Business Financing and the Capital Structure, Essay Example

1. Explain the process of financial planning used to estimate asset investment requirements for a corporation. Explain the concept of working capital management. Identify and briefly describe several financial instruments that are used as marketable securities to park excess cash.

The process of financial planning when a company seeks to approximate the level of assets they need to match their liabilities is majorly based on an asset management framework (Eichberger & Harper, 1997). Corporations that are involved in fast moving business will usually use a different approach in the financial planning and decision making process as opposed to business involved in long term business like real estate business. Obviously capital budgeting is the core activity in a financial plan. The financial manager will stand between the firms operation and the financial markets. The firms or the corporation operations involves the purchase of real assets, both tangible and intangible, these assets are then used by the firm to undertake profitable projects. This is what is called the capital budgeting decision. (Eichberger & Harper, 1997)

On the other hand the financial market is where the investors hold financial instruments like equities and bonds that are issued by the firms when raising money (Eichberger & Harper, 1997). This is called the financing decision. A comprehensive process seeks to address financial statements, accounting transactions, strategic planning and operating reports and looking for tax relief points in the process .All the processes in a corporation financial plan should include the interest of all stakeholders in order to avoid agency problems. If the firm is investing in long term project then the asset requirement might be funded by debentures or long term maturity corporate bonds. If the firm is involved in business using intangible assets like brand names and trademark rights then the financial planning process will usually involve constant revaluation of financial statements. (Mishkin, 1992)

Working capital management involves is a way financial manager use to enforce risk discipline in the firms operations (Mishkin, 1992). When a project is fully funded the working capital is at its optimal level every objective can be easily met. All employees to a business are an asset and when they are well motivated and incentivized then the business performance improves with no agency problems. Some of the marketable securities used by firms to park up excess cash are treasury bills, bonds, commercial papers and some other forms of short term fixed income securities. Commercial papers usually have a term of one year and are issued by entities that have high credit rating with the Moor’s. Treasury bills and bonds are generally issued by a government. Though these financial instruments yield rate are lower compared to equities firms use them to store excess cash due to high guarantee and zero default risk possibilities. (Mishkin, 1992)

2. Assume that you are financial advisor to a business. Describe the advice that you would give to the client for raising business capital using both debt and equity options in today’s economy.

Let us start by covering debts financing. Any business will always use a portfolio of both debts and equity to diverse their investments. Debt financing include getting loans from lending institutions (Eichberger & Harper, 1997). If a company is looking to raise cash through debt, some of the instruments to use in the short term financing are bank overdrafts, bills of exchange commercial papers and factoring. For medium term financing, firms can use bank loans, leases and credit sales or hire purchase. Long term financing after calculations of leverage ratios, firms can issue corporate bonds, purchase debentures or loan facilities that are more than run for more than a year. (Mishkin, 1992) An example given earlier is that firms that invest in capital projects like factory construction or real estate’s usually use debt financing and may be later issue rights in their share after going public.

Using equities to raise business capital is the most common form of financing for firms. Companies can do this by going public or looking for venture capitalist to invest in their business. A company can also hold a rights issue to raise additional capital (Eichberger & Harper, 1997). A rights issue is usually successful when the issuing firm has a profitable track record that convinces the existing shareholder of the firm to buy additional shares. For technological start-ups companies’ using venture capitalist is a much suitable option of financing. Venture capitalist equities usually have the option of converting into preference or ordinary shares upon going public.

3. Explain why a business may decide to seek capital from a foreign investor indicating the risk and rewards for such a decision. Provide support for rationale.

First of all foreign investors will usually receive incentives for putting their money in a given jurisdiction an example being foreign investment in developing countries. Developing countries mostly give tax holidays to firms with foreign investors. This is just an upside advantage. When the business is looking to fortify its portfolio and diversify its risk across a wide geography and financial markets using a foreign investor is the most obvious move (Mishkin, 1992). There are cases when a business prefers foreign investors from specific countries due to the belief that these investors have valuable expertise in financial markets and they have long and really performance track records in organization management. An example is when a developing country discovers minerals, it uses foreign investors due to lack of intellectual capacity in their country concerning mining. The same goes to development of communication technology. Some of the risk that comes with foreign investment is as follows, political volatility, legal issues and constant currency fluctuations. These factors can drastically affect the financial markets because to an extent they are interrelated in a way (Eichberger & Harper, 1997). Monetary policies that cap interest rates can affect the change in strength between two currencies since inflation rate must always affect market prices. Same as political decisions can favor home investor and give home investors tax reliefs on retirement benefits as opposed to firms with heavy foreign investments.

4. Explain the historical relationships between risk and return for common stocks versus corporate bonds. Explain how diversification helps in risk reduction in a portfolio. Support response with actual data and concepts learned in this course.

Common stocks or ordinary shares as they are called are usually the most financing option for businesses. Any rational investor will look at the risk in the investor and judge the return expected. As the norm goes, the higher the risk the higher the return expected. An equities investor will usually look at the uncertainty in future stream of income and the possibility of the company going burst leading to a possible capital loss (Eichberger & Harper, 1997). The return on common stock can be viewed in two perspectives. The investor can either settle for an annual dividend income or either reinvests dividends and realizes a capital growth on the share price.

Corporate bonds have a considerable risk of default hence usually charges a higher interest/coupon rate as opposed to treasury bonds. Infrastructure bond issued by construction companies is an example of corporate bond. The risk is risk of default while return is on coupon payments and a final principle amount on maturity of the bond. (Cothbertson, 1996)

Using the above fictitious data showing share price for five consecutive days, we get

Variance of Share price A=2.663, Variance of share price B=6.474

The correlation between share price A and B= -0.97147, this is got by

The two stock prices are negatively correlated. Almost a perfect -1 correlation is achieved hypothetically. Investing in both shares reduce the exposure risk. The fall in price in stock B is compensated for by rise in price of stock B. (Cothbertson, 1996)

References

Cothbertson, K. (1996). Quantitative financial economics: Stocks, bonds and foreign exchange. Chichester: John Wiley.

Eichberger, J., & Harper, I. L. (1997). Financial Economics. Oxford: Oxford Univesity Press.

Mishkin, F. S. (1992). The econmics of money, banking, and financial markets. New York: Harper Collins.