Real options method is one of the investment appraisal techniques for capital budgeting which can deal with the limitations of the Net Present Value (NPV) method. Real options method is a method of evaluating and managing strategic investments decisions in an uncertain business environment. Using real option methods has been recognized that the application of standard NPV techniques can lead to wrong conclusions in the presence of unrecognized embedded options. The central role of NPV techniques in financial decision making therefore makes it imperative that real option structures in investing opportunities are identified and accounted for. It turns out that real options can be found in most live environments where uncertainty or risk, waiting, investment irreversibility, growth opportunity, asymmetric information, staged investments, competitor response, economies of scale, project switching, suspension, abandonment and start-up are important. In fact, these include the full spectrum of investment decision making, including those concerning capital Continue reading
Financial Concepts
Ethical Issues in Cost Allocation
A cost is generally understood to be that sacrifice incurred in an economic activity to achieve a specific objective, such as to consume, exchange, or produce. All types of organizations- businesses, not-for-profits, governmental- incur costs. To achieve missions and objectives, an organization acquires resources, transforms them in some manner, and delivers units of product or service to its customers or clients. Costs are incurred to perform these activities. For planning and control, decisions are made about areas such as pricing, program evaluation, product costing, outsourcing, and investment. Different costs are needed for different purposes. In each instance, costs are determined to help management make better decisions. When incurred, costs are initially reviewed and accumulated by some classification system. Costs with one or more characteristics in common may be accumulated into cost pools. Costs are then reassigned, differently for specified purposes, from these cost pools to one or more cost objects. Continue reading
Relationship Between Financial Leverage and Risk
Not to be confused with operating leverage, financial leverage involves the use of debt in the firm’s financial structure. Though it may be operationally defined and measured in a variety of ways, it essentially entails the use of debt to extend the earning power of funds committed by the firm’s shareholders. When used properly financial leverage magnifies returns on committed funds. Because of the nature of financial leverage, it carries within it not only the general types of risk associated with operating leverage, but also two others that have rather specific implications. First, there is the risk of default-the inability to meet debt obligations as they come due. By definition, as financial leverage increases, cash flow requirements necessary to service additional debt increase as well. The risk of inadequate cash flow is, therefore, a primary concern in strategic decisions regarding financial structure. This, of course, suggests that liquidity and leverage Continue reading
Methods of Allocating Overhead Costs
Overhead cost is an ongoing expense of operating a business and is usually used to group expenses that are necessary to the continued functioning of the business, but cannot be immediately associated with the products/services being offered as in the costs do not directly generate profits. Overhead cost includes indirect product cost or indirect cost of responsibility center. Indirect product cost is known as manufacturing overhead whereas indirect cost of responsibility center is known as non-manufacturing cost. Manufacturing overhead is those manufacturing costs that are incurred to a variety of products. It cannot be traced to individual products like depreciation and insurance of manufacturing equipment, cost of occupying, managing and maintaining a production facility. Manufacturing overhead is the cost that could be traced to individual product but it is not worth the trouble to like cost of lubricants and glue used. Manufacturing overhead also include cost that is more appropriately Continue reading
Role of Stock Markets in an Economy
Financial market is one of the components of financial system. Financial market facilitates the efficient allocation of financial resources of the economy so as to achieve socially desirable and economically productive purposes. Existence of an efficient financial market is a pre requisite for promoting savings, investments and consequent economic growth. Financial markets are extremely important to the general health of an economy. The main function of financial system, viz. capital formation takes place practically in financial markets. Financial institutions work as financial intermediaries and establish link between suppliers and users of funds in financial market. Financial products, including the supply of credit, mortgages, company shares and insurance, are bought and sold in primary and secondary financial markets. Financial products and securities are first issued into primary financial markets, which is where all financial products originate and where contracts are first drawn up. Secondary markets exist to enable buyers and sellers Continue reading
Difference Between Money Market and Capital Market
In order to understand what the differences between things are you first need to understand what each of the items is. In this case before you can understand the difference between money market and capital market you are going to need to understand what money market is and what capital markets is. Once you understand the two items are it will be easier to see what the difference or differences are between the two markets. What is Money Market? Basically the money market is the global financial market for short-term borrowing and lending and provides short term liquid funding for the global financial system. The average amount of time that companies borrow money in a money market is about thirteen months or lower. Some of the more common types of things used in the money market are certificates of deposits, bankers’ acceptance, repurchase agreements and commercial paper to name a Continue reading