Opportunity Costs, Cost of Capital, The Firms Optimum Capital Structure - Assignment Example

1) Perhaps Time Value Of Money is one of the most critical concepts in finance which primarily explains the fact that a dollar today is worth more ascompared to the dollar sometime in the future. It is extremely important for firms to compound and discount cash flows to have a better estimation of their investments The Present Value explains the worth of the money to be received some time in the future in to days terms whereas the Future value compounds the money at a particular rate and explains what a sum of amount will be in the future.Interest rates reflect the inflationary nature of the economy and this rate is used as a factor to discount or compound cash flows. For example a firm is investing a sum of money in a project which promises to yield $200, $400 and $ 1000 in the next three years. Simply adding this figure would give us a wrong estimation as the money is to be received in the coming years and not today therefore we will have to discount these sums of money using a particular interest rate to know the actual worth of dollars that would be today. 2 ) Opportunity Costs are those costs that a firm foregoes in order to pursue some other investment or decision. For example a company has a plot of land that is vacant, it now has two options either to rent it and receive rent income or to use that land to construct its factories that will again earn it some benefit. Now, if the company decides to construct a manufacturing plant on that site it has to forego that rental income which otherwise it would have received if the factory was not built. Hence in finance and business we factor in that cost and include it as an expense to gauge the true outcome of our actual decision. 3) Cost of capital is the cost for a firm of raising capital either through equity or debt. A company has te decide the optimum mix of both as it will invest that money to gain higher returns therefore the lower the cost of capital the better. The cost of capital is determined by the firms target capital structure which is the weight ages in which it wants to raise equity and debt. It is the duty of the Finance Managers to manage a firms cost of capital and define an optimum kevel. 4) The firm’s optimum capital structure is the weight ages of both equity and debt for which the cost of capital is the lowest. We also know that a company cannot raise unlimited amounts of capital for that lowest cost and optimum weight age level. The WACC (Weighted Average cost if capital) changes after a particular level of capital is reached also known as Break Points. A company can stay in a particular cost level and raise an amount of capital until the break point is reached after which the cost of capital increases. We know that debt is cheaper than equity but too much debt makes the firm look risky therefore an optimum level needs to be targeted. 5) Dividend Policy is derived primarily by the company’s profitability. The decision for dividend payout is usually taken at annual general meetings where the company’s future is discussed. Ofcourse not all the amount available as FCFE (Free Cash flow to equity) can be paid out as dividends. It is necessary to hold down some revenues reserves for future company’s investments and projects. 6) Risk is uncertainty about any event. Firms must be very agile and continuously assess their risk portfolios. At the same time it ins undesirable to be completely risk averse and not take any risk. Having a lot of risk ion the company’s books will make the company look unattractive to investors and creditors alike. Having too much credit is risky simply because the chance of default is higher and higher credit may make it all the more probable whereas too little credit is also risky as it may not allow the company to take full leverage of the market and earn profits 7) Marketable Securities are investments in equities, fixed income and other related securities that are liquid and help the company earn some returns. Marketable Securities are used by companies to manage their liquidity positions as they would not want to leave a lot of money idle and not earning anything. Therefore marketable securities are usually safe and very liquid positions that a firm takes to grow its money and at the same time manage its liquidity. 8) Portfolio theory explains how investors can optimize or maximize their risk based ion their expected returns and to diversify your risk by investing in a pool of different security rather than all your money in one .The three points are Diversification, Correlation and Efficient frontier. 9) By putting your money in many different securities you not only minimize your risk but also get an efficient return. The concept of correlation explains that the movement of two assets in a portfolio should not be in tandem so that if one falls the other is still giving you profits and the efficient frontier explains that the investments must be based on risk averse investments that is having to get more return for a particular klevel of risk. 10) Forecasting is certainly and iterative process wherein you continuously remodel your predictions based on environmental factors and as they take shape around you. Forecasting primarily implies that you continuously take in variables in to your predictions and make decision. As that variable start to change or move in different directions it may significantly alter your forecast. Therefore it is imperative to be agile at forecasting Operating leases are a very common forms of off-balance-sheet financing. Here the asset itself is kept on the lessor’s balance sheet, whereas the company (lessee) that has taken the lease reports a simple operating expense for the use of that asset. It is extremely beneficial it helps to lower down taxes and no significant capital expenditure is requires and the ROA (Return on Asset) is also higher. It therefore makes the company look more efficient. It is terms as off balance sheet as no account appears on the balance sheet as the company is using the equipment under arental agreement Read More