JWI 530 Financial Management I, week2 summary, 1/20/13
What a fantastic week this was ! I thoroughly enjoyed the finance
education covering many core principles, concepts and terms. This
education opens my eyes to look at the world in entirely new light.
My takeaways are given below.
JWI 530 Week2 Summary, 1/20/13
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I. The goal of a finance manager
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Maximize reward while minimizing risk (Week2, Lecture1)
Principle of Risk-Reward Equilibrium: Always evaluate risk/reward and opportunity cost of an idea with alternatives
Discount rate is the rate of return required by investors.
II. US Treasury Note
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DQ1 took us through the history of the US Treasury Note and its role as a
global reference that is increasingly in question due to $16 Trillion
debt that appears to be growing out of control.
What led to the US Debt $16 Trillion (great links from JB)
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www.foxnews.com/politics/2012/09/04/who-do-owe-most-that-16-trillion-to-hint-it-isnt-china/
www.policymic.com/articles/15723/obama-and-the-national-debt-president-misleads-public-on-his-role-in-exploding-the-national-debt
http://abcnews.go.com/Business/national-debt/story?id=17159803#all
III. Cost of Capital (Week2, Lecture2)
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Vehicles of Financing are Bonds, Stocks (including Preferred Stock)
Debt vs Equity - best mix to finance a firm depends on business situation
Cost of Debt: After-tax rate = Pretax interest rate * (100% - tax rate)
Cost of Equity: Capital Asset Pricing Model (CAPM)
Weighted Average Cost of Captial (WACC) - used to determine the hurdle
rate for any project or idea that the firm intends to invest in
IV. DQ2 Debt vs Equity Financing - Pros & Cons
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Obtaining adequate capital is mission-critical for firms to grow and
succeed in the market place. A firm can get its capital through
borrowing (debt financing) or through selling corporate ownership share
(equity financing). Each form of capital has advantages and
disadvantages.
Debt Financing Pros & Cons
Debt Financing is done through loans that need to be repaid with
interest over time. Lenders include banks, government agencies such as
Small Business Administration.
Advantages
+ Interest paid on loans is tax deductible
+ Lower cost of capital. Once the loan is paid back the lender has no say ie. Lender does not get ownership rights
Disadvantages
- New businesses with irregular cash flows may find it stressful and difficult to make regular payments
- Firms become vulnerable to interest rate hikes and economic down turns
- A firm carrying too much debt can be perceived by investors as a high risk business, limiting the future ability to borrow.
- If the firm defaults, bondholders have the first right to get paid back with available assets (JWI 530, Week2, Lecture2)
Equity Financing Pros & Cons
Equity financing is done through money obtained from investors in
exchange for ownership share. Friends & family, Angel investors and
Venture Capitalists could be the source of such capital.
Advantages
+ The firm need not stress about repayment of the capital and instead can focus on growing for the long term
+ High profile investors can increase credibility of the business
Disadvantages
- Ownership dilution and loss of autonomy. Equity investors want to be
partners over and above being investors. As part owners of the business,
equity investors will invariably want a say in major business decisions
- Higher cost of capital. Equity investors will demand higher return with a risk premium of 4-6% (JWI 530, Week2, Lecture2)
Depending on the short term and long term objectives, a firm - whether
it is a start up or an established firm - must decide on the optimum
debt to equity ratio. Start ups, for instance, want to weight equity
higher and achieve a debt equity ratio in the range of 1:2. An
established firm may want to achieve a 1:1 ratio. During recent
financial crisis it became clear that many financial services firms were
heavily leveraged with Debt/Equity ratios in the range of 1:30 and so
such extremes should be avoided.
this is an exciting course for sure
Dr DP
Reference
http://www.enotes.com/debt-vs-equity-financing-reference/debt-vs-equity-financing
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