The cost of equity will rise by an amount just sufficient to offset any possible saving or loss. The supply of debt is determined by the lenders. The optimal level is simply the maximum amount of debt which lenders are prepared to subscribe in any given circumstances. For example, level of inflation, rate of economic growth, level of profits etc. The investors will exercise their own leverage by mixing their own portfolio with debt and equity. They call this the Arbitrage process. Under these conditions of investments the average cost of capital is constant. If two different firms which same level of business risks but with levels of gearing sold for different values, then shareholders would move from overvalued firm to the undervalued firm and adjust their level of borrowings through the market to maintain financial risk at the same level. The shareholders would increase their income through this method. Continue reading
Financial Management Concepts
Cost of Retained Earnings
The companies do not generally distribute the entire profits earned by them by way of dividend among their shareholders. Some profits are retained by them for future expansion of the business. Many people feel that such retained earnings are absolutely cost free. This is not the correct approach because the amount retained by company, if it had been distributed among the shareholders by way of dividend, would have given them some earning. The company has deprived the shareholders of this earnings by retaining a part of profit with it. Thus, the cost of retained earnings is the earning forgone by the shareholders. In other words, the opportunity cost of retained earnings may be taken as the cost of the retained earnings. It is equal to the income that the shareholders could have otherwise earned by placing these funds in alternative investments. For example, if the shareholders could have invested the Continue reading
Accounting Rate of Return (ARR) Method of Capital Budgeting
Accounting Rate of Return (ARR) Method Various proposals are ranked in order to rate of earnings on the investment in the projects concerned. The project which shows highest rate of return is selected and others are ruled out. The Accounting Rate of Return is found out by dividing the average income after taxed by the average investment, i.e., average net value after depreciation. The accounting rate of return, thus, is an average rate and can be determined by the following equation. Accounting Rate of Return (ARR) = Average income / Average investment There are two variants of the accounting rate of return; Original Investment Method, and Average Investment Method. 1. Original Investment Method. Under this method average annual earnings or profits over the life of the project are divided by the total outlay of capital project, i.e., the original investment. Thus ARR under this method is the ratio between average Continue reading
Asset Securitization – Meaning, Process, Parties Involved and Benefits
Asset securitization is way of financing for lenders to obtain funds in the capital markets for the origination of consumer and business loans. It is different from the traditional way of financing, where lenders finance loan origination’s with deposits. Started in 1970, the asset securitization market had a remarkable history of growth and development. By 2000, it became the largest sector of the U.S fixed income securities market. In matured capital market, asset securitization has proven to be an efficient way of financing in that it reduces the ultimate funding cost for the borrower, improves the financial operation for the lender and provides diversified investment products for the investor. The Process of Asset Securitization In today’s world, asset securitization means a process by which one entity pools its interest in a series of identifiable future cash flows and then transfers the claims on those future cash flows to another entity Continue reading
Financial Analysis with the DuPont Model
The dynamic environment of the world today suggests that one should be apt enough to apply his skills immanent to a system and also external with respect to credit management function. These functions include financial planning, plausibility of a defined business strategy or whether a particular merger or acquisition is feasible or not. This has to be done in a rapid yet meaningful way so as to be of immediate need to a particular firm or investor. There are basically four major reasons for an effective financial statement analysis. These have been mentioned as follows: It is useful for long-run business viability so as to determine whether a firm would be able to provide adequate business return when compared to the amount of risks taken. This is essential for outside investors. It is also used by creditors so as to find out whether a potential buyer has the capability to Continue reading
Approaches to Working Capital Financing
Having dealt with the size of investment in current assets, the methods of financing of working capital needs our attention. Working capital is financed both internally and externally through long-term and short-term funds, through debt and ownership funds. In financing working capital, the maturity pattern of sources of finance depended much coincide with credit period of sales for better liquidity. Generally, it is believed that funds for acquiring the fixed assets should be raised from long term sources and short-term sources should be utilized for raising working capital. But in the recent modern enterprises, both the types of sources are utilized for financing both fixed and current assets. There are basically three approaches to financing working capital. These are: the Hedging approach, the Conservative approach and the Aggressive approach. Hedging Approach: The hedging approach is also known as the matching approach. Under this approach, the funds for acquiring fixed assets Continue reading