top of page

Unit One

The Why of Financing

Why businesses need finance

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Finance - Why Businesses Need Finance

Adoptted from: http://www.tutor2u.net/business/gcse/finance_why_needed.htm

 

Finance is the money available to spend on business needs.

 

Right from the moment someone thinks of a business idea, there needs to be cash. As the business grows there are inevitably greater calls for more money to finance expansion. The day to day running of the business also needs money. The main reasons a business needs finance are to:

 

Start a business

 

Depending on the type of business, it will need to finance the purchase of assets, materials and employing people. There will also need to be money to cover the running costs. It may be some time before the business generates enough cash from sales to pay for these costs. Link to cash flow forecasting.

 

Finance expansions to production capacity

 

As a business grows, it needs higher capacity and new technology to cut unit costs and keep up with competitors. New technology can be relatively expensive to the business and is seen as a long term investment, because the costs will outweigh the money saved or generated for a considerable period of time. And remember new technology is not just dealing with computer systems, but also new machinery and tools to perform processes quicker, more efficiently and with greater quality.

 

To develop and market new products

 

In fast moving markets, where competitors are constantly updating their products, a business needs to spend money on developing and marketing new products e.g. to do marketing research and test new products in “pilot” markets. These costs are not normally covered by sales of the products for some time (if at all), so money needs to be raised to pay for the research.

 

To enter new markets

 

When a business seeks to expand it may look to sell their products into new markets. These can be new geographical areas to sell to (e.g. export markets) or new types of customers. This costs money in terms of research and marketing e.g. advertising campaigns and setting up retail outlets.

 

Take-over or acquisition

 

When a business buys another business, it will need to find money to pay for the acquisition (acquisitions involve significant investment). This money will be used to pay owners of the business which is being bought.

 

Moving to new premises

 

Finance is needed to pay for simple expenses such as the cost of renting of removal vans, through to relocation packages for employees and the installation of machinery.

 

To pay for the day to day running of business

 

A business has many calls on its cash on a day to day basis, from paying a supplier for raw materials, paying the wages through to buying a new printer cartridge.

 

Choosing the Right Source of Finance

 

A business needs to assess the different types of finance based on the following criteria:

 

Amount of money required – a large amount of money is not available through some sources and the other sources of finance may not offer enough flexibility for a smaller amount.

 

How quickly the money is needed – the longer a business can spend trying to raise the money, normally the cheaper it is. However it may need the money very quickly (say if had to pay a big wage bill which if not paid would mean the factory would close down). The business would then have to accept a higher cost.

 

The cheapest option available – the cost of finance is normally measured in terms of the extra money that needs to be paid to secure the initial amount – the typical cost is the interest that has to be paid on the borrowed amount. The cheapest form of money to a business comes from its trading profits.

 

The amount of risk involved in the reason for the cash – a project which has less chance of leading to a profit is deemed more risky than one that does. Potential sources of finance (especially external sources) take this into account and may not lend money to higher risk business projects, unless there is some sort of guarantee that their money will be returned.

 

The length of time of the requirement for finance - a good entrepreneur will judge whether the finance needed is for a long-term project or short term and therefore decide what type of finance they wish to use.

 

 

 

Why Business Finance?

 

Watch this short video for an overview of Business Finance.

 

Make note of the importance of business finance, the goals, and the associated risks.

Investment Decision Making

 

Investment decision making is a determination made by directors and/or management as to how, when, where and how much capital will be spent on investment opportunities. The decision often follows research to determine costs and returns for each option.

Read more: http://www.businessdictionary.com/definition/investment-decision.html#ixzz3PEZ21qVy

 

In order to fully understand the theory of investment decision making, there are some fundamental definitions that must become concrete:

  • Investment: An investment is the current commitment of money or other resources in the expectation of reaping future benefits. (Kane, Bodie and Marcus 2005)

 

Generally, “investments” refers to financial assets and in particular to marketable securities.

 

Financial assets are paper or electronic claims on some issuer, such as the government or a company.

 

Marketable securities financial assets that are easily and cheaply tradable in organized markets.

 

Real assets are tangible assets such as gold, silver, diamonds, real estate.

 

  • Speculation: Act of trading in an asset, or conducting transaction, that has significant risk of losing most or all of initial outlay, in expectation of substantial gain.

 

Difference Between Investment and Speculation

 

           Investment

  • Long term planning (at least one year)

  • Low or moderate risk.

  • Low or moderate rate of return.

  • Investment decisions are based on fundamentals.

  • Investors leveraged its own funds.  

