LADOKE AKINTOLA UNIVERSITY OF TECHNOLOGY SCHOOL OF POSTGRADUATE STUDIES
MASTER IN BUSINESS ADMINISTRATION ( MBA 1)
ASSIGNMENT ON BASIC FINANCIAL MANAGEMENT (COURSE CODE:MGS 703)
6TH MARCH, 2010.
SUBMITTED BY: EDOMWONYI OMOSUYI.
1
Question No.1 For the purpose of making an informed decision in an organization, a financial manager will be concern with an investment, financing and dividend decision. You are required to mention and explain vividly the type of forecast and present information that will be necessary under each of the decision mentioned.
Solution:
The Modern approach to financial Management is concerned with the solution of Major problems like Investment , financing and dividend decisions of financial operations in a business enterprise. These functions of a financial Manager must be evaluated in line with the overall objective of shareholders, for wealth maximization. Thus, the type of forecast and information crucial to making financial management decisions are explained as follows:
1. INVESTMENT DECISION:
2
This is also known as the Effective Utilization of funds or Capital Budgeting . It involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future.
Two important aspects of investment decision are: (a) the evaluation of the prospective profitability of new investments, and (b) the measurement of cut-off rate against that the prospective returns of new investment could be compared. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Because of the uncertain future, investment decisions involve risk. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision for investment ,managers do see where to commit funds when an asset becomes less productive or non-profitable.
There is a broad agreement that the correct cut-off rate is the required rate of return or the opportunity cost of capital. However, there are problems in computing the opportunity cost of capital in practice from available data and information. A decision maker should be aware of these problems.
The investment decision is one of the most significant decision areas. It has effect on future profitability because it results in an increase in revenue and efficiency and a reduction in cost.
The important steps in the decision process are:
1. Identifying possible Investments Projects 2. Identifying Possible alternatives to the project being evaluated. 3. Acquiring relevant data on the project under consideration. 4. Evaluating the Projects from the data assembled. 3
5. Project selection 6. Project Implementation 7. Project Monitoring and Control.
Project Evaluation criteria methods include: 1.Payback period 2. Accounting rate of return 3. Discounted cash flow techniques
2. FINANCIAL DECISIONS:
This involves making decisions concerned with the raising of funds to finance assets in a business enterprise. The Financial manager must decide when, where and how to acquire funds to meet the firm’s investment needs. The central issue before him or her is to determine the proportion of equity and debt. The mix of debt and equity is known as the firm’s capital structure. The Manager must strive to obtain the best financing mix or the optimum capital for his or her firm. The firm’s capital structure is considered to be optimum when the market value of shares is maximized. The use of debt affects the returns and risk of shareholders; it may increase the return on equity funds but it always increases risk. A proper balance will have to be struck between return and risk. When the shareholders’ return is maximized with minimum risk, the market value per share will be maximized and the firm’s capital structure would be considered optimum. Once the financial manager is able to determine the best combination of debt and equity, he or she must raise the appropriate amount through the best available sources. In practice, a firm considers many factors, such as control, flexibility loan convenience, legal aspects etc. in deciding its capital structure.
4
A company can acquire a capital asset through any of the following;
(i ) Utilization of its internal resources to buy the asset or equipment. (ii) Raising cash to buy the asset or equipment (iii)Buying the equipment under a hire purchase agreement (iv)Buying the equipment under a leasing agreement.
Apart from using internally generated cash resources, cash can be raised to buy a capital asset through ordinary shares, preference shares , Loan Stock debentures, Convertible securities and term loans.
3. DIVIDEND DECISION
In corporate finance ,dividend decision is a decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company’s stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay.
There are three main factors that may influence a firm’s dividend decision:
• Free-cash flow • Dividend Clienteles 5
• Information Signaling
The free cash flow theory of dividends. Under this theory, the dividend decision is very simple. The firm simply pays out, as dividends, any cash that is surplus after it invests in all available positive net present value projects. A key criticism of this theory is that it does not explain the observed dividend policies of real world companies. Most companies pay relatively consistent dividends from one year to the next and managers tend to prefer to pay a steadily increasing dividend rather than paying a dividend that fluctuates dramatically from one year to the next. These criticisms have led to the development of other models that seek to explain the dividend decision.
Dividend Clienteles. A particular pattern of dividend payments may suit one type of stock holder more than another. A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from employment may prefer to avoid dividend due to their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, a firm may be able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies. A key criticism of the idea of dividend clientele is that investors do not need to rely upon the firm to provide the pattern of cash flows that they desire. An investor who would like to receive some cash from their investment always hast the option of selling a portion of their holding. This argument is even more cogent in recent times, with the advent of very low-cost discount stockbrokers. It remains possible that there are taxation- based clienteles for certain types of dividend policies. Information Signaling
6
A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm’s future propects.Many earlier studies had shown that stock prices tend to increase when an increase in dividend is announced and tend to decrease when a decrease or omission is announced. Miller and Rock pointed out that this is likely due to the information content of dividends. When investors have incomplete information about the firm( perhaps due to opaque accounting practices) they will look for other information that may provide a clue as to the firm’s future prospects. Managers have more information than investors about the firm and such information may inform their dividend decisions. When managers lack confidence in a firm’s ability to generate cash flows in the future they may keep dividend constant, or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm( e.g. A full order book )are more likely to increase dividends. Investors can use this knowledge about managers’ behavior to inform their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividend do not meet expectations. This, in turn, may influence the dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firm, this also tend to lead to a dividend policy of a steady , gradually increasing payment. Nature of dividend decision ; The dividend decision of the firm is crucial for the finance manager because it determines : 1. The amount of profit to be distributed among the shareholders and 2. The amount of profit to be retained in the firm. There is a reciprocal relationship between cash dividends and retained earnings. While taking the dividend decision the management takes into account the effect of the decision on the maximization of shareholders ‘ wealth. Maximizing the market value of shares is the objective. Dividend pay or retention is guided by this objective. A company should look at a number things in determining their dividend decisions. The following factors should be considered. 1. Financial needs of the firm 7
2. Liquidity 3. Access to borrowing 4. Access to the capital market 5. Control 6. Restriction in loan agreement or Bond Indenture 7. Nature of shareholders and their desires for dividend 8. Legal Consideration 9. Stability of dividends. 10. Accessing any information that can affect market price e.g. security reports, expectations of investors, information effect of a change in dividend, etc.
