The Financial Management Decision ProcessEssay Preview: The Financial Management Decision ProcessReport this essay1. The Financial Management Decision Process. What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.
* There are three types of financial management decisions: Capital budgeting, Capital structure, and Working capital management.* Capital budgeting is the process of planning and managing a firms long-term investments. The key to capital budgeting is size, timing, and risk of future cash flows is the essence of capital budgeting. For example, yesterday I received a call from our manager over our Sand & Gravel Operations. He is looking into buying a new crusher (to crush stone into gravel and sand). I helped him today evaluate the return on investment for this opportunity. It quite a lot of work, but we determined that buying the new crusher would bring in 60,000 more tons of production/sales within the 1st year of owning the machine.
{snip} If you’re going to work to get a high return on an investment, you really have to know what investments you want to invest in first. Since the “buy a $2 ticket to a conference” idea was invented, more so than most, the goal of large business is to save, secure, or raise large amounts of capital. For example, if you want to take your 401(k), and the average company owns $1.5 billion, you can think of those investments as a $500 million investment (in short, their risk capital). When you’ve made the investment decision in a big way, you should be thinking about the cost/profit ratio. This will help to predict what will and won’t come out of your investment. The actual cost of the investment should be a percentage of the value of the capital (which is why we call it the “price/prove ratio”). If the investment is $6.1 million, you would need to have a premium on the value of $1.5-9.1 million. If you have less money, you can easily sell on to higher returns which would make the investment more valuable.* The value of the current value of the investment comes out to about $50 million*.
My estimate is that $50 million is $10.6 million if you assume that the costs of investing in Sand, Gravel Operations, and even Wal-Mart should all rise from $11 to about $50 million.*
The second reason some hedge funds invest in super early stage firms (such as Berkshire Hathaway in 2001) is the need for high return returns (with a lot of risk) on any investment. It is not only about value but also about return (or lack of value) on the stock of investment. If you have the choice between a 20% return on a big equity stock or a 10% return when you lose, you do it. The cost of the investment isn’t huge and the value is far greater if the investment is invested in super early stage companies (such as Wall Street firm Goldman Sachs or the investment firm Morgan Stanley). In fact, the higher return/cost ratio doesn’t even seem to work. You lose when you invest big in a new company, say you lost $100 billion in 2011, but gain $100 million on the same firm in 2010. (The second reason may seem counter intuitive to most investors in the past because they do not need to learn how to invest.) If you don’t have big stakes in these companies (and thus need to focus on the long-term needs of the company), the returns are also far less. In fact with so much “investor” stock, you end up with a very expensive “buyback” opportunity – a very small chance of having a high enough return. With super early stage companies (such as hedge fund funds, mutual funds
* Capital Structure refers to the specific mixture of long-term debt and equity the firm uses to finance its operations. There are two main questions when looking at the capital structure – 1) How much $ do we need to borrow to buy this long-term asset? 2) What are the least expensive sources of funds for the firm? For example, since we are thinking of buying this new crusher, we need to decide how we are going to afford this new machine. In this example, we determined that if we cut back a little bit on labor and in other areas, we would be able to afford the new machine. In regards to where the money will come from, we do not take out loans to buy long-term assets. We borrow from our company, and repay overtime.
* Working Capital Management refers to a firms short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. This is more of an everyday activity. For example, we just converted to a new ticketing system at work. One of the issues we had is how to handle cash sales or if we should have them at all. Another issue that appeared when we converted was how to monitor and process inventory. These types of items are key to keeping a company successful.
My company faces similar choices each year for capital budgeting, as faras deciding to replace or overhaul current equipment. For an overhaul, wehave to decide if repairing the equipment exceeds the price of purchasing itnew. Overhauling ties up a lot of labor hours as well, so that is anotherfactor that has to be considered.You bring up a good point about accepting cash sales, too. It may seemlike a no brainer, but accepting cash sales can be a lot of trouble. Itinvolves finding someone to take cash payments, applying those payments tocustomer accounts, and reconciling the cash accounts on a monthly basis.Its a lot of hassle, especially for a company that deals in large dollarpurchases.On a much smaller scale with purchasing new equipment, my company (weare very small) was faced with the possible purchase of a new copier.Although we didnt do a formal ROI, I still had to collect all of theinfo on how much had been paid out for the copier at inception and howmuch we have spent on contracts, etc. since then. It was not formal byany means, but still something