MNGT 422 –Managerial Finance 2

2. Research also on the following topics:

a. Cost of Capital
b. Dividends and Policy
c. Short Term Financial Management
d. Payout Policy and Capital Structure
e. Risk Management
f. Financial Palnning
Submit at least 5 pages on each subject and on the last page, write a narrative or reaction on what
you have learned from this research work.

1. Research on the overview of Managerial Finance.

Managerial Finance

It deals with the investment decision and the financing decision and the whole operation of the
firm form its own point of view. Decision-making and proper resource management are used to
create and maintain value through application of financial principles within a corporation.

Managerial finance is concerned with the duties of the financial manager in the business firm.
Financial managers actively manage the financial affairs of any type of businesses –financial and
nonfinancial, private or public, large and small, profit-seeking and not-for-profit. They perform
such varied financial tasks as planning, extending credit to customers, evaluating proposed large
expenditures, and raising money to fund the firm’s operations. In recent years, the changing
economic and regulatory environments have increased the importance and complexity of the
financial manager’s duties. As a result, many top executives have come from the finance area.

The Financial Manager's Responsibilities

 Forecasting and planning: Strategic planning, pro-forma financial statements, cash budgeting.

 Major investment and financing decisions: Capital budgeting, capital structure and cost of
capital decisions.

 Coordination and control

 Dealing with financial markets: Raising funds in the money and capital markets.

The size and importance of the managerial finance function depends on the size of the company.
In small firms, the financial decisions are usually made by the accounting department. As a firm
grows, a separate department is created for the finance function.

People in all areas of responsibility within the firm must interact with finance personnel and
procedures to get their jobs done. For financial personnel to make useful forecasts and decisions,
they must be willing and able to talk to individuals in other areas of the firm. The managerial
finance function can be broadly described by considering its role within the organization, its
relationship to economics and accounting, and the primary activities of the financial manager.

2. Research also on the following topics:

a. Cost of Capital

Cost of Capital

Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of
return that could have been earned by putting the same money into a different investment with
equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make
a given investment.

Cost of capital is determined by the market and represents the degree of perceived risk by
investors. When given the choice between two investments of equal risk, investors will generally
choose the one providing the higher return.

Investors frequently borrow money to make investments, and analysts commonly make the
mistake of equating cost of capital with the interest rate on that money. It is important to
remember that cost of capital is not dependent upon how and where thecapital was
raised. Put another way, cost of capital is dependent on the use of funds, not the source of funds.

The difference between cost of equity and cost of debt

Cost of Capital
Cost of Equity Cost of Debt
If the company’s only source has been
The cost of debt refers to situations
equity put in by the company’s owners or
where the company has funded itself
shareholders, then you can simply
through debt alone. This would mean the
calculate the cost of capital by analyzing
company has financed all of its operations
the cost of equity. The cost of equity then
simply by lending from creditors. By
represents the compensation the market
calculating the cost of debt, you’ll receive
demands in exchange for the company’s
the cost of capital.
assets.
The companies decrease the overall cost of capital in both cases and what it means for the
business’ finances because they are aiming for a balanced mixture of debt and equity financing is
to decrease.

Debt financing is more tax-efficient to equity financing. The higher the level of debt, the higher
the leverage, which means higher interest rates due to increased risk. Therefore, a mixture of
both financing sources often provides the lowest cost of capital.

The definition of weighted average cost of capital (WACC)

As we mentioned above, company financing hardly ever relies on a single source. Therefore, the
cost of capital is often calculated by using the weighted average cost of capital (WACC). Since it
analyses both equity and debt financing, it provides a more accurate picture of how much interest
the company owes for each operational currency it finances (per each US dollar, British pound
and so on).

It gives a proportional weight to the different costs of capital, such as equity and debt, to derive a
weighted average cost. Each capital component will be multiplied by its proportional weight and
the sums will be added together.

When companies refer to the cost capital, they often would have calculated it based of the
WACC method. The following sections will look at the calculations methods in more detail, but
here’s a quick example of what WACC means.

Consider that a business has a lender, which requires a 10% return on its money. Furthermore,
the shareholders of the business require a further minimum of a 20% on their investments. On
average then, the company’s capital must have a return of 15% to satisfy both the debt and equity
holders, meaning the WACC or cost of capital is 15%.

This means the company would need to invest in projects that would provide an annual return of
15% in order to continue paying back to both their shareholders and creditors.

WHY SHOULD A BUSINESS CALCULATE THE COST OF CAPITAL?

