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Replacement of old assets is one of the most common and critical decisions that have to be made by an organization dealing with goods or services. Many organizations do not know the correct method of replacing an existing asset and face huge losses later when the asset stops working altogether.There are some considerations that need to be addressed while taking a replacement decision. Here are some of the most needed ones.Do not let the machine decideMany organizations follow a very simple policy for the replacement of existing assets.Instead of trying to decide for the time of replacement, they let the ... Read More
Although depreciation does not affect the cash flows in a direct manner, it has an indirect influence on the latter. Depreciation is a non-cash item and so financial managers must know how depreciation affects the cash flows in order to present an accurate figure of cash flows.What is Depreciation?Depreciation is a concept in accounting wherein the loss of value of an asset is considered. Whether it is machinery, computing equipment or office stationery, all tangible assets lose value over time. In that manner, all tangible assets have a value of zero after its useful life. This reduction of value of ... Read More
Financial decision-making is one of the most integral parts of the overall business management of a company. The decisions made by a financial department of a company have to be under the framework of overall corporate objectives and policies. A finance department cannot take decisions that are not in sync with the corporate policies of a business concern.The decisions in financial management have been categorized into three parts −Investment decisionsFinancial DecisionsDividend decisionsThe investment decisions are related to assets in which the company will invest its funds. The assets that can be acquired within investment decisions are broadly divided into two ... Read More
Capital gearing and income gearing differ in the sense of their application, as the calculation of the two are different from each other. The measures of financial leverage, namely debt ratio and debt-equity ratio are related to capital gearing; whereas the interest coverage ratio is a measure of income gearing.Capital GearingCapital gearing measures are static in nature. Therefore, they are incapable of stating the financial risks an investor or a company may face in the long term.It also does not represent the true condition of a company’s financials and hence misses to report the repayments or payments of interests.Income GearingThere ... Read More
While computing the net cash flows, in theory, it is assumed that all revenues are received in cash and all expenses are paid in cash. However, in practice, cash receipts and cash payments are different from revenues and expenses as noted in the profit and loss account. This change is primarily caused by changes in accounts receivable (trade debtors), accounts payable (trade creditors), and stock of goods (inventory).It is also impossible for firms to make all payments and receipts in cash and in such situations, changes must be done in the calculation of net cash inflow from operations.It is notable ... Read More
Sunk costs and allocated overheads are important topics in the evaluation of an investment. Sunk costs need to be ignored while making a new decision, whereas the allocated overheads are not quite good for cash flow estimations. Let’s have a bit more detailed study of these two factors that affect an evaluation of investments.Sunk CostsSunk costs are funds that have been invested in the past that will make no difference to a current decision of funding a new project. The latter part is of importance to financial analysts and accountants because it shows the actual way a business must go ... Read More
Capital budgeting is an intricate process that a company follows to make the most out of it. The capital budgeting process needs enough decisions making which must be correct and closely followed. Capital budgeting has the power to either make a company hugely profitable or destroy the business entirely. That is why it is a very important process a business must master to obtain steady growth and profit from it.There are some fund-related and strategic issues in capital budgeting. Depending on the specific needs, the three levels of capital budgeting can be broadly classified into the following −Operating Capital BudgetingStrategic ... Read More
The pecking order theory is an explanation of a firm’s debt-to-equity financing portfolio. It helps investors to understand how a company sources its financing. In other words, the pecking order theory shows the optimal debt and equity structure of a firm’s financing model.Pecking order theory is essentially an idea that helps the managers of a company to decide how to finance the company.It is based on a hierarchy where the managers first use retained earnings (internal financing), then debt financing, and then equity financing.Internal FinancingUsually, the managers of a firm tend to use internal financing as the first choice because ... Read More
The FRICT approach is a very important way of measuring the results of the financial structure of a firm. It consists of the following factors −FlexibilityRiskIncomeControlTimingLet us now take a look at each of these factors in detail.FlexibilityThe capital structure of a company should be within its debt capacity and in no way should it exceed the maximum debt limit. The capacity usually originates from the company’s future cash flows.The company should have enough cash to meet the demands of the creditors and then should have extra cash to limit any future contingency.The capital structure should be able to adapt ... Read More
Also known as Fisher Hypothesis, the Fisher’s Effect was a theory proposed by economist Irving Fisher. The theory states that the real interest rate of an investment is not affected by other monetary measures, such as nominal interest rate and expected inflation. The theory describes the relationship between the inflation rate and both nominal and real interest rates.According to Fisher Hypothesis, the nominal interest rate is the difference between the real interest rate and the expected rate of inflation. It also states that an increase in real interest rate occurs with decreasing inflation rate and vice versa, unless the same ... Read More