1.

What are the four (4) major types of decisions that the finance manager of a
modern business firm be involved in?

Answer: 1. Capital Budgeting or Long term Investment Decision 2. Capital Structure or

Financing Decision 3. Dividend Decision 4. Working Capital Management Decision.

1. Investment decision - A financial decision which is concerned with how the

firm’s funds are invested in different assets.
- can be long-term or short-term.
A long term investment decision - is called capital budgeting decisions which involve
huge amounts of long term investments and are irreversible except at a huge cost.
Short-term investment decisions - are called working capital decisions, which affect day
to day working of a business. It includes the decisions about the levels of cash,
inventory and receivables.
A bad capital budgeting decision - normally has the capacity to severely damage the
financial fortune of a business.
A bad working capital decision - affects the liquidity and profitability of a business.
2. Give at least three (3) investing decisions that a finance manager
has to make.
1. Cash flows of the project- The series of cash receipts and payments over the life of
an investment proposal should be considered and analyzed for selecting the best
proposal.
2. Rate of return- The expected returns from each proposal and risk involved in them
should be taken into account to select the best proposal.
3. Investment criteria involved- The various investment proposals are evaluated on the
basis of capital budgeting techniques. Which involve calculation regarding investment
amount, interest rate, cash flows, rate of return etc. It is to be considered which
technique to use for evaluation of projects.
2. Financing Decision:
A financial decision - which is concerned with the amount of finance to be raised from
various long term sources of funds like, equity shares, preference shares, debentures,
bank loans etc. Is called financing decision. In other words, it is a decision on the
‘capital structure’ of the company.
Financing decisions - assert that the mix of debt and equity chosen to finance
investment should maximize the value of investments made.
- These decisions should consider the cost of finance
available indifferent forms and the risks attached to it.
Financing decisions - call for good knowledge of costs of raising funds, procedures in
hedging risk, different financial instruments and obligation attached to them.
Capital Structure Owner’s Fund + Borrowed
Financial risk - The risk of default on payment of periodical interest and repayment of
capital on ‘borrowed funds’.
Factors Affecting Financing Decision:
1. Cost- The cost of raising funds from different sources is different. The cost of equity is
more than the cost of debts. The cheapest source should be selected prudently.
2. Risk - The risk associated with different sources is different. More risk is associated
with borrowed funds as compared to owner’s fund as interest is paid on it and it is also
repaid after a fixed period of time or on expiry of its tenure.
3. Flotation cost - The cost involved in issuing securities such as broker’s commission,
underwriter’s fees, expenses on prospectus etc. Is called flotation cost. Higher the
flotation cost, less attractive is the source of finance.
4. Cash flow position of the business - In case the cash flow position of a company is
good enough then it can easily use borrowed funds.
5. Control considerations - In case the existing shareholders want to retain the complete
control of business then finance can be raised through borrowed funds but when they
are ready for dilution of control over business, equity shares can be used for raising
finance.
6. State of capital markets - During boom period, finance can easily be raised by issuing
shares but during depression period, raising finance by means of debt is easy.
3. Dividend Decision - A financial decision which is concerned with deciding
how much of the profit earned by the company should be distributed among
shareholders (dividend) and how much should be retained for the future contingencies
(retained earnings).
Dividend - refers to that part of the profit which is distributed to shareholders. The
decision regarding dividend should be taken keeping in view the overall objective of
maximizing shareholder s wealth.
Factors affecting Dividend Decision:
1. Earnings - Company having high and stable earning could declare high rate of
dividends as dividends are paid out of current and past earnings.
. Stability of dividends- Companies generally follow the policy of stable dividend. The
dividend per share is not altered in case earning changes by small proportion or
increase in earnings is temporary in nature.
3. Growth prospects - In case there are growth prospects for the company in the near
future then, it will retain its earnings and thus, no or less dividend will be declared.
4. Cash flow positions - Dividends involve an outflow of cash and thus, availability of
adequate cash is foremost requirement for declaration of dividends.
5. Preference of shareholders- While deciding about dividend the preference of
shareholders is also taken into account. In case shareholders desire for dividend then
company may go for declaring the same. In such case the amount of dividend depends
upon the degree of expectations of shareholders.
6. Taxation policy - A company is required to pay tax on dividend declared by it. If tax
on dividend is higher, company will prefer to pay less by way of dividends whereas if tax
rates are lower, then more dividends can be declared by the company.
4. Operating Decisions - is a broad-based function. Effective execution requires
managing and coordinating several tasks within the company, including managing
short-term investments, granting credit to customers and collecting on this credit,
managing inventory, and managing payables. Effective working capital management
also requires reliable cash forecasts, as well as current and accurate information on
transactions and bank balances. This also involves a number of activities related to the
firm’s receipts and disbursements of cash.

