Business Financing and the Capital Structure
Explain the process of financial planning used to estimate asset investment requirements
for a corporation.
The process of asset investment valuation involves several valuation methods. Among them is
the internal rate of return (IRR). These is the rate of interest at which NPV (Net Present Value) is
zero of both the positive and negative cash flows from an investment. Internal rate of return is
used to analyze the profitability of an investment. If the internal rate of a new investment is in
excess of a required rate of return, then that’s a good investment but if the IRR goes below the
needed IRR then the project is not good and should be rejected (Brealey, Myers, and Allen,
2006). The other types of asset investment valuation are the NPV, accounting rate of return and
the discounted NPV.
Explain the concept of working capital management. Identify and briefly describe several
financial instruments that are used as marketable securities to park excess cash.
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Working capital is the net operating income after the current assets have been deducted from the
current liabilities. Current ratio is normally used to determine its liquidity. The ratio of 1:1 is the
recommended ratio.(Khan, 1993)
Marketable securities are segments of the financial markets. Money market instruments are also
referred to as the cash equivalents and they include all the short term, low risk, liquid or
marketable securities. The money market securities include the T-bills that investors buy at a
certain discount from the stated face value or maturity value. Sales of the bills are normally
conducted in an auction where competitive bids are placed by the investors. These bids can also
be non competitive. The minimum denominations are in $10000. The income on T-bills is not
taxable. CDs are certificates of time deposits with a bank. They are negotiable and issued in
denominations that are greater than $100000. CPs are commercial papers that are issued by large
firms to secure short term debts that are not secured. Their maturity period ranges up to to 270
days.
Assume that you are financial advisor to a business. Describe the advice that you would give to
the client for raising business debt using both debt and equity options in today’s economy.
Debt financing of a business using debt is one way of financing company debts using external
sources of funds. Debt financing may be from bank loans, private individuals or from investment
companies. The major advantage of using debt to finance business debts is that the internal
financial sources can be utilized for other purposes. When an investment is available that attracts
a higher receivable interest than the bank loan then it would be wise to put your money in the
investment and use the external debt to pay the business debts. Debt financing also improves the
firm’s credit rating. The use of debts in a firm allows it to be flexible and venture into other
Business Financing and the Capital Structure 3
growth projects. The major limitation of using debt to settle is the interest charged on the money
borrowed. It increases the cost of the investment which can discourage future use of debt in
settling business debts. (Vance, 2003)
Funding from Equity options entails funding from internal company sources. The advantage of
Equity funding is that the capital is available immediately since it’s sourced from within the
company’s internal reserves. The capital is interest free and it’s not normally repayable as it’s
mostly converted into shares or if it’s repayable then it will only be paid back when the firm
achieves profitability. The firm does not have to undergo rigorous credit worthiness checks and
procedures as the funding belongs to the shareholders of the company. The company can also
rely on the Equity funding in the event that it may need further borrowing. The major limitation
of Equity funding is that it’s expensive as it’s not tax-deductible. There is also no increase or
expansion of capital as the new capital rotates within the firm. Equity funding is also not flexible
as its limited to the availability of funds within the company’s reserves. Losses accruing to the
company are also not tax-deductible.
Explain why a business may decide to seek capital from a foreign investor indicating the
risk and rewards for such a decision. Provide support for rationale.
Capital from a foreigner investor is one way of financing company investment using external
sources of funds. Capital from a foreign investor may be from a private individual or from an
investment companies. The major advantage of using a foreign investor to finance an investment
is that the internal financial sources can be utilized for other purposes. When an investment is
available that attracts a higher interest than a bank loan can offer then it would profitable to put
the money in the investment and use the external funds from the foreign investor to buy the
Business Financing and the Capital Structure 4
investment or invest in the project. Investment financing from foreign investors helps to improve
the company’s credit rating. The use of foreign investors in a firm allows it to be flexible and can
venture into other profitable and long term growth projects. The major risks of foreign investors
are the high interest rates involved.
- Explain the historical relationship between risk and return for common stocks versus
corporate bonds. Explain how diversification helps in risk reduction in a portfolio. Support
response actual data and concepts learned in this course.
Corporate bonds often come with specific options attached. Callable bonds give the company the
option to buy back the bond from the current holder at a specified price while convertible bonds
entitles the bondholder the option of converting each bond into a certain number of equivalent
shares of stock. Common stock, also known as equity securities represent the original ownership
shares in a specified corporation. Each share entitles the owner to vote on matters of corporate
governance. Risky investment come with higher interest rates unlike the common stock whose
dividends is pegged on the profits of the company and are normally stable while fluctuating with
the profits earned. The risky shares have a higher interest but have no voting rights and they do
not fluctuate with the profits of the company.
Diversification helps in spreading the risk to different portfolios. When one kind of stock is
affected then other investments in different portfolios are not affected.
.
Business Financing and the Capital Structure 5
Reference
Khan, M. (1993). Theory & Problems in Financial Management. Boston: McGraw Hill
Higher Education.
Vance, D. (2003) Financial analysis and decision making: tools and techniques to solve
financial problems and make effective business decisions. New York: McGraw-Hill.
Brealey, A., Myers, S and Allen, F (2006) Principles of Corporate Finance, 8th Edition.
