Category: Financial Management

Financial management is the process of planning, organizing, controlling, and monitoring an organization’s financial resources to achieve its goals and objectives effectively. It involves making financial decisions, managing investments, and ensuring the financial health and sustainability of the business. Financial management is essential for both businesses and individuals. As it helps in optimizing financial resources and making informed decisions about money matters.

Key aspects of financial management include:

  1. Financial Planning: This involves setting financial goals and developing a comprehensive plan to achieve them. It includes budgeting, forecasting, and identifying potential sources of funding.
  2. Capital Budgeting: This process entails evaluating and selecting long-term investment projects that align with the organization’s objectives. It involves analyzing the potential returns and risks associated with different investment opportunities.
  3. Financing Decisions: Financial managers need to decide how to fund the organization’s operations and investments. This may involve choosing between debt financing (e.g., loans, bonds) and equity financing (e.g., issuing shares).
  4. Working Capital Management: It involves managing the organization’s short-term assets and liabilities to ensure smooth day-to-day operations. The goal is to maintain an optimal balance between cash flow, inventory, accounts receivable, and accounts payable.
  5. Risk Management: Financial managers must assess and mitigate financial risks that the organization may face. This includes market risks, credit risks, liquidity risks, and operational risks.
  6. Financial Reporting and Analysis: Preparation of accurate and timely financial statements (e.g., income statement, balance sheet, cash flow statement) is crucial for decision-making. Financial analysis helps interpret these statements to assess the company’s performance and identify areas for improvement.
  7. Financial Control: Monitoring financial performance and comparing actual results with budgeted figures is essential to identify deviations and take corrective actions as needed.
  8. Tax Planning: Financial managers need to consider tax implications while making financial decisions to optimize tax efficiency and compliance.

Financial management is vital for individuals as well. It involves budgeting, saving, investing, and managing personal finances to achieve financial goals. Such as buying a house, funding education, or planning for retirement.

Overall, financial management plays a crucial role in the success and sustainability of organizations and individuals by ensuring the effective allocation and utilization of financial resources. It helps create a sound financial foundation, minimize risks, and support long-term growth and prosperity.

  • Preference Shares: Explanation, Features, Good and Bad

    Preference Shares: Explanation, Features, Good and Bad

    What does Preference Shares mean? Preference Shares, as its name suggests, gets precedence over equity shares on the matters like distribution of dividend at a fixed rate and repayment of capital in the event of liquidation of the company. Preference shares are one of the important sources of hybrid financing. As the name suggests, these have certain preferences as compared to other types of shares. These shares are given two preferences. There is a preference for payment of dividend. Whenever the company has distributable profits, the dividend is first paid on preference share capital.

    Know and Understand the Preference Shares.

    The content of study from Preferred Shares: Explanation of Preference Shares, Features of Preference Shares, Good and Bad of Preferred Shares (Advantages and Disadvantages of Preference Shares).

    The preference shareholders are also the part owners of the company like equity shareholders, but in general, they do not have voting rights. However, they get right to vote on the matters which directly affect their rights like the resolution of winding up of the company, or in the case of the reduction of capital.

    Other shareholders are paid a dividend only out of the remaining profits if any. The second preference for shares is repayment of capital at the time of liquidation of the company. After payment of outside creditors, preference share capital is returned. Equity shareholders will be paid only when preference share capital is paid in full.

    Explanation of Preference Shares.

    They are those shares which carry certain special or priority rights. Firstly, the dividend at a fixed rate is payable on these shares before any dividend is paid on equity shares. Secondly, at the time of winding up of the company, capital is repaid to preference shareholders prior to the return of equity capital. Preferred Shares do not carry voting rights. However, holders of preferred shares may claim voting rights if the dividends are not paid for two years or more on cumulative preference shares and three years or more on non-cumulative preferred shares.

    Meaning of Preference Shares.

    The share which entitles the holder to a fixed dividend, whose payment takes priority over that of ordinary share dividends. Preferred Shares are one of the important sources of hybrid financing. It is hybrid security because it has some features of equity shares as well as some features of debentures. The holders of preference shares enjoy the preferential rights with regard to receiving of dividend and getting back of capital in case the company winds-up.

    Definition of Preference Shares.

    They are a long-term source of finance for a company. They are neither completely similar to equity nor equivalent to debt. The law treats them as shares but they have elements of both equity shares and debt. For this reason, they are also called “Hybrid financing instruments”. These are also known as preferred stock, preferred shares, or only preferred’s in a different part of the world.

    Features of Preference Shares.

    They have the characteristics of both equity shares and debentures. Like equity shares, dividend on preferred shares is payable only when there are profits and at the discretion of the Board of Directors.

    Preferred Shares are similar to debentures in the sense that the rate of dividend is fixed and preference shareholders do not generally enjoy voting rights. Therefore, they are a hybrid form of financing.

    The features of preference shares are listed below:

    Dividends.

    They have dividend provisions which are cumulative or non- cumulative. Most shares have the cumulative provisions, which mean that any dividend not paid by the company accumulates. Normally, the firm must pay these unpaid dividends prior to the payment of dividends on the common stock. These unpaid dividends are known as dividends in arrears or arrearages. Non-cumulative dividends do not accumulate if they are not paid when due.

    An investor contemplating the purchase of preferred shares with a non-cumulative dividend provision needs to be especially diligent in the investigation of the company because of the investor’s potentially weak position vis-a-vis those preference shares with a cumulative dividend provision. In the case of cumulative preferred shares, even if the arrears of the preference dividend are cleared in full, the investor would be the loser as he is to get less in net worth.

    Participating.

    Most they are non-participating, meaning that the preference shareholder receives only his stated dividend and no more. The theory is that the preference shareholder has surrendered claim to the residual earnings of his company in return for the right to receive his dividend before dividends are paid to common shareholders.

    The participating preference shareholder receives stipulated dividend and shares additional earnings with the common shareholders. But this share is usually non-cumulative which confirms the view that preference share does have both protective and profit participating provisions.

    Voting Rights.

    They do not normally confer voting rights. The basis for not allowing the preference shareholder to vote is that the preference shareholder is in a relatively secure position and, therefore, should have no right to vote except in the special circumstances.

    The cumulative preferred shares can vote if their dividend is in arrears for 2 years. The voting right of each preference shareholder is to be in the proportion which the paid-up share capital on his shares bears to the total equity share capital of the company.

    Par Value.

