Business Financing and the Capital Structure - Essay Example

a) Financial planning is a process that every firm must undertake before starting any new project or expansion project. The process of financial planning starts with formulating pro-forma sales forecast for the next few years (Besley, Brigham, 2000). Based on your sales estimates the company will determine how much and which specific assets the firm will need to meet those sales objectives. Lastly, the firm will decide which method of financing the organization will use to acquire the necessary assets to meet with production demands.

Consequently an organization can use the available information in order to create the projected income statements and balance sheets as well as estimating the earnings per share, dividends per shares, as well as forecasting key financial ratios and measures in order to determine the viability of the new project. Afterwards the pro-forma financial statements and ratios are estimated management will want to know how realistic those results are, which steps are necessary to attain expected results and what impact changes in projected operations would have on our estimates.

At this stage the firm will enter into the financial control phase in which firms will be concerned with implementing steps needed to meet those financial plans as well as adjusting the process to meet your objectives and dealing with feedback in order to ensure that the firm's overall goals are achieved. b) The concept of working capital management involves the process of short-term financial management of current assets and liabilities in order to achieve the companies’ objectives at the lowest costs possible to the company and maximize profitability based on internal financing policy.

Some of the short term marketable securities used by firms to invest excess cash on hand which are near-cash equivalents are: U.S. Treasury Bills - Considered nearly risk-free investments instruments issued by the U.S. government with maturity of 91 days to 1 year and a low yield. Commercial Paper- unsecured short-term issued by a private corporation with a maturity date of less than 270 days. Typically issued at a discount based on prevailing market interest rates. Money Market Fund- a type of unsecured mutual fund characterized by low-risk, low-return on investment, but higher than U.S. T-Bills 2) A firm's capital determines the combination of debt and equity used to finance a firm.

The type of capital structure of a firm will determine the inherent risk profile of a firm's common stock and therefore will affect the rate of return required by investors and the stock's price. The capital structure policy is a trade-off between risks and returns. By utilizing more debt the firm increases overall financing risks, but leads to a higher rate of return versus using equity financing. Using equity will decrease overall risks, but will lead to a dilution of equity ownership therefore leading to lower return on investment for shareholders.

The four main factors influencing a firm's decision to use debt or equity for capital investment are: Business risk- the greater the business risk, the lower amount of debt that might be optimal. Company’s tax position-If the firm has enough profits the firm can use interest expense as a means to reduce tax expense, therefore increasing realized income and consequently lowering the effective cost of debt. The company's income must not be sheltered by other tax deductions such as accelerated depreciating of certain assets or tax loss carryovers, since the tax rate will already be low and increasing debt load might actually increase the firm's effective tax rate.

Financial flexibility-the ability of the firm to raise capital on reasonable terms regardless of adverse market conditions. Managerial attitude- How conservative or aggressive or conservative the firm's management is towards borrowing and the firm’s target capital structure. 3) A business might seek a capital investment from foreign investors when other options have been discarded. Money from a foreign investor is as good as cash from American investors. There are pros and cons associated with seeking investment from a foreigner.

An advantage of foreign investors is that they are willing to accept lower equity participation for their investment. Two risks associated with accepting a foreign investor are exchange rate risk and cultural risk. Cultural risk occurs when the investor wants to be an active partner and his cultural conflicts with the American way of doing things. 4) Whether a company decides to invest in bonds or stocks depends on the manager’s attitude towards risks and the capital investment policy. In the case of stocks the company takes a stake in the ownership in the company.

In return they share a stake in the profits or losses of the company as it directly impacts the value of their stock investment. Furthermore, the company can also receive dividend income if declared which increases the possible rewards in return for the inherent risks related to the stock investment. When a firm invests in a corporate bond the company is providing a type of loan to a company for a specific amount of time at a fixed interest with the principal being returned after the bond reaches maturity.

The investing firm does not have any ownership stake on the bond issuing company, so when the company reports profits the firm will have no participation on those gains. This eliminates the inherent stock market risks which could cost the investing firm if the stock loses value. References Besley, S., Brigham, E. (2000). Essential of Managerial Finance (12th ed.). Forth Worth: The Dryden Press.