1 Assignment: Understanding the Concepts

Assignment: Understanding the Concepts

Tien Dao

Prof. Thomas Alexander, Ph.D.

Strayer University

2 Assignment: Understanding the Concepts

1. Imagine you are a small business owner. Explain how you will apply the concept of NPV / payback rule to make a good financial decision.

Net present value (NPV) and payback rule are both capital budgeting techniques. They are required to evaluate capital budgeting projects so proper wealth-maximizing decisions can be made. They reflect the time value of money since cash outlays for plant and equipment occur now, while the benefits occur in the future. The NVP method is considered as the best method to use to evaluate capital budgeting projects. That projects net present value is calculated as the present value of all cash flows for the life of the project less the initial investment or outlay. It considers the time value of money and includes all of the projects cash flow in the analysis. It also measures the projects dollar impact on shareholder wealth. As a small business owner, I will use NVP to have a better evaluation and comparison of the financial impact of different alternatives in a decision-making situation. This helps me to correctly indentify how each alternative would affect the companys revenues and costs, and then I can make my moves to get the best results. The payback period method does not consider the time value of money. It determines the time in years it will take to recover, or pay back, the initial investment in fixed assets. I can use this method to determine the project, which is suitable for my firm. With the small business I will choose the projects whose paybacks are less than a management-specified period. The reason is that, small businesses do not have a strong base financing, so they need their payback fast to reinvest and keep their business steadily.

2. Explain the advantages and disadvantages of debt financing and why an organization would choose to issue stocks rather than bonds to generate funds

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Debt Financing is a strategy that involves borrowing money from a lender or investor with the understanding that the full amount will be repaid in the future, usually with interest. Like other funding sources, debt financing also have advantages and disadvantages. Advantages: Control: Debt financing allows borrower to have control of their own destiny regarding their business. They do not have investors or partners to answer to and they can make all the decisions. They own all the profit they make. Retain profit: The lenders do not share in debtors profits. All debtors have to do is make their loan payments in a timely manner. Tax deduction: The interest on borrowed money, paid to the lender is tax-deductible. This means exemption from paying tax for the part of business income used to pay interest, lowering the tax liability of the business. Timely Payments: Timely repayment of debt enhances and improves the credit rating of the business, making it easier to obtain other types of financing in the future. Easy Administration: Debt financing is easy to manage and administer, and require no extensive or complex reporting requirements. Disadvantages: Repayment: A debt requires repayment irrespective of whether the debtor makes a profit or loss with the loan. High Cost: The fixed interest costs can raise the companys break-even point, or the point where no profit and no gain occurs.

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Restricted Cash Flow: Debt repayments are a fixed obligation regardless of profits, loss, or delayed payments. This raises the risk of insolvency for the business, especially during difficult financial periods. Risk Outlook: Debt financing increases the company's risk outlook, for higher the businesss debt-equity ratio, the more risky the company becomes for other lenders and investors.

A stock is a security that represents a person's share of ownership in a company. It represents a claim on part of the company's assets and revenues. A bond is a debt instrument in which a company uses to borrow money from an investor. To expand the business, managers try to raise capital from potential and willing investors by inviting them to purchase the company's stocks or bonds. There are several reasons that managers prefer issuing stock than bone like: Repaying the Principal, Interest, Ownership, and Trading.

Repaying the principal: Stock, which is not like bond, does not have a maturity period. The company is under no obligation to repay the principal amount paid to purchase the stock unless the company is terminating its operations. The company can invest the money obtained from stocks in long-term profitable investments. Interest: Managers ought to pay interest on bonds when it is due. With stock, a company will only be obliged to pay dividends only when the company makes profits. Ownership and trading: A stock gives an investor ownership rights, while a bond do not confer such rights. An investor with ownership rights can participate in the management of the company. Investor will use these rights to ensure that the risk on his funds is minimized. An

