Imagine you are a small business owner. Determine the financial ratios that are

Question

Imagine you are a small business owner. Determine the financial ratios that are important to the business. Compare your ratios with those that are important to a manager of a larger corporation.

2. Explain the advantages and disadvantages of debt financing and why an organization would choose to issue stocks rather than bonds to generate funds.

3. Discuss how financial returns are related to risk.

4. Describe the concept of beta and how it is used.

5. Contrast systematic and unsystematic risk.

6. Imagine your manufacturing corporation has just won a patent lawsuit. After attorney and other fees, your corporation will have about $1 million. Explain how you plan to invest the money in order to diversify the risk and receive a good return. Support your decisions with concepts learned in this course.

Explanation / Answer

1.for small bussiness , you will have to make sure that amount that you are investing must get back as early as possible, so you will use inventory turnover ration, return on investment profit percentage 2.Advantages of Bonds i) Bonds do not affect shareholder control over an organization. Stocks purchased on the stock market represent equity or ownership of the corporation, however bonds do not. Bondholders lend cash to an organization and mark a “Bond Payable” liability on their balance, and a Receivable on their finances/books. ii) Interest on Bonds is Tax-Deductible – Interest paid on bonds is tax-deductible for an organization and represents a competitive advantage. However, dividends paid out by a corporation are not tax-deductible. This is so important, that an illustration sounds probable. Consider a corporation lends out a $2,000,000 bond to bondholders with a coupon rate of 10% paid annually. Thus, interest expense would be 10% x $2million = $200,000. Because Interest expense is tax deductible, the corporation would be able to deduct this $200,000 from its Net Income equalling $200,000 x 40% = $80,000. This results in a tax saving of $80,000, assuming an income tax rate of 40%! Thus, the true cost of borrowing the bonds is 120,000 / $2,000,000 = 6%. This means the corporation is really paying out a net of 6% interest (after-tax) on its $2 million bonds payable. If the corporation however would have raised this capital via shares issuance, the $200,000 dividends paid out (assuming the same scenario with a dividend yield of 10%) would not be tax deductible and the true cost of borrowing for the organization would be 10%. iii) Bonds increase return on equity – Bonds can increase financial leverage of an organization because when it earns higher interest with the borrowed funds through bonds issued than what it pays in interest, this increases its return on equity. Return on equity is net income available to common shareholders divided by common shareholders’ equity. Disadvantages of Bonds i) Bonds require repayment of both annual interest rate & principal at maturity – If a company does not maintain a good free cash flow, it might have difficulty making its interest payments & repaying the entire balance of the bonds at maturity may be even more difficult, and the company might have to refinance its line of credit to pay for this. Shares on the other hand do not require a company to pay out dividends; the company can choose to reinvest its dividend payments back into the expansion of the organization. Ii) Bonds can decrease return on equity – When a corporation earns a lower return on investment or interest rate than what it is paying to its bondholders, it is obviously losing money. This decreases return on equity and leads to the company not being able to fulfill its interest payment obligations and repaying the principal at maturity.

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