    Most they have a par value. When it does, the dividend rights and call price are usually stated in terms of the par value. However, those rights would be specified even if there were no par value. It seems, therefore, as with equity shares, the preference share that has a par value has no real advantage over preference share that has no par value.

    Redeemable or Callable.

    Typically, they have no maturity date. In this respect, it is similar to equity shares. Redeemable or callable preferred shares may be retired by the issuing company upon the payment of a definite price stated in the investment. Although the “call price” provides for the payment of a premium, the provision is more advantageous to the corporation than to the investor.

    When money rates decline, the corporation is likely to call in its preferred shares and refinance it at a lower dividend rate. When money rates rise, the value of the preference shares declines so as to produce higher yield, the call price acts as an upper peg or plateau through which the price will break only in a very strong market.

    Non-callable preferred shares and bonds are issued in periods of High-interest rates. The issue is barred from redeeming them later in the event of generally falling yields or for a certain period so the investor has important protection against declining income.

    Preference Shares Explanation Features Good and Bad
    Preference Shares: Explanation, Features, Good and Bad, #Pixabay.

    Advantages of Preference Shares:

    The following advantages of preference shares are:

    The obligation for Dividends:

    No Obligation for Dividends; A company is not bound to pay the dividend on preference shares if its profits in a particular year are insufficient. It can postpone the dividend in case of cumulative preferred shares also. No fixed burden is created on its finances.

    Interference:

    No Interference; Generally, they do not carry voting rights. Therefore, a company can raise capital without dilution of control. Equity shareholders retain exclusive control over the company.

    Trading on Equity:

    The rate of dividend on they are fixed. Therefore, with the rise in its earnings, the company can provide the benefits of trading on equity to the equity shareholders.

    Flexibility:

    A company can issue redeemable preference shares for a fixed period. The capital can be repaid when it is no longer required in business. There is no danger of over-capitalization and the capital structure remains elastic.

    Variety:

    Different types of preference shares can be issued depending on the needs of investors. Participating preferred shares or convertible they may be issued to attract bold and enterprising investors.

    They can be made more popular by giving special rights and privileges such as voting rights, right of conversion into equity shares, right of shares in profits and redemption at a premium.

    Disadvantages of Preference Shares:

    They suffer from the following disadvantages:

    Obligation:

    Fixed Obligation; The dividend on preferred shares has to be paid at a fixed rate and before any dividend is paid on equity shares. The burden is greater in the case of cumulative preference shares on which accumulated arrears of dividend have to be paid.

    Appeal:

    Limited Appeal; Bold investors do not like preferred shares. Cautious and conservative investors prefer debentures and government securities. In order to attract sufficient investors, a company may have to offer a higher rate of dividend on preference shares.

    Return Earning:

    Low Return in this shares; When the earnings of the company are high, fixed dividend on they becomes unattractive. Preference shareholders generally do not have the right to participate in the prosperity of the company.

    Voting Rights:

    No Voting Rights; They generally do not carry voting rights. As a result, preference shareholders are helpless and have no say in the management and control of the company.

    Fear of Redemption:

    The holders of redeemable preference shares might have contributed finance when the company was badly in need of funds. But the company may refund their money whenever the money market is favorable. Despite the fact that they stood by the company in its hour of need, they are shown the door unceremoniously.

  • Equity Shares: Explanation, Characteristics, and Features

    Equity Shares: Explanation, Characteristics, and Features

    Equity Shares: Explanation, Characteristics, and Features

  • Business Risk: Explanation, Characteristics, and Sources

    Business Risk: Explanation, Characteristics, and Sources

    What does Business Risk mean? Business risks related to the response of the firm’s earnings before interest and taxes, or operating profits, to changes in sales. When the cost of capital is used to evaluate investment alternatives, it is assumed that acceptance of the proposed projects will not affect the firm’s business risk.

    Know and understand the Explanation of Business Risk.

    The business risk may be defined in terms of the possibility of occurrence of un-favorable events; which maximize chances of losses and minimize chances for gain, in business. The term business risk refers to the possibility of inadequate profits or even losses due to uncertainties e.g., changes in tastes, preferences of consumers, strikes, increased competition, change in government policy, obsolescence etc.

    Every business organization contains various risk elements while doing the business. Business risks imply uncertainty in profits or danger of loss and the events that could pose a risk due to some unforeseen events in the future, which causes the business to fail. The types of projects accepted by a firm can greatly affect its business risk.

    If a firm accepts a project that is considerably more risky than average, suppliers of funds to the firm are quite likely to raise the cost of funds. This is because of the decreased probability of the fund suppliers receiving the expected returns on their money. A long-term lender will charge higher interest on loans if the probability of receiving periodic interest from the firm and ultimately regaining the principal is decreased.

    Common stockholders will require the firm to increase earnings as compensation for increases in the uncertainty of receiving dividend payments or ably appreciation in the value of their stock. In analyzing the cost of capital it is assumed that the business risk of the firm remains unchanged (i.e., that the projects accepted do not affect the variability of the firm’s sales revenues).

    This assumption eliminates the need to consider changes in the cost of specific sources of financing resulting from changes in business risk. The definition of the cost of capital developed in this chapter is valid only for projects that do not change the firm’s business risk.

    Meaning of Business Risk:

    Business risk is that portion of the unsystematic risk caused by the prevailing environment of the business. In other words, business risk is a function of operating conditions being faced by a firm. These risks influence the operating income of a firm and consequently the dividends.

    Every company has its own objectives and goals and aims at a particular gross profit and operating income. It expects itself to pay to its shareholders a certain rate of dividend and plow back some profits.

    For example, an owner of a business may face different risks like in production, risks due to irregular supply of raw materials, machinery breakdown, labor unrest, etc. In marketing, risks may arise due to different market price fluctuations, changing trends and fashions, error in sales forecasting, etc. In addition, there may be the loss of assets of the firm due to fire, flood, earthquakes, riots or war and political unrest which may cause unwanted interruptions in the business operations. Thus business-risks may take place in different forms depending upon the nature and size of the business.

    Definition of Business Risk:

    Definition: By the term “Business risk” we mean the uncertainty with respect to the firm’s operations. It is a type of systematic risk wherein there is volatility associated with the future income or earnings arising from events, circumstances, conditions, action, or inactions that hinders the attainment of goals and objectives and carry out the strategies.

    Business risk refers to the anticipation that the firm may earn lower than expected profits or even suffer losses, because of the uncertainties inherent in the business such as competition, change in customer tastes and preferences, input cost, change in government policies, and so forth. It may impede the business ability to provide returns on the investment.

