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mb0045

mb0045

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Published by: gurugabru on Dec 23, 2011
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01/08/2013

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Q.1.what are 4 Finance decisions taken by a Finance Manager.Answer:
Corporate finance is the field of finance dealing with financial decisions that business enterprisesmake and the tools and analysis used to make these decisions. The primary goal of corporate finance is tomaximize corporate value while managing the firm’s financial risks. Although it is in principle differentfrom managerial finance which studies the financial decisions of all firms, rather than corporations alone,the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.The discipline can be divided into long-term and short-term decisions and techniques. Capital investmentdecisions are long-term choices about which projects receive investment, whether to finance that investmentwith equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short termdecisions deal with the short-term balance of current assets and current liabilities; the focus here is onmanaging cash, inventories, and short-term borrowing and lending (such as the terms on credit extended tocustomers).[citation needed]The terms corporate finance and corporate financier are also associated with investment banking. Thetypical role of an investment bank is to evaluate the company's financial needs and raise the appropriate typeof capital that best fits those needs. Thus, the terms “corporate finance” and “corporate financier” may beassociated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.Capital investment decisions are long-term corporate finance decisions relating to fixed assets and capitalstructure. Decisions are based on several inter-related criteria.(1) Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate in consideration of risk.(2) These projects must also be financed appropriately.(3) If no such opportunities exist, maximizing shareholder value dictates that management must returnexcess cash to shareholders (i.e., distribution via dividends).Capital investment decisions thus comprise an investment decision, a financing decision, and a dividenddecision. The investment decision Main article: Capital budgeting Management must allocate limitedresources between competing opportunities (projects) in a process known as capital budgeting Making thisinvestment, or capital allocation, decision requires estimating the value of each opportunity or project,which is a function of the size, timing and predictability of future cash flows.Project valuation further information: Business valuation, stock valuation, and fundamental analysisIn general, each project's value will be estimated using a discounted cash flow (DCF)valuation, and theopportunity with the highest value, as measured by the resultant net present value (NPV) will be selected(applied to Corporate Finance by Joel Dean in 1951;see also Fisher separation theorem, John Burr Williams:theory). This requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future cash flows are then discounted to determine their present value (see Time valueof money). These present values are then summed, and this sum net of the initial investment outlay is the NPV. See financial modeling.The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate - often termed,the project "hurdle rate"[5] - is critical to making an appropriate decision. The hurdle rate is the minimumacceptable return on an investment—i.e. the project appropriate discount rate. The hurdle rate should reflectthe riskiness of the investment, typically measured by volatility of cash flows, and must take into accountthe financing mix. Managers use models such as the CAPM or the APT to estimate a discount rateappropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect thefinancing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC thatapplies to the entire firm. Such an approach may not be appropriate where the risk of a particular projectdiffers markedly from that of the firm's existing portfolio of assets.)In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporatefinance. These are visible from the DCF and include discounted payback period, IRR, Modified IRR,equivalent annuity, capital efficiency, and ROI.Alternatives (complements) to NPV include MVA / EVA (Joel Stern, Stern Stewart &Co) and APV(Stewart Myers). See list of valuation topics. Valuing flexibility In many cases, for example R&D projects,
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a project may open (or close) the paths of action to the company, but this reality will not typically becaptured in a strict NPV approach. Management will therefore (sometimes) employ tools which place anexplicit value on these options. So, whereas in a DCF valuation the most likely or average or scenariospecific cash flows are discounted, here the “flexible and staged nature” of the investment is modeled, andhence "all" potential payoffs are considered. The difference between the two valuations is the "value of flexibility" inherent in the project.The two most common tools are Decision Tree Analysis (DTA) and Real options analysis (ROA);[9] theymay often be used interchangeably:DTA values flexibility by incorporating possible events (or states) and consequent management decisions.(For example, a company would build a factory given that demand for its product exceeded a certain levelduring the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarlyexpand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" -eachscenario must be modeled separately.) In the decision tree, each management decision in response to an"event" generates a "branch" or "path" which the company could follow; the probabilities of each event aredetermined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this “knowledge” of the events that could follow, andassuming rational decision making, management chooses the actions corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See Decision theory:Choice under uncertainty.ROA is usually used when the value of a project is contingent on the value of some other asset or underlyingvariable. (For example, the viability of a mining project is contingent on the price of gold; if the price is toolow, management will abandon the mining rights, if sufficiently high, and management will develop the ore body. Again, a DCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory as framework, the decision to be taken isidentified as corresponding to either a call