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investor can sell and purchase stocks on the stock market even when a company has not issued new stocks. This gives a stockholder freedom to buy and sell stocks when he deems so. Both of ownership and trading give more rights and freedom to investor, which will attract more investments for organization. 3. Discuss how financial returns are related to risk In investment risk and finance return are two different concepts, but cannot be integral. No matter what you decide to do with your savings and investments, your money will always face some risk. The more risk they face the more return you get. In order to receive an increased return from your investment portfolio, you need to accept an increased amount of risk. Modern portfolio theory (MPT) is a theory of finance which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, but collectively. In short-word, this can reduce the risk that you lose all your money in just one investment. When you diversify your investment, you can take the return to make up for the loss also can have profit. 4. Describe the concept of beta and how it is used Beta is the measure of an assets systematic risk. Beta is a measure of relative risk. Beta measures the volatility or variability of an assets returns relative to the market portfolio. Assets that are more volatile than the market, or equivalently, those that have greater systematic risk than the market, have betas greater than 1.0. Whatever the market return is, these assets average

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return are larger in absolute value. Assets that are less volatile than the market have betas less than 1.0. These assets returns are less in absolute value than those of the market. Beta has several practical uses in finance. It is used to determine investors required rate of return on investment. Beta also is used to develop estimates of shareholders required returns on their investments.

5. Contrast systematic and unsystematic risk

Unsystematic risk is the risk that can be diversified. That risk that is diversified away as assets are added to a portfolio is the firm- and industry-specific risk, or the microeconomic risk. There are several sources of risk, such as business risk, financial risk, event risk, liquidity risk.

On contract, systematic risk is the risk that cannot be eliminated through diversification. Diversification cannot eliminate risk that is inherent in the macro economy. Macroeconomic events-such as changes in GDP, war, major political events, rising optimism or pessimism among investors, tax increases or cut, or a stronger or weaker dollar etc.- have broad effects on product and financial markets. Even a well-diversified portfolio cannot escape these risks.

6. Imagine your manufacturing corporation has just won a patent lawsuit. After attorney and other fees, your corporation will have about $1 million. Explain how you plan to invest the money in order to diversify the risk and receive a good return. Support your decisions with concepts learned in this course.

With one million in hand, I will try to diversify this money in several different assets. I would like to take from 10-20% to invest in start-up firms, which have a potential to grow at 3040% per year. According to Jeffrey Sohl, director of the Center for Venture Research, he

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estimates that only 10-15% of private companies fit that description. So, until I find a potential one, I wont invest that money. Next, I want to take 40-45% to invest in Treasury bond. Those to bonds have low risk, which are a good long-term investment. Next, I will invest the rest to stock market, because I dont want my money be idle and pay tax for them. I want my money to move, use money make money. Of course, before investing I will have to study portfolio return and risk, the companies annual reports, analyze their financial statement etc. I would like to invest in low return stocks, which their risks are low. I also want to invest in potential stocks, which have higher risks.

References
Introduction to Finance: Markets, Investments, and Financial Management; Ronald W. Melicher, Edgar A. Norton; John Wiley and Sons, 2011 Harry M. Markowitz - Autobiography, the Nobel Prizes 1990, Editor Tore Frngsmyr, [Nobel Foundation], Stockholm, 1991. Koponen, Timothy M. 2003. Commodities in action: measuring embeddedness and imposing values. The Sociological Review. Volume 50 Issue 4, Pages 543 569

"Corporate Finance and Investment, 6th edition"; Richard Pike.; et al; 2009

DeThomas, Art. Financing Your Small Business: Techniques for Planning, Acquiring, and Managing Debt. PSI Research, 1992.

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W. Keith. The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital. Prentice Hall, 1990.

Smith, Richard L., and Janet Kiholm Smith. Entrepreneurial Finance. Wiley, 2000.

Van Note, Mark. ABCs of Borrowing. U.S. Small Business Administration, 1990.

http://finance.yahoo.com/education/beginning_investing/article/101171/Risk_and_Return