Before we look at the formulas to calculate the cost of capital in more detail, it is important to
understand why it is essential to do the maths. As mentioned briefly above, the cost of capital
can be an essential part of a business’ financial decision-making.

Since cost of capital provides the business with the minimum rate of return it needs on its
investments, it is an essential part of budgeting decisions. By knowing the cost of capital, the
business can make better decisions on its future investments and other such financing options.

For example, it can help the business to find projects that will generate appropriate gains for the
business. On the other hand, it can prevent the business from making an investment, which
wouldn’t provide quick enough returns for the company.

Therefore, a cost of capital reveals the business plenty about the type and value of its past and
future investments. If a business doesn’t know the rate of return or the cost of financing its
operations, it can’t expect much business success.

In addition, it’ll help better attract new investors for the business, as they are able to understand
the kind of rate of return they will receive. It also ensures the business doesn’t go after creditors
or investors it cannot repay at the current time.

Overall, understanding the cost of capital will boost the business’ financial decision-making.
Because the cost of capital is used to design the market fluctuations, it can help build better
financial structures.

In some instances, businesses even use it to better understand financial performance and to
evaluate whether the management is performing well enough.

CALCULATING THE COST OF CAPITAL

Now that you understand the definition of cost of capital and the importance of calculating it, it’s
time to look at the calculating methods.

First, we’ll go through the formulas for calculating both the cost of equity and debt, as they’ll be
used in the final calculations of WACC. Naturally, if the business only uses either debt or equity
alone, you can also use the formulas as the basis for calculating the cost of capital.
Calculating the cost of debt
First, lets look at how you can calculate the cost of debt. Debt in this formula includes all forms
of debt the company uses in order to finance its operations. These could be various bonds, loans
and other such forms of debt.

As mentioned earlier, there are two formulas for calculating the cost of debt. This is because it
deals with interest, which can be deducted from tax payments. Thus, the alternatives are to
calculate the cost of debt either before- or after-tax. Generally, the after-tax cost is more widely
used.

The before-tax rate can be calculated by two different methods. First, you can calculate it by
multiplying the interest rate of the company’s debt by the principal. For instance, a $100,000
debt bond with 5% pre-tax interest rate, the calculation would be: $100,000 x 0.05 = $5,000.

The second method uses the after-tax adjusted interest rate and the company’s tax rate.

Even if you use the after-tax rate, you’ll still need the above before-tax rate. The formula for
calculating the after-rate tax is:

Cost of debt (after-tax rate) = before-tax rate * (1 – marginal tax rate)

Keep in mind the before-tax rate is also often referred to as the yield-to-maturity on long-term
debt.

Calculating the cost of equity

There are also two ways of calculating the cost of equity: the more traditional dividend
capitalization model and the more modern capital asset pricing model (CAPM).

The dividend capitalization model uses the following formula:

Cost of equity = (dividends per share [for next year] / current market value of stock) + growth
rate of dividends

More recently, many companies have started to the use the CAPM method. Under this method,
the idea is that investors need a minimum rate of return, which is equal to return from a risk-free
investment, as well as a return for bearing extra risk.

The formula is as follows:

Cost of equity = risk free rate + beta [i.e. risk measure] * (expected market return – risk free
rate)

Calculating WACC
If the company has used different methods of financing, then the cost of capital is calculated by
the weighted average cost of capital. The above formulas are also needed in this method.
The method for calculating WACC is often expressed in the following formula:

WACC = percentage of financing that is equity * cost of equity + percentage of financing that is
debt * cost of debt * (1 – corporate tax rate)

In order to calculate the percentage of financing that is equity, you need the following formula:

Percentage of financing that is equity = market value of the firm’s equity / total market value of
the firm’s financing (equity and debt)

To calculate the percentage of financing that is debt, you can use the following formula:

Percentage of financing that is debt= market value of the firm’s debt / total market value of the
firm’s financing (equity and debt)

The WACC will increase if the beta (risk measure) and the rate of return on equity increase. This
is because a growing WACC denotes a drop in valuation and a growth in risk.

b. Dividends and Policy

A share of the after-tax profit of a company, distributed to its shareholders according to the
number and class of shares held by them.

Smaller companies typically distribute dividends at the end of an accounting year, whereas
larger, publicly held companies usually distribute it every quarter. The amount and timing of the
dividend is decided by the board of directors, who also determine whether it is paid out of
current earnings or the past earnings kept as reserve. Holders of preferred stock receive dividend
at a fixed rate and are paid first. Holders of ordinary shares are entitled to receive any amount of
dividend, based on the level of profit and the company's need for cash for expansion or other
purposes.

