In order to get prepared for participation in the class discussion of these questions, write a short paragraph on the following:

a) What questions do financial managers (treasurers, controllers) face daily?

b) What financial ratios are taken into account by managers to enable them to conduct their business effectively?

c) What do capital structure and cost of capital imply?

Ex. 15. Prepare a short talk on the following:

a) The main sources and uses of funds for a business firm.

b) The roles of the chief financial officer, the treasurer and the controller.

c) Current and fixed assets and their management.

d) Leverage and its role in striking a balance between debt and equity.

e) Why do you think some companies choose to obtain working capital through a sale of stock instead of going to some other sources of funds? Do they try to achieve a better balance between debt and equity?

Ex 16. While reading business news look for items about firms that are losing money and firms that are doing well. Make your conclusions about the financial management of the firms. One of the conclusions is likely to be that the key to success is upgrading professional skills of the employees. What skills are likely to be in demand in the next five years – computer literacy, knowledge of foreign languages, anything else?

There are a lot of jobs in finance and accounting for the simple reason that all types of organizations have financial needs. What careers in finance will be attractive: economists, bank managers, bank tellers, securities sales workers, insurance agents, brokers, actuaries, underwriters?

Reading practice

Ex. 17. Read the text quickly to find the sentences giving a definition of the cost of capital:

Capital Structure and Cost of Capital

The capital structure refers to the weight which different types of capital have in the total capital employed. The question of capital structure becomes particularly significant when a choice of debt and equity capital is made. The relationship between the long-term debt and equity capital invested in the business is called gearing.

Gearing is the indicator of the relative proportion of debt capital and equity capital. The higher the proportion of debt, the more highly geared is the company. The degree of gearing affects the overall cost of capital.

The conventional view is that at very low levels of gearing debt capital will be cheaper than equity capital because the level of risk is low, with debt interest being a prior charge. The overall cost of capital is thus brought down with the use of debt. As the debt-equity ratio increases, interest becomes a bigger proportion of expected profits. The higher the gearing, the more exposed the company is at times of economic difficulty.

The concept is difficult to measure in practice. The most elementary measure is nominal value of fixed-interest capital versus nominal value of equity capital.

The ratio has limitations as it ignores some types of interest-bearing finance such as bank loans and mortgages.

* * *

Cost of capital is the cost measured as a percentage rate of the various sources of capital required to finance capital expenditure. All sources of capital have a cost which can be a direct one as, say, with a loan or an opportunity cost as, say, with retained earnings. At any time a company's cost of capital will be the weighted average of the cost of each type of capital: ordinary shares, preference shares and long-term debt.

Companies have a choice of the capital structure which they adopt and will generally try to minimize the overall cost of capital in making their choice.

Ex. 18. Read the text quickly to find the answer to the following question:

What happens after a winding-up order is granted by the court?

Liquidation

If a company is unsuccessful in its operations, or if for any other reason it decides to go out of business, it goes into liquidation. There are two kinds of liquidation – voluntary and compulsory.

Voluntary liquidation may be brought about by the shareholders passing a resolution directing the company to go into voluntary liquidation. When this happens one or more liquidators are appointed whose duties are to realize (to sell) the assets, pay all liabilities, and distribute the balance assets of the company, if any.

Compulsory liquidation can be brought about for a variety of reasons connected with the failure to fulfil the rules laid down by the Companies Act. But a company is usually compulsorily liquidated by order of the court given on a creditor's petition, when the creditor is unable to obtain satisfaction of his debt from the company.

When a winding-up order is granted by the court, the directors are deposed, the employees of the company receive notice that their agreements with the company are at an end, and the company's business is stopped.

Whatever assets remain after the claims of all the creditors have been settled, will be distributed among the shareholders in accordance with the rights carried by their shares.

Ex. 19. Read the text quickly to find the part of the text explaining how managers can solve the problem of a cash shortfall.

The Cash Flow Concept

The concept of cash flow is one of the central elements of financial analysis, planning, and resource allocation decisions. Cash flows are important because the financial health of a firm depends on its ability to generate sufficient amounts of cash to pay its creditors, employees, suppliers, and owners.

Only cash can be spent.

Sometimes firms are expected to have an excellent year but unexpectedly cash shortages arise. Shortages of cash may arise for several reasons.

First, not all sales are expected to be for cash or to be credit sales (accounts receivable) collected during the year.

Firms may have debt repayment obligations. Payment of taxes, interest and a cash dividend may further reduce the firm's cash position.

The firm's managers have to arrange to meet this cash shortfall through actions such as borrowing, the sale of new common equity, a reduction in dividend payments, sale of accounts receivable, or increases in accounts payable.

Preparation of a cash budget is useful in helping a firm plan for its cash needs over some future period of time.

Financial managers know that generally accepted accounting principles (GAAP) provide considerable latitude in the determination of the net income of a firm. As a consequence, GAAP concepts of net income do not provide a clear indication of the economic performance of a firm. Cash flow concepts provide a clear measure of the performance of a firm.

To evaluate the cash flows generated from the firm's activities managers use the net present value concept.

Net present value represents the difference between the present value of future cash flows associated with a project and the present value of the initial investments to acquire that project. It is the most commonly used technique to evaluate capital budgeting proposals.