Liquidity

Management

Account Receivable

Management

Inventory
Operating Decisions
Management

Accounts payable
management

Understanding Working Capital

Working capital is the difference between a company’s current assets and its current
liabilities.

Current assets include cash, accounts receivable, and inventories.

Current liabilities include accounts payable, short-term borrowings, and accrued

liabilities.
Some approaches may subtract cash from current assets and financial debt from
current liabilities.

Why Working Capital Management is Important

Ensuring that the company possesses appropriate resources for its daily activities
means protecting the company’s existence and ensuring it can keep operating as a
going concern. Scarce availability of cash, uncontrolled commercial credit policies, or
limited access to short-term financing can lead to the need for restructuring, asset sales,
and even liquidation of the company.

Factors That Affect Working Capital Needs

Working capital needs are not the same for every company. The factors that can affect
working capital needs can be endogenous or exogenous.

Endogenous factors include a company’s size, structure, and strategy.

Exogenous factors include the access and availability of banking services, level

of interest rates, type of industry and products or services sold, macroeconomic
conditions, and the size, number, and strategy of the company’s competitors.

2. operating decisions that a finance manager makes

Managing Liquidity

Properly managing liquidity ensures that the company possesses enough cash
resources for its ordinary business needs and unexpected needs of a reasonable
amount. It’s also important because it affects a company’s creditworthiness, which can
contribute to determining a business’s success or failure.

The lower a company’s liquidity, the more likely it is going to face financial distress,
other conditions being equal.

However, too much cash parked in low- or non-earning assets may reflect a poor
allocation of resources.

Proper liquidity management is manifested at an appropriate level of cash and/or in the

ability of an organization to quickly and efficiently generate cash resources to finance its
business needs.

 
Managing Accounts Receivables

A company should grant its customers the proper flexibility or level of commercial credit
while making sure that the right amounts of cash flow in via operations.

A company will determine the credit terms to offer based on the financial strength of the
customer, the industry’s policies, and the competitors’ actual policies.

Credit terms can be ordinary, which means the customer generally is given a set
number of days to pay the invoice (generally between 30 and 90). The company’s
policies and manager’s discretion can determine whether different terms are necessary,
such as cash before delivery, cash on delivery, bill-to-bill, or periodic billing.

Managing Inventory

Inventory management aims to make sure that the company keeps an adequate level of
inventory to deal with ordinary operations and fluctuations in demand without investing
too much capital in the asset.

An excessive level of inventory means that an excessive amount of capital is tied to it. It
also increases the risk of unsold inventory and potential obsolescence eroding the value
of inventory.

A shortage of inventory should also be avoided, as it would determine lost sales for the
company.

Managing Short-Term Debt

Like liquidity management, managing short-term financing should also focus on making
sure that the company possesses enough liquidity to finance short-term operations
without taking on excessive risk.

The proper management of short-term financing involves the selection of the right
financing instruments and the sizing of the funds accessed via each instrument. Popular
sources of financing include regular credit lines, uncommitted lines, revolving credit
agreements, collateralized loans, discounted receivables, and factoring.

A company should ensure there will be enough access to liquidity to deal with peak
cash needs. For example, a company can set up a revolving credit agreement well
above ordinary needs to deal with unexpected cash needs.

 
Managing Accounts Payable

Accounts payable arises from trade credit granted by a company’s suppliers, mostly as

part of the normal operations. The right balance between early payments and
commercial debt should be achieved.

Early payments may unnecessarily reduce the liquidity available, which can be put to
use in more productive ways.

Late payments may erode the company’s reputation and commercial relationships,
while a high level of commercial debt could reduce its creditworthiness.

EXERCISE 1: WHAT TO DO
Answer the following:

1.What are the three forms of business organization? Provide examples in each form.

1. Sole Proprietorship - one person forms their own business, unlimited liability -
you can be sued for your business assets and personal assets.
-tend to be the smallest of businesses. Just one person running a business, perhaps
with a few employees. They have no bothered to incorporate.

Examples might be a plumber, florist, small shop owner, or bed and breakfast
operator.

2. Partnership –a collaboration of two or more people form a business and also with
unlimited liability.
Example: Shawarma Wrap brother two owners working together one person on
production side and one aslo on internal processing.

3. Corporation - separate legal entity, limited liability - only business can be sued
and not your personal assets. Subject to double taxation the company income is
taxed, when income is passed to shareholders there’s taxed again.
Example: ABS-CBN - the largest multimedia in a country operates in three segments,
TV and Studio, Pay TV Networks and New Business.