    Following are cited some popular definition of the term business risk:

    According to B.O.Wheeler,

    “Risk is the chance of loss. It is the possibility of some un-favorable occurrence.”

    According to C.O. Hardy,

    “Risk may be defined as uncertainty in regard to cost, loss, or damage.”

    Characteristics of Business Risk:

    Characteristics of business-risks could be highlighted with reference to its following features:

    The Time.

    In ancient times, business-risks were less and limited. In the present-day-times-characterized by intense competition, advanced technology and globalization of the economy; business-risks are quite severe. Further, in times to come, business-risks are likely to increase in intensity.

    The Size of Business Enterprise.

    Small businesses are less exposed to business-risks; because they enjoy the flexibility of operations and can easily adapt themselves to changing circumstances. On the other hand, the bigger is the size of business; the lesser is the flexibility possessed by it. Hence bigger businesses are more exposed to business risks.

    Nature of Business Risks.

    In case of business enterprises engaged in the manufacture/purchase of necessary items e.g. salt, sugar, oil, cloth etc. there is the lesser risk because demand for most of the necessary item is inelastic or less elastic. On the other hand, business enterprises engaged in the manufacture/purchase of luxury items are more exposed to business-risks; because demand for luxury items is highly elastic.

    Terms of Sales.

    In the case of business enterprises conducting sales only on a cash basis, business-risks are nil; so far as the possibility of bad debts is concerned. On the other hand, business enterprises conducting large scale credit sales are severely exposed to the risk of bad debts.

    The Degree of Competition.

    In those lines of business activities, where there is intense competition; business enterprises are exposed to severe risks caused by the actions and reactions of competitors. As such, business enterprises characterized by monopolistic situations face little risk on account of competition. Actually, in a perfectly monopolistic situation, the business enterprise has no risk caused by competition.

    The Competence of Management.

    The more competent the management of business enterprises is; the lesser is the possibility of losses to be caused as a result of business risks, and vice-versa.

    The Age of the Business Enterprise.

    From this viewpoint, old business enterprises are less exposed to business-risks, because of the experience of successfully handling business-risks, in the past. New business concerns are more exposed to business-risks, because of the lack of experience.

    Opportunities for Gains are Hidden in Business Risks.

    If the management of the business enterprise is able to successfully handle and manage business-risks; these provide many opportunities for gains to the business enterprise.

    Sources of Business Risk:

    Business risk can be divided into two broad Sources, namely;

    • Internal business risk, and.
    • External business risk.

    Now explain;

    Internal Business risks.

    Internal business risk is associated with the internal environment of the firm. The internal business-risks are such that the firm has to conduct its business within its limiting environment. The internal business-risks will vary from firm to firm depending upon the constraints in the internal environment. Thus, each firm has its own set of internal risks and the firm’s success depends upon the ability to coping with these risks.

    The important internal risks include:

    1. Fluctuations in sales.
    2. Research and development.
    3. Personnel Management.
    4. Fixed Cost, and.
    5. Production of a single product.

    The risks that emerge as a result of the events occurring within the organization is termed as an internal risk. These risks can be predicted as the possibility of their incidence, and so, they are controllable in nature. They arise due to factors like strikes & lockouts by a trade union, accidents in the factory, negligence of workers, failure of the machine, technological obsolescence, damages to the goods, fire outbreak, etc.

    External Business risks.

    External business-risks are associated with circumstances beyond a firm’s control. Each firm has to deal with specific external factors that may be unique and peculiar to its industry.

    However, important external factors influencing all businesses are:

    1. Business cycle.
    2. Demographic factors.
    3. Government policies, and.
    4. Social and regulatory factors.

    The risk arising as a result of the events external to the firm and so the firm’s management has no control over it. So, these cannot be forecasted easily. It may arise due to price fluctuations, changes in customer taste, earthquake, floods, changes in government regulations, riots, etc.

    Business Risk Explanation Characteristics and Sources
    Business Risk: Explanation, Characteristics, and Sources, #Pixabay.

    Types of Business Risks:

    Some risks are common to all human being alike everywhere e.g. risks due to fire, theft, flood, earthquakes, cyclones, drought, war, civil riots etc. As such these are not the risks peculiar only to business. Moreover, some risks are insurable with insurance companies.

    Hence, as such, in the present- day-times offering many types and varieties of insurances; these risks could not be termed as risks in the real sense of the term. Accordingly, business-risks are those which are peculiar only to business and are also not- insurable.

    Following is a brief account of the above types of business-risks:

    Natural Types.

    Risks which arise due to the actions of Nature (and hence uncontrollable) are called natural risks. For example, the risk of rainfall not occurring on time or excessive rain­fall causing flood is a serious risk for farmers. Again, there may be the risk of hail storm destroying crops in the field.

    Political Types.

    Risks due to political causes may arise, in the forms of:

    1. Price regulations, restricting profit margins for businessmen.
    2. High rates of taxes, taking away a major part of business profits.
    3. Un-favorable economic policies, discouraging some lines of business activities, and.
    4. Strict legislation imposed on business enterprises etc.

    Social Types.

    Risks due to social causes are those which may arise from consumer behavior or due to changes taking place in the social scene.

    Examples of social risks may be:

    1. Changes in fashions.
    2. Change in the tastes or preference of consumers.
    3. Changes in the income of consumers, and.
    4. Changing social values leading to a new pattern of social life etc.

    Economic Types.

    Some of the economic types leading to business-risks may be:

    1. The rising cost of raw materials due to inflation or crop failure.
    2. The economic recession in industry, leading to poor demand.
    3. Increase in the rate of interest, making borrowings costlier, and.
    4. Pessimistic capital market conditions, discouraging people to invest in companies etc.

    Managerial Types.

    Risks due to managerial types may be (a few examples only):

    1. Wrong estimation of demand by management.
    2. Poor labor-management relations, and.
    3. The inefficient operational life of the business enterprise due to incompetent or untrained managerial staff.

    Competitive Types.

    Competitive Types may cause business-risks e.g. in the form of the following:

    1. Entry of an unduly large number of persons in the same line of business activity, and.
    2. Entry of multinational companies threatening the very survival of domestic companies.

    Technological Types.

    In the present-day times, technology is changing at a very fast pace; so much so that business experts call this phase of changes as a “technological revolution”. The appearance of new technology renders the old technology as obsolete (i.e. out of use); causing severe financial losses to firms operating with old technology. They are virtually compelled to install new technology to ensure their survival amidst intensely competitive conditions.

