Principles of Finance 1 - Term Paper Example

Principles of Finance Principles of Finance The principles of finance include valuation principles, risk management, finance and investment principles. An understanding of these principles will provide the financial manager with the analytical tools necessary in the decision-making process in solving financial problems. The resources of firms are scarce; thus, investment decisions should be made wisely. Market prices are essential components of a financial manager in his decision-making process.

Prices of goods and services are necessary inputs in almost all cost-benefit analysis that are undertaken by the company. The risk and return of the proposed investment project requires a study of the project’s cash flows. To analyze the profitability of the investment project, one method that may be done is to make use of the net present value (NPV) method. NPV is the difference between the present value of cash inflows and the present value of cash outflows. A positive NPV means that the project is acceptable while a negative NPV means that the project is not profitable.

Once a decision has been reached to undergo the project, the next step is to determine the sources of financing and establish the appropriate financing mix. Here lies the decision on whether to use debt or equity to maximize the value of the investment. Also, the source of financing should match the nature of the asset being financed. If a decision is made to finance the project through debt, it must also be determined whether it will be a long-term debt or a short-term debt. Long-term debt can be a term loan with a bank or a bond issuance.

A bond is like a loan because it is also a debt instrument. It is issued for a period of more than a year with the purpose of raising capital for borrowing. Its difference from a term loan is that it is generally offered to the public rather than to a single lender or a small group of lenders. Once a bond is issued, upon maturity date the principal and interest must be paid. With financing comes the decision on interest rates. How much interest is a company willing to pay for the loan that it will obtain?

Interest rate is actually just a price because it is the price that you pay for the use of money. The firm will be charged interest when it borrows money from the bank. On the other hand, interest rate will be paid by the company to its creditors if they decide to issue bonds. A company may instead of debt, decide to finance a proposed project with equity. Equity financing involves the selling of common stock or preferred stocks to investors. The price of the common stock or preferred stock to be offered can be determined by the projected earnings per share of the stock, the timing of the earnings stream, the riskiness of the projected earnings, the use of debt and the dividend policy of the company (Brigham & Gapenski, 1996).

Dividends may either be in the form of cash dividends or stock dividends. Another important decision here is how much of the earnings should be plowed back to the company and how much should be declared as dividends and shared to its stockholders. The principles of finance emphasizes that a company must only invest in projects which will be profitable to the company. In the end, every finance manager’s objective is to maximize the value of the firm. And maximizing the value of the firm means making wise investment, financing and dividend decisions.

References Brigham, E. & Gapenski, L. (1996). An overview of financial management. Financial management: Theory and Practice (p. 1-5). The Dryden Press. What is corporate finance? Retrieved 16 April 2011. http://pages.stern.nyu.edu/~adamodar/New_Home_Page/background/cfin.htm