option or a put option; (2) an appropriate valuation technique isthen employed - usually a variant on the Binomial options model or a bespoke simulation model, whileBlack Scholes type formulae are used less often; see Contingent claim valuation. (3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporatefinance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options wasoriginally per Timothy Luehrman, in the late 1990s.)Quantifying uncertainty Further information:Sensitivity analysis, Scenario planning, and Monte Carlo methods in finance Given the uncertainty inherentin project forecasting and valuation] analysts will wish to assess the sensitivity of project NPV to thevarious inputs(i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst will vary onekey factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in thatfactor is then observed, and is calculated as a "slope": ΔNPV /Factor. For example, the analyst willdetermine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%,-5%, 0%, 5 %....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and their various combinations produce a "value-surface" (or even a "value-space"), where NPV isthen a function of several variables. See also Stress testing.Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as well as for company-specific factors (unit costs, etc...). As an example, the analyst mayspecify various revenue growth scenarios (e.g. 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, andcalculate the NPV for each. Note that for scenario based analysis, the various combinations of inputs must be internally consistent, whereas for the sensitivity approach above, the simulation produces severalthousand random but possible outcomes, or "trials"; see Monte Carlo Simulation versus “What If”Scenarios. The output is then a histogram of project NPV, and the average NPV of the potential investment – as well as its volatility and other sensitivities – is then observed. This histogram provides information notvisible from the static DCF: for example, it allows for an estimate of the probability that a project has a net
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 present value greater than zero (or any other value).Continuing the above example: instead of assigningthree discrete values to revenue growth, and to the other relevant variables, the analyst would assign anappropriate probability distribution to each variable (commonly triangular or beta), and, where possible,specify the observed or supposed correlation between the variables. These distributions would then be"sampled" repeatedly - incorporating this correlation - so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram. Theresultant statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project’s “randomness" than the variance observed under the scenario based approach. These are often usedas estimates of the underlying "spot price" and volatility for the real option valuation as above; see Realoptions valuation: Valuation inputs. A more robust Monte Carlo model would include the possibleoccurrence of risk events (e.g., a credit crunch) that drive variations in one or more of the DCF modelinputs.[edit] The financing decision Main article: Capital structure Achieving the goals of corporate financerequires that any corporate investment be financed appropriately.[12] As above, since both hurdle rate andcash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact the valuation.Management must therefore identify the "optimal mix" of financing—the capital structures those results inmaximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)The sources of financing will, generically, comprise some combination of debt and equityfinancing. Financing a project through debt results in a liability or obligation that must be serviced, thusentailing cash flow implications independent of the project's degree of success. Equity financing is less riskywith respect to cash flow commitments, but resultsin a dilution of share ownership, control and earnings. The cost of equity is also typically higher than thecost of debt (see CAPM and WACC), and so equity financing may result in an increased hurdle rate whichmay offset any reduction in cash flow risk. Management must also attempt to match the financing mix to theasset being financed as closely as possible, in terms of both timing and cash flows. One of the main theoriesof how firms make their financing decisions is the Pecking Order Theory, which suggests that firms avoidexternal financing while they have internal financing available and avoid new equity financing while theycan engage in new debt financing at reasonably low interest rates. Another major theory is the Trade-Off Theoryin which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costsof debtwhen making their decisions. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining theright investment objectives, policy framework, institutional structure, source of financing (debt or equity)and expenditure framework within a given economy and under given market conditions. One last theoryabout this decision is the Market timing hypothesis which states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity. The dividend decisionMain article: The Dividend Decision Whether to issue dividends,[13] and what amount, is calculated mainlyon the basis of the company’s un appropriated profit and its earnings prospects for the coming year. Theamount is also often calculated based on expected free cash flows i.e. cash remaining after all businessexpenses, and capital investment needs have been met. If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdler ate, then - finance theory suggests - management must returnexcess cash to investors as dividends. This is the general case, however there are exceptions. For example,shareholders of a "Growth stock", expect that the company will, almost by definition, retain earnings so asto fund growth internally. In other cases, even though an opportunity is currently NPV negative,management may consider “investment flexibility” / potential payoffs and decide to retain cash flows; seeabove and Real options. Management must also decide on the form of the dividend distribution, generally ascash dividends or via a share buyback. Various factors may be taken into consideration: where shareholdersmust pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both casesincreasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see corporate action. Today, it is generally accepted that dividend policy is value neutral(see Modigliani-Miller theorem).
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