Working Capital, Capital Rationale and Journal Post

In real world situations, the risk of any single investment would not be viewed independently of other assets. New investments must be considered in light of their impact on the risk and return of the portfolio of assets. The financial manager’s goal is to create an efficient portfolio, one that maximizes return for a given level of risk or minimizes risk for a given level of return.

Diversification

The concept of correlation, which is a statistical measure of the relationship between any two series of numbers, is essential to developing an efficient portfolio. To reduce overall risk, it is best to combine, or add to the portfolio, assets that have a negative (or a low positive) correlation. Combining negatively correlated assets can reduce the overall variability of returns.

Risk, which is basically the chance of financial loss, can never be completely controlled. However, there are ways to manage it over time. Some risks directly affect both financial managers and shareholders. Overall, business risk and financial risk are more firm-specific and therefore are of greatest interest to financial managers. Interest rate, liquidity, and market risks are more shareholder-specific and therefore are of greatest interest to stockholders.

Risk Aversion

Financial managers generally seek to avoid risk. Most managers are risk-averse – for a given increase in risk they require an increase in return. This perspective is believed consistent with that of the owners, who manage the firm. Managers generally tend to be conservative rather than aggressive when accepting risk. A risk-averse manager requiring higher return for greater risk is the ideal situation.

Capital Budgeting

The capital budget is an outline of planned investments in fixed assets, and capital budgeting is the process of planning expenditures on assets whose cash flows are expected to extend beyond one year.

*   A number of factors combine to make capital budgeting perhaps the most important function financial managers and their staffs must perform.  Since the results of capital budgeting decisions continue for many years, the firm loses some of its flexibility.  Also, a firm’s capital budgeting decisions define its strategic direction.  Timing is also important since capital assets must be put in place when they are needed.

*   The same general concepts that are used in security valuation are also involved in capital budgeting;  however, whereas a set of stocks and bonds exists in the securities market from which investors select, capital budgeting projects are created by the firm.

 *  Normally, a more detailed analysis is required for projects requiring larger investments or projects having more risk.

*   Once a potential capital budgeting project has been identified, its evaluation involves the same steps that are used in security analysis.

*   The cost of the project must be determined.

*   Cash flows from the project are estimated.

*   The riskiness of these projected cash flows is determined.

*   Given the riskiness of the projected cash flows, the appropriate cost of capital is determined at which cash flows are to be discounted.

* The cash flows are evaluated using the following methods.

*   Six key methods are currently used to rank projects and to decide whether or not they should be accepted for inclusion in the capital budget:  (1) Net Present Value (NPV), (2) Internal Rate of Return (IRR), (3) Modified Internal Rate of Return (MIRR), (4) Profitability Index (PI), (5) payback, and (6) discounted payback.