Financial Management: Principles and Applications

2021-05-13 17:45:16
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Financial manager is a person whom the shareholders give money to invest on their behalf. The financial managers have a very complex goal to achieve on behalf of shareholders which require him to have the knowledge on the overall functionality of the business. Financial managers have a goal of minimizing cost of the company and ensuring that he meets the profit and wealth maximization goals of shareholders (Petty & Nguyen, 2012). This is the main reason why the shareholders give the financial manager money to invest so that he can make profit for them. These goals can be achieved when he efficiently manages the budget which requires him to efficiently allocate resources to various investment projects to influence perpetual continuity of the business. The financial managers can also achieve these goals by being able to figure out the financial projection which allows him to understand or estimate the possible cost to be incurred and the appropriate revenue to be generated in order to produce appropriate profit (Trifan & Anton, 2011). This wills allow the financial manager to achieve his goal requiring him to allocate financial resources efficiently to different projects to enable the business organization maximize its profits. It is also important for the financial manager to achieve the goals of ensuring that the business has sufficient cash to meet the organization financial needs such as to pay creditors and to pay loan and its interest (Petty & Nguyen, 2012). This can be achieved through efficient management of current assets which ensure that the business does not hold too much cash or inventories. Financial manager also has a goal of managing business and financial risks in the organization. This can be achieved by effective diversification process that enables the business to minimize its costs but maximize its profits.

1.2 The Relevance of the concept of Risk- Return trade off Principle

This is a concept or a financial principle which explains the relationship between investment returns and the possible risk involve (Petty & Nguyen, 2012). The principle suggests that a more risky project has the highest returns. This therefore creates a tradeoff between the risk and return. This concept is very relevant in investment decision.

 

This principle helps the investors make a choice on the investment which is able to provide high returns. It highlights to the investor the appropriate investment that can produce high return by indicating the level of risk involves when investing in a given project. When the investment project is less risky, it therefore means that it has less reward (Trifan & Anton, 2011). The essence of this principle in two different investment projects that has the same returns but one has a lesser risk, would influence most investors to invest in ales risky project. In the contrary when the two investment projects that have varied risks and returns, it is important for the investor to invest in a risky project in order to maximize returns (Petty & Nguyen, 2012). The principle of risk aversion therefore has been introduced to ensure that investors only invest in less risky projects when there are two alternative choices which have the same returns but different risks.

Illustration

The principle of risk return trade off has applied by Air New eland when making a decision to use either short term financing or long term financing (Trifan & Anton, 2011). The decision to use long term source of finance by this business organization was chosen because short term sources of finance are only less expensive but bear high risk than long term sources of finance. The trade off which the management Air New eland faces was how to select the best source of finance which could support its investment. This trade off therefore helped the management to use long term source of finance to finance its investment project through the use of risk aversion principles.

Question 2

2.1Computation of breakeven point

This is the level of production where sales revenues are equal to production cost. At this point profit is equal to zero (Pounder, 2010). To effectively determine the breakeven point, it is important to compute contribution margin which is the difference between selling price per unit minus variable cost per unit.

Breakeven point computation

Contribution margin ($2400 - $1400) = $1000

Breakeven point = Fixed costContributio$90,000$1000= 90 Units

But when there is a new dealer

Contribution = ($2500-$1520) =$980

The breakeven point = $90000$980= 92 units of coolers

The result of my computation show that this company can make zero profits when it produces 92 units when the demand of the dealer is accepted but when the dealer is rejected, this business organization will breakeven at 90 units of sales. It is therefore possible for this company to make profit when the deal of selling 100 units went through. This is because it is above the breakeven points in units. This indicates that it will be able to start making profit at 93rd cooler.2.2 Risk associated with cash management strategies

Management of cash in the organization is very important but it has some risks which affects cash management strategies. The risk which are likely to affect the strategies involve over investment or under investment of cash on current assets (Trifan & Anton, 2011). It is important for the business organization to avoid excessive investment of cash in current assets because it increases the risk of reducing the company profitability. This is because excess cash in the business will make some cash be idle but idle cash earns nothing. Under utilization of cash in the investment in current assets threatens the solvency of the business. This is because it is able to make the company have the problem of meeting its short term needs. For efficient cash management, it is important to allocate optimal cash in current assets so that there is no over investment of cash or under to allow the business run smoothly.

Question 5

5.1 Investment Appraisal

This is the process of determining the ability of an investment to produce adequate returns to investors (Trifan & Anton, 2011). It can be determined by the use of discounting cash flow method and non discounting cash flow method. In this case we are going to use both methods so that we can determine the period of time which the firm can use to recover its initial cash outlay and also know its ability to produce financial returns.

 

Payback Period

This is the period of time that the investment portfolio takes to recoup its investment cost or capital employed. It is simple to calculate but the only problem it has is that it does not consider time value of money and also does not use all the cash flows of the project.

 

6.1 Capital structure

Capital structure is relevant to the value of the firm is all the basic assumptions of Modigliani and Miller Capital structure theorem are potentially violated because the assumptions of their theorem require that the company capital structure must have proper proportion of different sources of finance (Trifan & Anton, 2011). The violation of these peoples theorem allows the business to finance the project using all sources of finance without the effect of taxes, bankruptcy cost and agency cost. This therefore allows the business organization to finance its investment using any source of finance because there is no effect on the value of the firm without the incorporation of taxes, agency cost and bankruptcy cost. It may remain the same because the firms value cannot be affected by the dividend policy and the decision which the management has made to finance the business. The adoption of taxes and interest will affect the value of the firm because when the business uses debt as a source of finance, it will benefit from interest tax shield which increases the value of the firm.

6.2 Weighted Average Cost of Capital

This is the rate of return which the company project to pay security holders for financing their investment project. It is also called cost of capital and it is calculated as shown below.

Ordinary shares capital (100 *6000) = $600000

Debt Capital (1000*400) = $400000

Proportion

Ordinary share capital =$600000$1000000 = 60%

Debt =4000001000000 = 40%

Total proportion (40+60) = 100%

After tax cost of capital

Ordinary share capital = Dop0-f* 100 +g

Do = 6% *100 = 6

Po= 100

Ke =6100* 100 = 6%

Bondholder = Kd =i(1-t)Po *100

Kd = 5%*1000(1-0.35)1000*100

Kd = 3.35%

Sources Value Proportion After tax WACC

Ordinary share $600000 60% 6% 3.6%

Bond $400000 40% 3.25% 1.3%

Total $1000000 100% 4.9%

Finance manager need to compute the WACC to make investment decision. This is because it is able to help the investor know the amount of money he needs to pay as the cost of capital (Yahya-Zadeh, 2011). With that knowledge the finance manager can select the source of finance which has the least cost of capital using WACC. It is also act as a way in which the investors or the finance manager check or monitor the success of the business.

 

References

Petty J & Nguyen H, 2012, Financial management: principles and applications, 6th edn, Pearson Australia (ISBN: 9781442539174).

Titman, S, Martin, T, Keown, AJ & Martin, JD 2016, Financial management: principles and applications, 7th edn, Pearson Australia (ISBN: 9781486019649).

Pounder, B 2010, Integrating the income statement, Strategic Finance, vol. 92, no. 1, pp. 1516.

Trifan, A & Anton, C 2011, Using cost -- volume -- profit analysis by management, Bulletin of the Transilvania University of Brasov, Series V: Economic Sciences, vol. 4, no. 2, pp. 207212.

Yahya-Zadeh, M 2011, A new framework for capacity costing and inventory variance analysis, Journal of Applied Management Accounting Research, vol. 9, no. 2, pp. 6181.

 

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