Financial_Decisions

FIRMS FINANCIAL DECISIONS As an individual or group of individuals are looking at either establishing a business or expanding on an existing business, several factors and processes in the decision making need to be considered and addressed. This is most important when starting or expanding a business funds may need to be acquired to meet expected growth. There are various ways that a firm can raise revenue. The most common way for a public firm is through stocks or bonds. Bonds allow a company to borrow money from investors and pay back the Principal by a specific future date or paid periodically through the period of the loan. The price of the bond varies inversely to the interest rate that is calculated by open market operations and the discount rate set by the Feds. The payments paid on a bond is a fixed amount. The price in which a bond is purchased determines its yield or interest rate. The lower the bond the higher the yield and visa versa when the higher the price of the bond the percentage of return is lower. An organization is given a bond rating by Moody’s and Standard & Poor’s. The quality of a bond is based on the rating that the firm is given based on their ability in paying back the loan. The value of the bond can be calculated by Bond value = Bond value (assuming no chance of default) - value of put . Another way to look at bond value is to base it on a companies asset and is calculated as Bond value = asset value - value of call on assets. The put value isn’t the easiest to calculate, therefore the best approach in finding a value for the company’s bond is by using the asset value approach. Bond valuation is the ability to calculate the present value of the interest to be paid on the loan and the value of the bond upon maturity. The value uses several factors which include the bond rating based on the firm’s ability to pay back the loan, the potential of the bond’s price appreciation, the company’s growth capabilities, and the market interest rates and their fluctuations over time in either going up or down. Systematic risk is also known as market risk and is impacted by the company’s uncontrollable ability to diversify its securities to market changes due to the forward markets as well as the spot market. There is no way that a company can eliminate forces in the market that is outside of the firm’s control. These market influences also include war, interest rate fluctuations, and recessions. Therefore, systematic risk will always impact the company’s return on its securities portfolio. Unsystematic risk is more specific and unique to a firm. This would include a company’s earnings, employees striking and other labor problems, and weather conditions. Unsystematic risk is specific to a particular market or company. A firm can diversify its securities portfolio to totally eliminate the impacts of unsystematic risk to its portfolio returns. The role of a pro forma financial statement in the financial planning process is to project future financial activity for a company. These projections look at both sales projections, income forecasts, various company expenses, such as salaries, benefits, operating expenses, etc. Both income statement and balance sheet accounts are detailed based on specific company projections and the industry. A pro forma financial statement is created to attach to a business plan when seeking investors and/or loans, proposed changes to current company’s operations, mergers or acquisitions, or when a firm announces to the public on its earnings based on various internal and external factors. The first process in preparing a pro forma financial statement is to research industry forecasts, current conditions in the industry, and competing companies within the industry. The one preparing the pro forma financial statement must calculate expected earnings or cash flow, assets and liabilities. Secondly, the preparer must create a Balance Sheet to reflect fixed assets, any current assets, liabilities, and shareholders‘ equity. The next step is to prepare an Income Statement that includes all projected sales revenue, cost of goods sold, losses both expected and unexpected, operating expenses, taxes, depreciation of assets, and any plant and equipment. The final process in preparing a pro forma financial statement is to create a Statement of Cash Flows. This statement should include net sales, cost of goods sold, gross profit from sales, operating expenses, and net income. The benefits that are gained in using a shorthand approach for estimating external funds is to acquire funds as needed not too much or too little. Also, the ability to project future fund needs over a period of time to level out debt to the firm. The most common Financial Leverage is debt-to-equity. If a company has too much debt, then the risks during down times in the market can expose the firm to bankruptcy. Financial leverage is the use of borrowed money generally to increase production volumes, thus increasing sales and earnings. Factors observed in determining leverage is debt, equity, assets, and interest expenses. Firm’s that have high fixed costs receive a greater increase in operating revenue when output is increased after meeting the breakeven point. The main reason for this is that costs are already incurred, causing sales after the breakeven tranfers to the operating income. A firm that is less leveraged during market down times can survive, whereas, a company that has too much debt is at risk of bankruptcy during the same period. Another major component to any business and investors in a business is the capital structure of the firm. Capital structure refers to the percentage of money or capital at work in a company. Analysts, investors, and executives often discuss a business’ capital structure and how it impacts earnings and returns on investments. The two forms of capital structure are equity capital and debt capital. Equity capital is the money generally received from stocks and is directly invested in the business. Another component of equity capital is retained earnings that represent profit and is used to strengthen the balance sheet that reflects growth for a company. Debt capital refers to the monies borrowed, such as bonds, that is also used in the operations of the business. Another form of capital is vendor financing that doesn’t cost the company anything. This is where the firm can sell product before paying the vendor. No steps should be overlooked due to an impact on returns or profits. In making financial decisions, a business must consider many factors that are important in obtaining investors in the firm, borrowing money, and to survive the economic downturns on a particular market. These factors include bonds, various risks, financial statements, estimating external funds, leverage, and capital structure of a company and market.