  •  

Speculation

 

  • Short term Planning (few days or months)

  •  High Risk.

  • High rate of return.

  • Decisions are based on hearsay and market psychology.

  • Resort to borrowed funds.

  •  

Why to Invest?

 

  • Investment increases future consumption possibilities

    • By foregoing consumption today and investing the savings, investors expect to increase their future consumption possibilities by increasing their wealth

    •  

If we do not invest, then?

 

  • If we have savings and we do not invest, we can’t earn anything on our savings.

  • Second, the purchasing power of cash diminishes in inflation

  • This means that if savers do not invest their savings, they will not only lose possible return on their savings, but will also lose  value of their money due to inflation

  •  

 Investment has problems

 

  • A. Sacrifice   -           While investing, investor delay their current consumption (delaying consumption is kind of sacrifice)

  • B. Inflation - Investment loses value in periods of inflation

  • C. Risk - giving your money to someone else involves risk

 

Understanding the investment decision process

 

  •   The basis of all investment decisions is to earn return and assume risk

  • By investing, investors expect to earn a return (expected return)

  •  

Different approaches to investment decision making

 

  • Fundamental Approach: Believed that there is an intrinsic value of a security that can be company, industry and economy.

  • Psychological Approach: This approach based on the premises that stock prices are guided by the emotions. It is more important to analyse that how investor tend to behave as the market is swept by the waves of optimism and pessimism.

  •  

  • Academic Approach: Suggest that: 

  •  

  •    -Stock market is efficient in reacting quickly and rationally hence it reflects intrinsic value fairly well.

  •     -Stock price behavior correspond to the random walk, hence past price behavior can not be used to predict the future price.

  •     - There is positive relationship between risk and return.

  •  

  • Electric Approach: This approach draws on all the three approaches.

  •  

  •     -Fundamental analysis is helpful in establishing basic standard benchmarks.

  •     - Technical analysis is useful in broadly gauging the mood of the investor.

  •       - there is a strong correlation between risk and return.

  •  

Steps in the decision process

 

  • Traditionally, the investment decision process has been structured using two-steps:

    • Security analysis

    • Portfolio management

    •  

Security analysis: this is the first part of investment decision process

 

  • It involves the analysis and valuation of individual securities

  • To analyze securities, it is important to understand the characteristics of the various securities and the factors that affect them

  • Then valuation model is applied to find out their value or price

  • Value of a security is a function of estimated future earnings from the security and the risk attached

  • For securities valuation, investors must deal with economy, industry or the individual company

  • Both the expected return and risk must be estimated keeping in view the economic, market or company related factors

The second major component of the decision processes is portfolio management

  • After securities have been analyzed and valued, portfolio of selected securities is made

  • Once a portfolio is made, it is managed with the passage of time

  • For management, there can be two approaches

  • Approaches to portfolio management:

  • A. Passive investment strategy

  • B. Active investment strategy

  • In Passive Strategy, investors make few changes  in the portfolio so that transactions costs, time and search costs are minimum

  • In Active Strategy, investors believe that they can earn better returns by actively making changes in the portfolio

  •  

Common Errors in Investment Decision Making

 

Inadequate comprehension of return and risk.

 

            Investor do not has correct understanding of risk & return and misled by:

            -Tall and unjustified claims made by people.

-Exceptional performance of some portfolios due to fortuitous factors.

-promises made by the tipsters, operators etc.

 

Investment policy is not clearly defined

 

            -Investment policy and risk disposition is not clearly spelled out.

            -conservative investors become aggressive when the market is bullish.

            -Aggressive investor become over cautious in bearish market.

 

Naïve exploration of the past.

 

            -Investor is inexperienced and excessively rely on the past

 

Cursory of decision making

            - Decision are taken on tips and fads rather than on thoughtful assessment.

            - Risks are not considered as greed overpower.

            - Try to follow bandwagon decisions due to lake of confidence in their own judgment.

 

Stock switching

 

            - Irrational start-and-stop.

            -Entry (after the market advance has long been underway)

            -Exit (after a long period of stagnation and decline)

 

High Cost Love for a cheap stock

 

            -Cost of transaction is ignored in the greed of quick profits

 

Over and Under-diversification

 

            -Over diversification caused difficulties and excessive cost in portfolio management.

            -Under diversification exposes to risk.

 

Wrong attitude towards profit and losses

            - Investor try to dilute the loses by averaging the price of its holdings.

            -Try to sell when the prices more or less equal to holding price even there are chances of further increase.    

  • w-facebook
  • Twitter Clean
  • w-googleplus
bottom of page