Capitalization is the total amount of a company’s long-term financing. Such financing may include retained earnings, preferred and common stock and other forms of long-term debt (bonds and debentures). Capitalization can be distinguished from capital structure. Capital structure is a broad term and it deals with qualitative aspect of finance. While capitalization is a narrow term and it deals with the quantitative aspect. The two main theories of capitalization which are used to determine the amount of capitalization are as follows: 1. Cost Theory of Capitalization According to the cost theory of capitalization, the value of a company is arrived at by adding up the cost of fixed assets like plants, machinery patents, etc., the capital regularly required for the continuous operation of the company (working capital), the cost of establishing business and expenses of promotion. The original outlays on all these items become the basis for calculating the capitalization Continue reading
Financial Management Concepts
Why Wealth Maximization is Considered to be Better Operating Goal?
The wealth maximization objective is almost universally accepted goal of a firm. According to this objective, the managers should take decisions that maximize the shareholders’ wealth. In other words, it is to make the shareholders as rich as possible. Shareholders’ wealth is maximized when a decision generates net present value. The net present value is the difference between present value of the benefits of a project and present value of its costs. A decision that has a positive net present value creates wealth for shareholders and a decision that has a negative net present value destroys wealth of shareholders. Therefore, only those projects which have positive net present value should be accepted. For example, suppose a firm invests $ 10,000 in a project that generates net cash flow $ 3,000 each year for five years. If the firm requires 10% return on its capital, the net present value of the Continue reading
The Concept of Securitization
Securitization is a process by which identified pools of receivables, which are usually illiquid on their own, are transformed into marketable securities through suitable repackaging of cashflows that they generate. The Broader Meaning of Securitization Securitization is the process of commoditization. The basic idea is to take the outcome of this process into the market, the capital market. Thus, the result of every securitization process, whatever might be the area to which it is applied, is to create certain instruments, which can be placed in the market. Securitization is the process of integration and differentiation: The entity that securitizes its assets first pools them together into a common hotchpot (assuming it is not one asset but several assets, as is normally the case). This process of integration. Then, the pool itself is broken into instruments of fixed denomination. This is the process of differentiation. Securitization is the process of de-construction Continue reading
The Concept of Time Value of Money
The concept of time value of money suggests that the money received at different point of time has different values. The financial manager must appreciate this fact and understand why they are different and how they are made comparable. Time value of money is a concept to understand the value of cash flows occurred at different point of time. If we are given the alternatives whether to accept $ 100 today or one year fro now, then we certainly accept $ 100 today. It is because there is a time value to money. Every sum of money received earlier has reinvestment opportunity. For example, if we deposited $ 100 in saving account at 5% annual rate of interest, it will increase to $ 105 at the end of one year. Money received at present is preferred even if we do not have reinvestment opportunity. The reason is that the money Continue reading
Audit Risk – Definition, Formula and Models
Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. In simple terms, audit risk is the risk that an auditor will issue an unqualified opinion when the financial statements contain material misstatement. ISA 200 states that auditor should plan and perform the audit to reduce audit risk to an acceptably low level that is consistent with the objective of an audit. (Auditing and Assurance Standard) AAS-6(Revised), “Risk Assessments and Internal Controls”, identifies the three components of audit risk i.e. inherent risk, control risk and detection risk. Audit Risk Model: AR = IR x CR x DR Where, AR= Audit risk (the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated) IR = Inherent risk (the risk that an assertion is susceptible to a material misstatement, assuming there Continue reading
Factors to Consider when Choosing a Source of Finance
There are many sources of finance available to a business. Finance is needed for several purposes and different purposes need sources of finance which are most suitable to them. When choosing an appropriate source of finance some factors have to be considered. The factors that need to be considered when choosing an appropriate source of finance are: The amount of money needed: This is the amount of finance the organisation wants to raise. Not all sources of finance provide all amounts of funds. Some sources are notable to raise large amounts of funds whereas others are not flexible enough to put up for the small sum of money the business requires. Therefore it is necessary to identify the amount of money needed by the company to choose a suitable source of finance. For example borrowing a commercial loan for a small and short-term cash-flow problem is unwise because loans may Continue reading