    Miscellaneous Types.

    Some miscellaneous types of business-risks may be:

    1. Insolvency of a customer.
    2. Worker’s strike.
    3. Sudden power failure.
    4. The premature death of an expert employee or manager, and.
    5. Speculative losses.

    References;

    • https://en.wikipedia.org/wiki/Business_risks.
    • http://www.yourarticlelibrary.com/business/risk-management/business-risk-nature-and-causes-of-business-risk-risk-management/69663.
    • https://accountlearning.com/business-risk-meaning-types-categories-of-business-risks/.
    • https://businessjargons.com/business-risk.html.

  • What does Income Tax mean? Introduction, Meaning, and Definition

    What does Income Tax mean? Introduction, Meaning, and Definition…Waiting for best or correct answers.

  • What does the Value-added Tax (VAT) mean? Introduction, Meaning, and Definition

    What does the Value-added Tax (VAT) mean? Introduction, Meaning, and Definition…Waiting for best or correct answers.

  • Venture Capital: Definition Advantages Disadvantages

    Venture Capital: Definition Advantages Disadvantages

    What does Venture Capital mean? They define and comprise two words that are, “Venture” and “Capital”. It is a type of funding for a new or growing business. It usually comes from venture-capital firms that specialize in building high-risk financial portfolios.

    The concept of Venture Capital explained by their points in Meaning, Introduction, Definition, Characteristics, Advantages, and Disadvantages.

    Capital invested in a project in which there is a substantial element of risk, typically a new or expanding business. The venture is a course of processing, the outcome of which is uncertain but to which attended the risk or danger of “loss”. “Capital” means resources to start an enterprise. To connote the risk and adventure of such a fund, the generic name Venture-Capital existed coined.

    #Meaning of Venture Capital:

    Venture capital’s a type of private equity, a form of financing provide by firms or funds to small, early-stage, emerging firms that exist deemed to have high growth potential, or which have demonstrated high growth. This is a very important source of financing for a new business. Here money is provided by investors to start a business that has a strong potentiality of high growth and profitability. The provider of venture capital also provides managerial and technical support. Venture capital stands also known as risk capital.

    #Introduction of Venture Capital:

    Venture capital’s considered the financing of high and new technology-based enterprises. It exists said that Venture-capital involves investment in new or relatively untried technology, initiated by relatively new and professionally or technically qualified entrepreneurs with inadequate funds. The conventional financiers, unlike Venture capitals, mainly finance proven technologies and established markets.

    However, high technology need not be a prerequisite for them. They have also existed described as “unsecured risk financing”. The relatively high risk of venture capital’s compensated by the possibility of high returns usually through substantial capital gains in the medium term. They are in the broader sense is not solely an injection of funds into a new firm; it is also an input of skills needed to set up the firm, design its marketing strategy, organize and manage it.

    Thus it is a long-term association with successive stages of the company’s development under high-risk investment conditions, with a distinctive type of financing appropriate to each stage of development. Investors join the entrepreneurs as co-partners and support the project with finance and business skills to exploit the market opportunities. Venture capital’s not passive finance.

    It may be at any stage of the business/production cycle, that is, start-up, expansion or to improve a product or process; which exist associated with both risk and reward. They make higher capital gains through appreciation in the value of such investments when the new technology succeeds. Thus the primary return sought by the investor is essentially capital gain rather than steady interest income or dividend yield.

    #Definition of Venture Capital:

    “The support by investors of entrepreneurial talent with finance and business skills to exploit market opportunities and thus obtain capital gains.”

    They commonly describe not only the provision of start-up finance or “seed corn” capital but also development capital for later stages of business. A long-term commitment of funds exists involved in the form of equity investments, with the aim of eventual capital gains rather than income and active involvement in the management of customers’ business.

    #Characteristics of Venture Capital:

    The following features/characteristics below are;

    Participation In Management:

    They provide value addition by managerial support, monitoring, and follow-up assistance. It monitors physical and financial progress as well as a market development initiative. It helps by identifying the key resource person. They want one seat on the company’s board of directors and involvement, for better or worse, in the major decision affecting the direction of the company.

    This is a unique philosophy of “hands-on management” where Venture capitalist acts as complementary to the entrepreneurs. Based upon the experience of other companies, a venture capitalist advises the promoters on project planning, monitoring, financial management, including working capital and public issue. Their investor cannot interfere in day to day management of the enterprise but keeps close contact with the promoters or entrepreneurs to protect his investment.

    High Risk:

    By definition, their financing is highly risky and chances of failure are high as it provides long-term start-up capital to high risk-high reward ventures.

    Venture capital assumes four types of risks, these are:

    • Management risk; Inability of management teams to work together.
    • Market risk; Product may fail in the market.
    • Product risk; Also, Product may not be commercially viable.
    • Operation risk; Operations may not be cost effective resulting in increased cost decreased gross margins.

    High Tech:

    As opportunities in the low technology, area tend to be few of lower order, and hi-tech projects generally offer higher returns than projects in more traditional areas, venture-capital investments stand made in high tech. areas using new technologies or producing innovative goods by using new technology.

    Not just high technology, any high-risk ventures where the entrepreneur has conviction but little capital gets venture finance. Venture capital’s available for expansion of existing business or diversification to a high-risk area. Thus technology financing had never been the primary objective but incidental to venture capital.

    Length of Investment:

    Venture capitalists help companies grow, but they eventually seek to exit the investment in three to seven years. An early-stage investment may take seven to ten years to mature; while most of the later-stage investment takes only a few years. The process of having significant returns takes several years and calls on the capacity and talent of venture capitalists and entrepreneurs to reach fruition.

    Illiquid Investment:

    Their investments are illiquid, that is, not subject to repayment on demand or following a repayment schedule. Investors seek to return ultimately using capital gains when the investment stands sold at the marketplace.

    The investment is realized only on the enlistment of security or it is lost if the enterprise is liquidated for unsuccessful working. It may take several years before the first investment starts to lock for seven to ten years. Venture capitalist understands this illiquidity and factors this in their investment decisions.

    Equity Participation & Capital Gains:

    Investments are generally in equity and quasi-equity participation through direct purchase of shares, options, convertible debentures where the debt holder has the option to convert the loan instruments into the stock of the borrower or debt with warrants to equity investment.