Cash dividend. The cash dividend is by far the most common of the dividend types used. On the
date of declaration, the board of directors resolves to pay a certain dividend amount in cash to
those investors holding the company's stock on a specific date. The date of record is the date on
which dividends are assigned to the holders of the company's stock. On the date of payment, the
company issues dividend payments.

Stock dividend. A stock dividend is the issuance by a company of its common stock to its
common shareholders without any consideration. If the company issues less than 25 percent of
the total number of previously outstanding shares, you treat the transaction as a stock dividend. If
the transaction is for a greater proportion of the previously outstanding shares, then treat the
transaction as a stock split. To record a stock dividend, transfer from retained earnings to the
capital stock and additional paid-in capital accounts an amount equal to the fair value of the
additional shares issued. The fair value of the additional shares issued is based on their fair
market value when the dividend is declared.
Property dividend. A company may issue a non-monetary dividend to investors, rather than
making a cash or stock payment. Record this distribution at the fair market value of the assets
distributed. Since the fair market value is likely to vary somewhat from the book value of the
assets, the company will likely record the variance as a gain or loss. This accounting rule can
sometimes lead a business to deliberately issue property dividends in order to alter their taxable
and/or reported income.

Scrip dividend. A company may not have sufficient funds to issue dividends in the near future,
so instead it issues a scrip dividend, which is essentially a promissory note (which may or may
not include interest) to pay shareholders at a later date. This dividend creates a note payable.

Liquidating dividend. When the board of directors wishes to return the capital originally
contributed by shareholders as a dividend, it is called a liquidating dividend, and may be a
precursor to shutting down the business. The accounting for a liquidating dividend is similar to
the entries for a cash dividend, except that the funds are considered to come from the additional
paid-in capital account.

A firm’s dividend policy refers to its choice of whether to pay out cash to shareholders, in what
fashion, and in what amount. The most obvious and important aspect of this policy is the firm’s
decision whether to pay a cash dividend, how large the cash dividend should be, and how
frequently it should be distributed. In a broader sense, dividend policy also encompasses
decisions such as whether to distribute cash to investors via share repurchases or specially
designated dividends rather than regular dividends, and whether to rely on stock rather than cash
distributions. Non-traditional forms of dividend payments, especially share repurchases are much
more commonly used today, and so the dividend decision is much more complex and difficult
than in the past. Also, there are many more important categories of shareholders who must be
satisfied today—especially institutional investors—whereas managers once merely had to satisfy
individual stockholders.

Dividend Payout Policies

A company that issues dividends may choose the amount to pay out using a number of methods.

 Stable dividend policy: Even if corporate earnings are in flux, stable dividend
policy focuses on maintaining a steady dividend payout.
 Target payout ratio: A stable dividend policy could target a long-run dividend-to-earnings
ratio. The goal is to pay a stated percentage of earnings, but the share payout is given in a
nominal dollar amount that adjusts to its target at the earnings baseline changes.
 Constant payout ratio: A company pays out a specific percentage of its earnings each year
as dividends, and the amount of those dividends therefore vary directly with earnings.
 Residual dividend model: Dividends are based on earnings less funds the firm retains to
finance the equity portion of its capital budget and any residual profits are then paid out
to shareholders.

c. Short Term Financial Management

Short-term Financial Planning and Management

This topic discusses the fundamentals of short-term financial management; the analysis of decisions
involving cash flows which occur within a year or less. These decisions affect current assets and /or
current liabilities. We know that net working capital is the difference between current assets and
current liabilities; since short-term finance is concerned with current assets and current liabilities, this
topic is also referred to as working capital management. Some examples of short-term financial
decisions are questions such as:
1) How much inventory should be kept on hand
2) How much cash should be kept on hand
3) Should goods be sold on credit
4) How should the firm borrow short-term

Cash and net working capital

Current assets are defined as cash and other assets that are expected to be converted to cash
within one year. The four major categories of current assets are:
1) cash
2) marketable securities
3) accounts receivable
4) inventory

Current liabilities are short-term obligations which require payment within one year. The three major
categories are:
1) accounts payable
2) accrued wages and taxes, and other expenses payable
3) notes payable.

The size of the firm’s investment in current assets A flexible current asset policy implies that the
firm maintains relatively high levels of cash, marketable securities and inventories, and grants
liberal credit terms which result in relatively high levels of accounts receivable. Restrictive
policies mean that the firm maintains relatively low levels of current assets. In order to determine
the optimal levels of current assets, the costs and benefits associated with each policy must be
identified
d. Payout Policy and Capital Structure
e. Risk Management
f. Financial Planning