can support the investment decision. Irreversibility The investment decision which has been passed cannot be reversed to suit certain situation. This makes it to be very rigid and irreversible. Once the investment assets have been purchased, it is very hard to get a fresh market for capital assets which have been acquired to expand the company (GTG, 2008). This therefore enables the firm to incur great losses as a result of reversal of investment decisions Complexity Investment decision is very complex and difficult to make. It involves the evaluation of future events which are not easy to predict. It is also very hard to correct future estimates such as cash flow estimates. Task 2 The financing decision This is a decision which is made by financial managers which ensure there is selection of appropriate source of finance. This decision is made from the choice of different sources of finance which are available for different business organizations. It also involve decision to decide how much to raise from a single source of finance. Financing decision involves the comparison of different sources of finance based on their disadvantages and advantages so that that suits the needs of the business are selected (Grossman and Livingstone, 2009). It also involves the assessment of different financial implications which include legal, financial and cost implication. Finance manager prefer to have a mix of finances where the ratio is chosen between the owners and borrowed funds to form appropriate capital structure that gives great benefit to the company. How the financing decision relates to: There is a strong relationship between three different decisions which include investment decision, dividend decision and financing decision. The investment decision Financing decision has a positive relationship with investment decision. The relationship comes because both of them are require achieving the business objective of profit and shareholders wealth maximization (GTG, 2008). The investment decision is to increase the revenues and profitability while financing decision ensure that the company has enough fund to helps in the management of current assets and to have adequate investment assets that can help the business organization achieve its objectives (Pike and Neale, 2008). The investment decisions and financing decision also ensure that the business organization run efficiently for a foreseeable time since the investors has managed to choose a sustainable investment project which is financed by adequate finance that matches with the project lifespan. The dividend decision Financing decision also relates to dividend decision in several ways. The relationship is that each one of them affects each other positively since good divided decision results from good financing decision (IFP, 2008). The increase in dividend pay out ratio reduces retained earnings this is because retained earnings form part of financing. The use of other sources of finance to finance the investment project ensures there is an increase in dividend which is distributed to shareholders. A short analysis of one article from a business magazine about the financing decisions There are different financial decisions and they include investment in fixed assets and capital budgeting and it require the financial managers to take a serious action when making this kind of decision (GTG, 2008). These decisions are very important due to the following It has long term growth and effect Financing decision involves the investment of long term assets which supports the production of more products (Pike and Neale, 2008). It ensures that the company has sufficient finance to support its investment decision to enable the company meet its goals. It therefore promotes internal and external growth which has an effect on future possibilities. Large Amount of Funds Involved This kind of decision requires the use of large sums of money as it involves the use of fixed assets which are costly (Correia, et al, 2007). Its costliness is also associated with its long term period that it takes when investing in long term assets. In case there is a wrong decision on this, the business is able to loose huge sums of money. Risk There is high risk in capital budgeting because the decision involve long term period which makes the company to have long term expectation for profits (Correia et al 2007). It can easily be affected by financial risks which increase with the increase with the length of the source of finance. Irreversible Decision Financing decision is also not possible to be reversed once it has been made. The revisal of this decision may lead to loss of high amount of money (Pike and Neale, 2008). Task 3 The dividend decision This is a decision which is concerned with the distribution of profit after tax to shareholders (BPP, 2009). The decision is made between the shareholders and the financial manager which is given the finance by the investors to invest to produce returns to shareholders. In this decision, not all profits are distributed to shareholders but some are kept aside as retained earnings to be used as a source of finance. It is the role of financial manager to make decision on the amount of profit to be distributed to shareholders (BPP, 2009). During this decision financial manager must have in mind the growth plan of the organization to increase future dividends to shareholder. To make appropriate decision, it is important to use different quantitative models. To make dividend decision the model below can be used. Walter Valuation Model How the dividend decision relates to: The investment decision Dividend decisions have a strong relationship with the investing decision because good investing decision positively affects the dividend paid to shareholders (BPP, 2009). Good investment decision is able to increase profitability of the business organization which has direct impact on the divided paid to shareholders. Dividend decision also contributes to the amount of capital that is used by the financial manager to finance the investment decision. The financing decision The relationship between dividend decision and financing decision is also there. Dividend decision influence the amount of capital used to finance the investment project (Agar, 2005). It contributes towards the retained earnings which the company used to finance part of its expansion project. The increase in dividend there is a reduction in retained earnings which negatively affects the amount the company uses as capital. A short analysis of one article from a business magazine about the dividend decision Influence Growth Dividend decision is also able to increase the growth of the company (Agar, 2005). This result from the way the financial manager distributes end year profits by leaving significant amount to be used for expansion purposes. Influence the Value of the Firm The dividend per share is also able to influence the value of the firm. It shows the ability of the firm to meet the desires of the shareholders (Agar, 2005). If the company pays high dividends to shareholders, potential investors will be attracted and as a result the company goodwill increases. Affects the share prices The dividend decision also affects the price of shares (Artill and Mcaney, 2009). When there is increase in dividend payout ratio, the share prices increases since it shows that the company has high value. It also dictates the capital structure of the company since it reflects the amount of retained earnings that the company has. Conclusion Decision making is a very important exercise in the company. The business organization usually makes investment decision, financing decision and dividend decision to ensure that it achieves its profit maximization goals. The decision making process takes place between the investors and the financial managers. All these decisions have a strong relationship with each other and they operate towards a common goal. References Artill, P. and Mcaney, E. (2009), Management Accounting for Decision Makers (6th edition), Financial Times/Prentice Hall Schuster, P. (2007), Investment Appraisal: Methods and Models, Springer Agar, C. (2005), Capital investment & financing: a practical guide to financial evaluation, Butterworth-Heinemann BPP (2009), ACCA - P4 Advanced Financial Management: Study Text Edition: 3, BPP Learning Media Correia, C; et al (2007), Financial Management (6th edition), Juta and Company Ltd Grossman, T. and Livingstone, J. (2009), The Portable MBA in Finance and Accounting (4th edition), John Wiley and Sons GTG (2008), ACCA - P4 Advanced Financial Management (INT), Get Through Guides IFP (2008), ACCA - P4 Advanced Financial Management, International Financial Publishing Limited Ogilive, J. (2007), CIMA Official Learning System Management Accounting Financial Strategy (4th edition), Elsevier Pike, R. and Neale, B. (2008), Corporate finance and investment: decisions & strategies (6th edition) Trans-Atlantic Publications. Read More