    The funds in the form of equity help to raise term loans that are a cheaper source of funds. In the early stage of business, because dividends can delay, equity investment implies that investors bear the risk of venture and would earn a return commensurate with success in the form of capital gains.

    #Advantages and Disadvantages of Venture Capital:

    The following advantages and disadvantages below are;

    Advantages of Venture Capital:

    Business expertise: Aside from financial backing, obtaining venture-capital financing can provide a start-up or young business with a valuable source of guidance and consultation. This can help with a variety of business decisions, including financial management and human resource management. Making better decisions in these key areas can be vitally important as your business grows.

    Additional resources: In several critical areas, including legal, tax, and personnel matters, a VC firm can provide active support, all the more important at a key stage in the growth of a young company. Faster growth and greater success are two potential key benefits.

    The advantages of venture capital are as follows:

    • New innovative projects financed through venture-capital which generally offers high profit­ability in long run.
    • In addition to capital, venture-capital provides valuable information, resources, technical assistance, etc., to make a business successful.

    Disadvantages of Venture Capital:

    Loss of control: The drawbacks associated with equity financing, in general, can compound with venture-capital financing. You could think of it as equity financing on steroids. With a large injection of cash and professional, and possibly aggressive, investors, it is likely that your VC partners will want to exist involved. The size of their stake could determine how much say they have in shaping your company’s direction.

    Minority ownership status: Depending on the size of the VC firm’s stake in your company; which could be more than 50%, you could lose management control. Essentially, you could be giving up ownership of your own business.

    The disadvantages of venture capital are:

    • It is an uncertain form of financing.
    • Benefit from such financing can realize in long run only.
    Venture Capital Introduction Definition Characteristics Advantages and Disadvantages
    Venture Capital: Introduction, Definition, Characteristics, Advantages, and Disadvantages, #Pixabay.

    #Know and understand the Dimensions of Venture Capital:

    It is associated with successive stages of the firm’s development with distinctive types of financing, appropriate to each stage of development. Thus, there are four stages of the firm’s development, viz., development of an idea, startup, fledgling, and establishment. The first stage of development of a firm is the development of an idea for delineating precise specifications for the new product or service and establishing a business plan.

    The entrepreneur needs seedling finance for this purpose. Venture capitalist finds this stage the most hazardous and difficult; because the majority of the business projects are abandoned at the end of the seedling phase. The Start-up stage is the second stage of the firm’s development. At this stage, the entrepreneur sets up the enterprise to carry into effect the business plan to manufacture a product or to render a service.

    In this process of development, venture-capitalist supply start-up finance. In the third phase, the firm has made some headway, entered the stage of manufacturing a product or service, but is facing enormous teething problems. It may not be able to generate adequate internal funds. It may also find its access to external sources of finance very difficult.

    To get over the problem, the entrepreneur will need a large amount of fledgling finance from the venture capitalist. In the last stage of the firm’s development when it stabilizes itself; and may need, in some cases, establishment finance to explicit opportunities of scale. This is the final injection of funds from venture capitalists. It has been estimated that in the U.S.A., the entire cycle takes a period of 5 to 10 years.

  • Understand the Modigliani Miller Proposition with the Capital Structure Theory!

    Understand the Modigliani Miller Proposition with the Capital Structure Theory!

    What is the Modigliani Miller? The Modigliani–Miller theorem is an influential element of economic theory; it forms the basis for modern thinking on capital structure. Modigliani and Miller approach to capital theory, devised in the 1950s advocates capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. So, what is the topic we are going to discuss; Understand the Modigliani Miller Proposition with the Capital Structure Theory!

    Here are explained formula of the Modigliani Miller Proposition for the Capital Structure Theory!

    The capital structure of a company is the way a company finances its assets. A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity or a mix of both debt and equity. Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition.

    Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. They theorized that the market value of a firm is determined by its earning power and by the risk of its underlying assets and that its value is independent of the way it chooses to finance its investments or distribute dividends.

    Modigliani and Miller’s Capital Structure Irrelevance Proposition:

    The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. In this simplified view, the weighted average cost of capital (WACC) should remain constant with changes in the company’s capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC.

    Additionally, since there are no changes or benefits from increases in debt, the capital structure does not influence a company’s stock price, and the capital structure is therefore irrelevant to a company’s stock price. However, as we have stated, taxes and bankruptcy costs do significantly affect a company’s stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs.

    Modigliani Miller Proposition:

    The following Proposition is two types below are:

    Proposition-I

    The Modigliani-Miller Proposition-I Theory (MM-I) states that under a certain market price process, in the absence of taxes, no transaction costs, no asymmetric information and in a perfect market, the cost of capital and the value of the firm are not affected by the change in capital structure. The firm’s value is determined by its real assets, not by the securities it issues. In other words, capital structure decisions are irrelevant as long as the firm’s investment decisions are taken as given.

    The Modigliani and Miller explained the theorem was originally proven under the assumption of no taxes. It is made up of two propositions that are (i) the overall cost of capital and the value of the firm are independent of the capital structure. The total market value of the firm is given by capitalizing the expected net operating income by the rate appropriate for that risk class. (ii) The financial risk increase with more debt content in the capital structure. As a result, the cost of equity increases in a manner to offset exactly the low-cost advantage of debt. Hence, the overall cost of capital remains the same.

    The assumptions of the MM theory are:

    1. There is a perfect capital market. Capital markets are perfect when: 1) Investors are free to buy and sell securities. 2) Investors can trade without restrictions and can borrow or lend funds on the same terms as the firms do. 3) Investors behave rationally. 4) Investors have equal access to all relevant information. 5) Capital markets are efficient. 6) No costs of financial distress and liquidation, and 7) There are no taxes.
    2. Firms can be classified into homogeneous business risk classes. All the firms in the same risk class will have the same degree of financial risk.
    3. All investors have the same view for the investment, profits, and dividends in the future; they have the same expectation of a firm’s net operating income.
    4. The dividend payout ratio is 100%, which means there are no retained earnings.

    In the absence of the tax world, base on MM Proposition-I, the value of the firm is unaffected by its capital structure. In other words, regardless of whether a company has liabilities, the total risk of its securities holders will not change even the capital structure is changed. As the weighted average cost of capital unchanged, so must the same as the total value of the company.  That is VL = VU = EBIT/equity, where VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity, VU is the value of an unlevered firm = the price of buying a firm composed only of equity and EBIT is earnings before interest and tax. Whether or not the company has loans or the loans for high or low, investors are all accessible through the following two kinds of investment on their own to create the desired type of earning.

