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Business Organisation
What is an Organisation ? Organisation is a social arrangement which pursues collective goals, which controls its own performance, and which has a boundary separating it from its environment. Types of Business Organisation:
Sole Proprietorships.
Partnerships. Corporations.
Limited Companies.
Limited Liability Companies. Non-Profit Organisations.
Sole Proprietorship
Easily and inexpensively formed. Corporate tax obligations are eliminated. Less prone to complex government regulations. Raising capital from the market is a tedious tasks. Full ownership of all liabilities associated with the organisation. In many cases, the life of the organisation is linked to the life of the individual who creates it. Complexities may arise in terms of transfer of ownerships and liabilities from previous owners.
Partnerships
Partnerships may operate under different degrees of formality ranging from informal, oral understandings to formal agreements. Unlimited Liabilities. Limited life of an organisation and difficulty in transferring ownership. Difficulty in raising capital. Enjoys certain tax advantages similar to that of a sole proprietorships. Partners can potentially loose all of their assets in case of bankruptcy. All partners are deemed to have equal share in both growth and bankruptcy.
Corporations
Corporations are legal entity created by the state and it is distinct and separate from its owners and managers.
Unlimited life.
Easy transferability of ownership interest. Ownership may come in the form of shares.
Non-Profit Organisations Government organisations, & NonGovernmental organisations. More prone to organisations slacks. Profit maximisation is not seen an objective and they do not obviously work towards achieving it.
Capital Structure
Capital Structure refers to the way a corporation finances its assets through some combination of equity, debt or hybrid securities. In other words, a firm capital structure is the composition or structure of its liabilities. Financing can be done from within its own resources i.e. cash at its disposal, through issue of equities or through debt financing i.e. tapping the money market.
Firms can consider changing its capital structure through issue of further shares, converting existing convertible assets like bonds, rights issues, bonus issues, warrants etc.
Capital Structure
Capital structure, therefore, forms an important aspect in assessing the companys value.
In a perfect market, the value of the firm is not so affected by its capital structure.
Example: Proponents of the perfect market and classical tax system argue that there is deduction of taxes from interests on debt financing which makes external financing a lot more attractive and internal financing is of lesser value.
In reality, however, we know that such perfect market and market norms is incorrect and that there is cost associated to its external financing structure. Bankruptcy costs, Agency Costs, Asymmetric Information all adds up to the risk associated with long term external financing.
Capital Structure
Capital structure, in real world Trade off theory - explains the fact that firms or corporations usually are financed partly with debt and partly with equity. There is an advantage to financing with debt - the Tax Benefit of Debt and the cost of financing with debt, the costs of financial distress including Bankruptcy Costs of debt and nonBankruptcy costs such as employee attrition, suppliers demanding disadvantageous payment terms. The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Bankruptcy Costs of Debt are the increased costs of financing with debt instead of equity that result from a higher probability of bankruptcy.
Capital Structure
Pecking Order Theory - It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Once internal funds have been used and on its depletion, debts are issued, and when it is not sensible to issue any more debt or once the marginal benefits coming from debt financing reduces, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required.
Financial Planning
Financial planning is the process of solving financial problems and achieving financial goals by developing and implementing a corporate "game plan." Financial Planning do NOT focus on one aspect or process. It is a series of processes that culminates into end-results which are likely to be achieved in the long run. The process may require many adjustments as economic scenarios can change. Short run adjustment may be required to accommodate for the changes in the long run.
In other words, most decisions pertaining to financial planning have a long lead times, which means that they take a long time to implement.
Financial Planning
Various component that go into financial planning model Sales forecast all financial plans require near accurate sales forecast. Forecasting sales, however, cannot be predicted accurately and depends significantly on prevailing and future macroeconomic conditions. Pro-forma statement based on forecasted sales and costs (P&L statements), and various balance sheet components, financial planning can be conducted and adjusted. Asset requirement the plan will describe projected capital spending. The use of net working capital can also be discussed. Feasibility different / alternative financial plans must fit into overall corporate objective of maximizing shareholders wealth.
Financial Planning
Financial requirements and options provides the opportunity for the firm to work through various investment and financing options.
Economic Assumption the plan must explicitly include the current state of economic affairs and the likely consequences from such economic indicators i.e. the prevailing and forecasted rate of interest
See: the sample example. Ross Westerfield Jaffe, Corporate Finance, Chap-3, Financial Planning and Growth, pg 48/49
Therefore,
Changes in Assets = Changes in Debts + Changes in Equity.
T: ratio of total assets/sales. p: net profit margin (NP/Sales). d: dividend payout ratio. L: debt equity ratio. S0: current sales. S1: projected sales. S: changes in sales (S1 S0).
To increase sales by S, the firms need to increase its assets by TS. TS can financed through
Retained Earnings / Reserves and Surpluses which is a component in Equity Funding. Retained earnings is depended on the sales, dividend-pay out ratio. External Borrowings.
Given the above equation, we can now derive the sales growth
S =
S0
p * (1 - d) * (1 + L) T [p * (1 d) * (1 + L)]
= 0.10 or 10 percent
In principle it can be done Sell news shares of stock. Increase its reliance on debts. Reduce its dividend pay out ratio. Increase profits margin. Decrease its asset-requirement ratio.
Financial Markets
Physical asset markets are those that primarily deal in physical assets such as wheat, cars, automobile, machineries. Financial asset markets deal in stocks, bonds, notes, mortgages and other financial instruments. Types of market: Spot, forwards and futures markets. Money markets those that deal in short and medium term highly liquid securities. Capital markets medium and long term debts and corporate stocks. Mortgage Market. IPO market, Primary markets and Secondary markets
Financial Markets
Interest Rate
S Rate Hike S1
Interest Rate
S1
10
8
D1
12
D2 Recession Induced
D1
Real / Effective Interest Rate - effective rate is the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest.
Consider Debt Security with a quoted/nominal interest rate of r. r = r* + IP + DRP + LP + MRP Nominal rate r is composed of r* : Risk-free interest rate. DRP: Default risk premium. MRP: Maturity risk premium. IP: Inflation premium. LP: Liquidity premium.
$1000 @ 5% = $1050.
NPV = $955.
Liquidity Premium the risk of not being able to convert the underlying security into cash at a fair market value.
Maturity Risk Premium premium added to the expected returns when the duration of an underlying securities is longer. Since longer duration leads to longer payment schedules, the risk of default is higher. Also the underlying security is more prone to changing interest rates.