3. What are the primary advantages and disadvantages of sole proprietorships

and partnerships?
sole proprietorships
Advantage
 You're the boss.

 It's easy to get started.

  You keep all profits.

 Income from business is taxed as personal income.

 You can discontinue your business at will.

Disadvantages

 You assume unlimited liability.

 The amount of investment capital you can raise is limited.

 You need to be a generalist. Retaining high-caliber employees is difficult.

 The life of the business is dependent on the owner's.

Partnership
Advantages of Partnership

 Capital – Due to the nature of the business, the partners will fund the
business with start up capital. This means that the more partners there are,
the more money they can put into the business, which will allow better
flexibility and more potential for growth. It also means more potential profit,
which will be equally shared between the partners.

 Flexibility – A partnership is generally easier to form, manage and run. They
are less strictly regulated than companies, in terms of the laws governing
the formation and because the partners have the only say in the way the
business is run (without interference by shareholders) they are far more
flexible in terms of management, as long as all the partners can agree.

 Shared Responsibility – Partners can share the responsibility of the running

of the business. This will allow them to make the most of their abilities.
Rather than splitting the management and taking an equal share of each
business task, they might well split the work according to their skills. So if
one partner is good with figures, they might deal with the book keeping and
accounts, while the other partner might have a flare for sales and therefore
be the main sales person for the business.

 Decision Making – Partners share the decision making and can help each
other out when they need to. More partners means more brains that can be
picked for business ideas and for the solving of problems that the business
encounters.

Disadvantages of Partnership
  Disagreements – One of the most obvious disadvantages of partnership is
the danger of disagreements between the partners. Obviously people are
likely to have different ideas on how the business should be run, who should
be doing what and what the best interests of the business are. This can lead
to disagreements and disputes which might not only harm the business, but
also the relationship of those involved. This is why it is always advisable to
draft a deed of partnership during the formation period to ensure that
everyone is aware of what procedures will be in place in case of
disagreement and what will happen if the partnership is dissolved.

 Agreement – Because the partnership is jointly run, it is necessary that all

the partners agree with things that are being done. This means that in some
circumstances there are less freedoms with regards to the management of
the business. Especially compared to sole traders. However, there is still
more flexibility than with limited companies where the directors must bow to
the will of the members (shareholders).

 Liability – Ordinary Partnerships are subject to unlimited liability, which

means that each of the partners shares the liability and financial risks of the
business. Which can be off putting for some people. This can be countered
by the formation of a limited liability partnership, which benefits from the
advantages of limited liability granted to limited companies, while still taking
advantage of the flexibility of the partnership model.

 Taxation – One of the major disadvantages of partnership, taxation laws

mean that partners must pay tax in the same way as sole traders, each
submitting a Self Assessment tax return each year. They are also required
to register as self employed with HM Revenue & Customs. The current laws
mean that if the partnership (and the partners) bring in more than a certain
level, then they are subject to greater levels of personal taxation than they
would be in a limited company. This means that in most cases setting up a
limited company would be more beneficial as the taxation laws are more
favourable (see our article on the Advantages and Disadvantages of a
Limited Company).

 Profit Sharing – Partners share the profits equally. This can lead to
inconsistency where one or more partners aren’t putting a fair share of effort
into the running or management of the business, but still reaping the
rewards.

Taxation and liability – are several levels of advantages and disadvantages of

partnership in terms of a business undertaking.
 4. Why is the corporate form superior when it comes to raising cash?
Answer: Corporations are easier to raise money because they are held to stricter
financial requirements by the Securities Exchange Commission. With these
stricter regulations, investors will feel at ease investing in the organization. limited
liability separation of ownership and management and transfer of ownership is
easy.
5. What are financial markets?
Answer:
Financial markets-refer broadly to any marketplace where the trading of
securities occurs, including the stock market, bond market, forex market, and
derivatives market, among others. Financial markets are vital to the smooth
operation of capitalist economies.

Financial markets serve six basic functions. These functions are briefly listed below:

Borrowing and Lending: Financial markets permit the transfer of funds (purchasing
power) from one agent to another for either investment or consumption purposes.

Price Determination: Financial markets provide vehicles by which prices are set both for
newly issued financial assets and for the existing stock of financial assets.

Information Aggregation and Coordination: Financial markets act as collectors and

aggregators of information about financial asset values and the flow of funds from
lenders to borrowers.

Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.

Liquidity: Financial markets provide the holders of financial assets with a chance to
resell or liquidate these assets.

Efficiency: Financial markets reduce transaction costs and information costs.

In attempting to characterize the way financial markets operate, one must consider both
the various types of financial institutions that participate in such markets and the various
ways in which these markets are structured.