    1. Direct investments in the company’s stock borrowing
    2. If shares of levered firms are priced too high, investors will try to take advantage of borrowing on their own and use the money to buy shares in unlevered firms. The use of debt by the investors is known as homemade leverage.

    The investors of homemade leverage can obtain the same return as the levered firms, therefore, for investors; the value of the firm is not affected by the debt-equity mix.

    The MM Proposition I assumptions are quite unrealistic, there have some implications,

    1. Capital structure is irrelevant to shareholder wealth maximization.
    2. The value of the firm is determined by the firm’s capital budgeting decisions.
    3. Increasing the extent to which a firm relies on debt increases both the risk and the expected return to equity – but not the price per share.

    Based on the inadequate of MM Proposition-I, Franco Modigliani and Merton H.Miller revised their theory in 1963, which is MM Proposition-II.

    Proposition-II

    The Modigliani-Miller Proposition II Theory (MM II) defines the cost of equity is a linear function of the firm’s debt/equity ratio. According to them, for any firm in a given risk class, the cost of equity is equal to the constant average cost of capital plus a premium for the financial risk, which is equal to debt/equity ratio times the spread between average cost and cost of debt. Also, Modigliani and Miller recognized the importance of the existence of corporate taxes.

    Accordingly, they agreed that the value of the firm will increase or the cost of capital will decrease with the use of debt due to tax deductibility of interest charges. Thus, the value of the corporation can be achieved by maximizing debt component in the capital structure. This theory of capital structure for the study provided an important and analytical framework. According to this approach, value of a firm is VL = VU = EBIT (1-T) / equity + TD where TD is tax savings. MM Proposition II is assuming that the tax shield effect of each is the same, and continued insight.

    Leverage firms are increased in interest expense due to reduced tax liability, has also increased the allocation to the shareholders and creditors of the cash flow. The above formula can be deduced from the company debt the more the greater the tax saving benefits, the greater the value of the company. The revised capital structure of the MM Proposition-II pointed out that the existence of tax shield in a perfect capital market conditions cannot be reached, in an imperfect financial market, the capital structure changes will affect the company’s value.

    Therefore, the value and cost of capital of the corporation with the capital structure changes in different leverage, the value of the levered firm will exceed the value of the unlevered firm. MM Proposition theory suggests that the higher the debt ratio is more favorable to corporate, but through borrowing adds an interest tax shield it may lead to costs of financial distress. Financial distress occurs when promises to creditors are broken or honored with difficulty.

    Financial distress may lead to bankruptcy. The trade-off theory of capital structure theory in MM based on the added risk of bankruptcy and further improves the capital structure theory, to make it more practical significance. A firm that follows the trade-off theory sets a target debt to value ratio and then gradually moves towards the target. The target is determined by balancing the tax benefits of using debt against the costs of financial distress that rise at an increasing rate with the use of leverage.

    It so predicts the moderate amount of debt as optimal. But there is evidence that the most profitable firm in an industry tend to borrow the least, while their probability of entering in financial distress seems to be very low. This fact contradicts the theory because if the distress risk is low, an increase in debt has a favorable tax effect. Under the trade-off theory, high profits should mean more debt-servicing capacity and more taxable income to shield and therefore should result in a higher debt ratio.

    Understand the Modigliani Miller Proposition with the Capital Structure Theory
    Understand the Modigliani Miller Proposition with the Capital Structure Theory! Image credit from #Pixabay.

    Understand the Capital Structure Decision in Corporate Finance:

    Corporate finance is a specific area of finance dealing with the financial decisions corporations make and the tools as well as analysis used to make these decisions. The discipline as a whole may be divided among long-term and short-term decisions and techniques with the primary goal being maximizing corporate value while managing the firm’s financial risks. Capital investment decisions are long-term choices that investment with equity or debt, and the short-term decisions deal with the balance of current assets and current liabilities which is managing cash, inventories, and short-term borrowing and lending.

    Corporate finance can be defined as the theory, process, and techniques that corporations use to make the investment, financing and dividend decisions that ultimately contribute to maximizing corporate value. Thus, a corporation will first decide in which projects to invest, then it will figure out how to finance them, and finally, it will decide how much money, if any, to give back to the owners. All these three dimensions which are investing, financing and distributing dividends are interrelated and mutually dependent. The capital structure decision is one of the most fundamental issues in corporate finance.

    The capital structure of a company refers to a combination of debt, preferred stock, and common stock of finance that it uses to fund its long-term financing. Equity and debt capital are the two major sources of long-term funds for a firm. The theory of capital structure is closely related to the firm’s cost of capital. As the enterprises to obtain funds need to pay some costs, the cost of capital in the investment activities is also the main consideration of the rate of return.

    The weighted average cost of capital (WACC) is the expected rate of return on the market value of all of the firm’s securities. WACC depends on the mix of different securities in the capital structure; a change in the mix of different securities in the capital structure will cause a change in the WACC. Thus, there will be a mix of different securities in the capital structure at which WACC will be the least.

    The decision regarding the capital structure is based on the objective of achieving the maximization of shareholders wealth. With regard to the capital structure of the theoretical basis, the most well-known theory is Modigliani-Miller theorem of Franco Modigliani and Merton H.Miller. Yet the seemingly simple question as to how firms should best finance their fixed assets remains a contentious issue.

    The Designing an Optimal Capital Structure:

    The optimal capital structure refers to a proportion of debt and equity at which the marginal real cost of each available source of financing is the same. This is also viewed as a capital structure that maximizes the market price of shares and minimizes the overall cost of capital of the firm. Theoretically, the concept of optimal capital structure can easily be explained, but in operational terms, it is difficult to design an optimal capital structure because of a number of factors, both quantitative and qualitative, that influence the optimum capital structure. Moreover, the subjective judgment of the finance manager of the firm is also an influencing factor in designing the optimum capital structure of a firm. Designing the capital structure is also known as capital structure planning and capital structure decision.

  • Financial Control: Meaning Definition Objectives Importance

    Financial Control: Meaning Definition Objectives Importance

    What does mean Financial Control? Finance Control has now become an essential part of any company’s finances. It refers to the systems implemented in place to trace the directed resources of an organization with timely monitoring and measurement. So, what is the topic we are going to discuss; Financial Control – Meaning, Definition, Objectives, Importance, and Steps. Hence, it is very important to understand the meaning of financial control, its objectives and benefits, and the steps that must be taken if it is to implement correctly.