The Risk and Uncertainty In Investment Decisions (Forecast).
Investment decision involves some risk or uncertainty because it is impossible to predict accurately what will happen in the future.
Risk is a variable that is likely associated with future returns from a project. Risk and uncertainty are used interchangeably .Strictly, risk is a situation where the future outcome is unknown, but the likelihood of various possible future outcomes may be assessed with some degree of confidence ,probably based on knowledge of past or existing events. In other words, probabilities of possible outcome can be estimated. Whereas uncertainty is a situation where the future outcome cannot be predicted with any degree of confidence from knowledge of past or existing events, so that no probability estimate are available.
Business risk is the potential variability of earnings caused by the nature and type of business risk which are as follows: 8
1. General Uncontrollable factors affecting the whole economy. This includes economic and political factors(internal and external).government monetary and fiscal policies, social conditions,etc. 2. The inherent risk of the industry or market itself; for instance, an industry with constant change in technology is a risky industry.Furthermore,there might be changes in operational cost in the industry. 3. Company risk. This includes : a. The stage of the company’s product life circle. Every product has a life circle, and the classical product life cycle consist of four stages namely: Introduction, growth, maturity and decline. b. Operating Risk, that is , proportion of fixed cost in total cost. An investment involving a high proportion of fixed cost will need to achieve greater sales volume just to break even and so the business risk will be higher. c. Change in Management, strike, fire and other factors affecting the company directly.
METHODS OF TREATING RISK OR UNCERTAINTY 1. Non probability based approach pay back period risk adjusted discount rate approach certainty equivalent cash flow approach sensitivity analysis 2. Probability based approach 9
3. Simulation Approach.
Question No.2 What are the types of capital a limited liability Company may issue. Explain this In conjunction with the funds that can be obtained in money and capital market. Solution:
There are various forms of finance in the money and capital market ready for sourcing By those interested and they are of three (3) types:
Long term source Medium term source Short term source.
LONG TERM SOURCE: 1. Ordinary shares: This is an investment by members of the organization who hope to reap yearly dividends from positive operation results, they have residual claims on the income of the company after all expenses and preferred dividends have been settled. 2. Preference Shares: They are long term sources of operating fund. They carry fixed interest rates or dividend which must be settled every year irrespective of the achieved trading result and it must be settled. 3. Debenture: They are called promissory notes; they thus provide needed operating funds for the issuing company. They are always for a period of time or seven (7) years before they are instamentally referred.
10
4. Terms Loan: They are usually for establishment of projects and are provided by development finance houses like banks for industry urban development banks they provide initial capital for the purchase of relevant operating fixed asset. 5. Reserve: These are huge operating profit funds retained or distributed to providers of operating capital members as dividend however, when the need for serious and very profitable expansion programme or establishment of a new venture are embarked upon. 6. Factoring: 7. Hire Purchase 8. Equipment hiring: 9. Directors Loans 10.Retained Earnings:
MEDIUM TERM SOURCE Bank Loans Hire Purchase Banks are known to fund medium term operations of corporate organizations. These loans have tenors ranging from 6 months to 15 months . Regular interests payments are required to enable the banks continue to advance more funds. Hire purchase source assets like goods and equipment are delivered to an organization in return for the undertaking to pay agreed amount at specified intervals within a certain period of time. At the completion of Payment the vendor has no more claims or rights over the assets. SHORT TERM SOURCES: Trade Credits 11
Deferred Income Accorded Expenses Bank Finances Bonds and guarantees Commercial Papers or bank acceptance
These sources of business finance are normally for 30 days period though they could stretch to 60 days if there are arrangement to that effect with the providers of the credit. In manufacturing environment ,raw materials could be sourced from those who have them with the promise to pay them after 30 days of delivery. This way, the factory is kept running uninterrupted if the supply chain is properly oiled. Bank finance equally bank grants some funds for business houses to operate on reveling scheme arrangement without going into tedious mortgage arrangements. These issues depend on the rating the bank has given to such organization in Nigeria. Commercial papers or bank acceptance are arranged under very heavy interest charge for companies to meet their short term financial obligation default penalties are heavy hence ,it’s necessary to meet with the obligation at due rates. Bonds and guarantees are the assurance given to the company giving out a contract job that the contractor is capable of carrying out the specified jobs at the stated amount and that payment therefore can be made at relevant times. This is a sort of comfort guarantees to the organization giving out the contract to make advance payments to ensure that the contractor which has been adjudged compliment can have enough funds to complete the job on schedule.
12
Reference.
Books: R.A Olowe:
Financial Management Concept, analysis and capital Investment.
Khan and Jain: James van Horne:
Financial Management
Websites: htttp://www.scribd.com/doc/2058982/FM-case Study-Final-Project. http://www.dividendmatter.com 13
14