    The Concept of Financial Control explains – their Meaning, Definition, Objectives, Importance, and finally Steps.

    Exercising financial control is one of the important functions of a finance manager. Also, It aims at planning, evaluation, and coordination of financial activities to achieve the objective of the firm.

    Meaning and Definition of Financial Control:

    Control of financial activities carried out in an organization to achieve the desired objectives. They also provide a set of rules and regulations about the financial management systems followed in an organization.

    All organizations have financial controls to ensure effective financial management. Also, Most organizations have financial controls to ensure that everyone is aware of procedures to follow and to ensure that there is a better understanding of each one’s responsibility.

    The concept of Financial Control: It is concerned with the policies and procedures framed by an organization for manag­ing, documenting, evaluating and reporting financial transactions of an organization. In other words, they indicate those tools and techniques adopted by a concern to control its various finan­cial matters.

    Objectives of Financial Control:

    The main objectives of financial control discuss below:

    1] Economic Use of Resources:

    As well as, They aim to evaluate and coordinate financial activities. This helps prevent leakage of funds and thus desired returns on investments can realize.

    2] Preparation of Budget:

    They help the management prepare the budget for a particu­lar department. Also, Budgets provide a basis to compare actual performance with standard performance.

    3] Maintenance of Adequate Capital:

    It shows the way to maintain adequate capital, i.e. proper implementation of financial control verifies the adequacy of capital, and hence the evils of over-capitalization or under-capitalization can avoid.

    4] Maximization of Profit:

    As well as they compel the management to procure funds from cheaper sources and to apply the said funds efficiently to lead to profit maximization.

    5] Survival of Business:

    A good financial control system ensures proper utilization of resources, which creates a sound and strong base for an organization’s existence.

    6] Reduction in Cost of Capital:

    They aim at raising capital from cheaper sources by maintaining a proper debt-equity mix. So, the overall cost of capital remains at its lowest.

    7] Fair Dividend Payment:

    Their system aims to distribute a fair and adequate dividend to the investors thereby creating satisfaction among the shareholders.

    8] Strengthening Liquidity:

    One of the important objectives of financial control is to maintain the liquidity of the firm by exercising proper control over different components of the working capital.

    9] Checking that everything is running on the Right Lines:

    Sometimes, it just checks that everything is running well and that the levels set and objectives proposed at the financial level regarding sales, earnings, surpluses, etc., are being met without any significant alterations.

    The company thus becomes more secure and confident, its operating standards and decision-making processes being stronger.

    10] Detecting Errors or Areas for Improvement:

    An irregularity in the company finances may jeopardize the achievement of an organization’s general goals, causing it to lose ground to its competitors and in some cases compromising its very survival.

    Therefore, it is important to detect irregularities quickly. Various areas and circuits may also identify which while not afflicted by serious flaws or anomalies could improve for the general good of the company.

    11] Increase in Goodwill:

    A sound financial control system increases the productivity and efficiency of a firm. This helps in increasing the prosperity of the firm in the short run and its goodwill in the long run.

    12] Increasing Confidence of Suppliers of Funds:

    The proper, they prepare the ground to cre­ate a sound financial base of a firm and thereby increases the confidence of investors and suppliers.

    Financial Control Meaning Definition Objectives Importance and Steps
    Financial Control: Meaning, Definition, Objectives, Importance, and Steps. Image credit from #Pixabay.

    Importance of Financial Control:

    Finance is important for any organization and financial management is the science that deals with man­aging of finance; however the objectives of financial management cannot achieve without the proper controlling of finance.

    The importance of financial control discuss below:

    1] Financial Discipline:

    They ensure adequate financial discipline in an organization by efficient use of resources and by keeping adequate supervision on the inflow and outflow of resources.

    2] Coordination of Activities:

    As well as they seek to achieve the objectives of an organization by coordinating the activities of different departments of an organization.

    3] Ensuring Fair Return:

    Proper financial control increases the earnings of the company, which ulti­mately increases the earnings per share.

    4] Reduction in Wastages:

    Adequate financial control ensures optimal utilization of resources leav­ing no room for wastages.

    5] Creditworthiness:

    As well as they help maintain a proper balance between the debt collection period and the creditors’ payment period; thereby ensuring proper liquidity exists in a firm that increases the creditworthiness of the firm.

    The Steps of Financial Control:

    According to Henry Fayol,

    “In an undertaking, control consists in verifying whether everything occurs in conformity with the plan adopted, the instructions issued and principles established”.

    Thus, as per the definition of Fayol’s, the steps of financial control are:

    1] Setting the Standard:

    The first step in financial control is to set up the standard for every financial transaction of the concern. Standards should be set in respect of cost, revenue, and capital. Also, Standard costs should determine in respect of goods and services produced by the concern taking into account every aspect of costs.

    Revenue standard should fix taking into account the selling price of a similar product of the competitor, sales target of the year, etc. While determining capital structure, the various aspects like production level, returns on investment, cost of capital, etc., should take into account so that over-capitalization or under-capitalization can avoid.

    However, while setting up the standard, the basic objective of a firm, i.e. wealth-maximization, should take into account.

    2] Measurement of Actual Performance:

    As well as the next step in financial control is to measure the actual per­formance. For keeping records of actual performance financial statements should systematically prepare periodi­cally.

    3] Comparing Actual Performance with Standard:

    In the third step, actual performances compare with the pre-determined standard performance. The comparison should finish regularly.

    4] Finding Out Reasons for Deviations:

    If there are any deviations in the actual performance with the standard performance, the amount of variation or deviations should also ascertain along with the causes of the deviations. This should report to the appropriate authority for necessary action.

    5] Taking Remedial Measures:

    The last and final step in financial control is to take appropriate steps so that the gaps between actual performance and standard performance can bridge in the future, i.e. so that there is no deviation between actual and standard performance in the future. Read and share, Their Meaning, Definition, Objectives, Importance, and Steps in Hindi.

  • How do you Understand the Time Value of Money in Cost of Capital?

    What is the Time Value of Money? If an individual behaves rationally, then he would not equate money in hand today with the same value a year from now. In fact, he would prefer to receive today than receive after one year. The time value of money or TVM is a basic financial concept that holds that money in the present is worth more than the same sum of money to be received in the future. The time value of money is the greater benefit of receiving money now rather than later. It is founded on time preference. How do you Understand the Time Value of Money in Cost of Capital?

    Here is explained the Time Value of Money in Cost of Capital.

    Time value of money (TVM) is the idea that money that is available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received. The time value of money explains why interest is paid or earned: Interest, whether it is on a bank deposit or debt, compensates the depositor or lender for the time value of money. It also underlies investment. Investors are willing to forgo spending their money now only if they expect a favorable return on their investment in the future, such that the increased value to be available later is sufficiently high to offset the preference to have money now.

    The reasons cited by him for preferring to have the money today include:

    • The uncertainty of receiving the money later.
    • Preference for consumption today.
    • Loss of investment opportunities, and.
    • The loss in value because of inflation.

    The last two reasons are the most sensible ones for looking at the time value of money. There is a ‘risk-free rate of return’ (also called the time preference rate) which is used to compensate for the loss of not being able to invest in any other place. To this, a ‘risk premium’ is added to compensate for the uncertainty of receiving the cash flows.

    The required rate of return = Risk-free rate + Risk premium

    The risk-free rate compensates for the opportunity lost and the risk premium compensates for risk. It can also be called as the ‘opportunity cost of capital’ for investments of comparable risk. To calculate how the firm is going to benefit from the project we need to calculate whether the firm is earning the required rate of return or not. But the problem is that the projects would have different time frames of giving returns. One project may be giving returns in just two months, another may take two years to start yielding returns.

    If both the projects are offering the same %age of returns when they start giving returns, one which gives the earnings earlier is preferred. This is a simple case and is easy to solve where both the projects require the same capital investment, but what if the projects required different investments and would give returns over a different period of time? How do we compare them? The solution is not that simple. What we do in this case is bring down the returns of both the projects to the present value and then compare.

    Before we learn about present values, we have to first understand future value.

    Future Value:

    Future value is the amount that is obtained by enhancing the value of a present payment or a series of payments at the given rate of interest to reflect the time value of money. If we are getting a return of 10 % in one year what is the return we are going to get in two years? 20 %, right. What about the return on 10 % that you are going to get at the end of one year? If we also take that into consideration the interest that we get on this 10 % then we get a return of 10 + 1 = 11 % in the second year making for a total return of 21 %. This is the same as the compound value calculations that you must have learned earlier.

    Future Value = (Investment or Present Value) * (1 + Interest) No. of time Periods

    The compound values can be calculated on a yearly basis, or on a half-yearly basis, or on a monthly basis or on a continuous basis or on any other basis you may so desire. This is because the formula takes into consideration a specific time period and the interest rate for that time period only. To calculate these values would be very tedious and would require scientific calculators. To ease our jobs there are tables developed which can take care of the interest factor calculations so that our formulas can be written as:

    Future Value = (Investment or Present Value) * (Future Value Interest Factor n, i)

    where n = no of time periods and i = is the interest rate.

    Present Value:

    When a future payment or series of payments are discounted at the given rate of interest up to the present date to reflect the time value of money, the resulting value is called present value. When we solve for the present value, instead of compounding the cash flows to the future, we discount the future cash flows to the present value to match with the investments that we are making today. Bringing the values to present serves two purposes:

    • The comparison between the projects become easier as the values of returns of both areas of today, and.
    • We can compare the earnings from the future with the investment we are making today to get an idea of whether we are making any profit from the investment or not.

    For calculating the present value we need two things, one, the discount rate (or the opportunity cost of capital) and two, the formula. The present value of a lump sum is just the reverse of the formula of the compound value of the lump sum:

    Present Value = Feature Value/(1 + i)n

    Or to use the tables the change would be:

    • Present Value = Future Value * (Present Value Interest Factor n, i).
    • where n = no of time periods and i is the interest rate.

    Perpetuity:

    If the annuity is expected to go on forever then it is called perpetuity and then the above formula reduces to:

    Present Value= A/i

    Perpetuities are not very common in financial decision making as no project is expected to last forever but there could be a few instances where the returns are expected to be for a long indeterminable period. Especially when calculating the cost of equity perpetuity concept is very useful.

    For growing perpetuity, the formula changes to:

    Present Value= A/i – g

    All these calculations take into consideration that the cash flow is coming at the end of the period.

    Present Value of Future Money Formula:

    The formula can also be used to calculate the present value of money to be received in the future. You simply divide the future value rather than multiplying the present value. This can be helpful in considering two varying present and future amounts. In our original example, we considered the options of someone paying your $1,000 today versus $1,100 a year from now. If you could earn 5% on investing the money now, and wanted to know what present value would equal the future value of $1,100 – or how much money you would need in hand now in order to have $1,100 a year from now – the formula would be as follows:

    PV = $1,100 / (1 + (5% / 1) ^ (1 x 1) = $1,047

    The calculation above shows you that, with an available return of 5% annually, you would need to receive $1,047 in the present to equal the future value of $1,100 to be received a year from now. To make things easy for you, there are a number of online calculators to figure the future value or present value of money.

    Time value of money principle also applies when comparing the worth of money to be received in future and the worth of money to be received in further future. Time value of money is the concept that the value of a dollar to be received in future is less than the value of a dollar on hand today. One reason is that money received today can be invested thus generating more money. Another reason is that when a person opts to receive a sum of money in future rather than today, he is effectively lending the money and there are risks involved in lending such as default risk and inflation.

  • What is the Future and Historical Cost?

    Understand Future Cost and Historical Cost; Future cost of capital refers to the expected cost of funds to be raised to finance a project. In contrast, historical cost represents cost incurred in the past in acquiring funds. In financial decisions, future cost of capital is relatively more relevant and significant. While evaluating the viability of a project, the finance manager compares expected earnings from the project with an expected cost of funds to finance the project.

    Here are explained; What is the Future and Historical Cost?

    Likewise, in making financing decisions, the attempt of the finance manager is to minimize the future cost of capital and not the costs already defrayed. This does not imply that historical cost is not relevant at all. In fact, it may serve as a guideline in predicting future costs and in evaluating the past performance of the company.

    Future cost: Future costs are based on forecasts. The costs relevant for most managerial decisions are forecasts of future costs or comparative conjunctions concerning future situations. An estimated quantification of the amount of a prospective expenditure. Forecasting of future costs is required for expense control, the projection of future income statements; appraisal of capital expenditures, the decision on new projects and on an expansion programme and pricing.

    Historical Cost: Historical cost is an accounting method in which the assets of the firm are recorded in the books of accounts at the same value at which it was first purchased. Cost and historical cost usually mean the original cost at the time of a transaction. The historical cost method is the most widely used methods of accounting as it is easy for a firm to ascertain what price was paid for the asset.