Financial Management for Cornerstones of Managerial Accounting

Question: Discuss about theFinancial Management for Cornerstones of Managerial Accounting. Answer: Financial management Maximization of shareholder wealth vs. Notion of Maximization of Profit for Business Companies Shareholders are referred to as individuals who own shares in the company and thus are entitled to receive profits. The business companies should emphasize on creating maximum wealth for shareholders. This is possible when business managers focuses on promoting long-term performance of the company. The shareholders ware the owners who appoint business managers to act on their behalf for carrying out business operations. The concept of wealth maximization for shareholders states that a business manager should not only emphasize on creating profits fro shareholders but promoting its sustainable growth and development. As such, the main focus should be placed on increasing sales, expanding the market share and carrying out the operational activities of the business in the sustainable manner. The maximization of wealth refers to creating large value for shareholders so that shareholders are able to realize continuous profits from the business (Shim and Siegel, 2008). The business mangers by placing focus on maximizing wealth for shareholders are intending to increase the stock process. As such, the increase in the stock prices subsequently leads to a rise in the wealth of the shareholders. This in turn enhances the value of the firm and net worth of the shareholders. The business managers are only the representatives of the shareholders and therefore it is possible to the occurrence of conflict between owners and managers in the process of wealth maximization. This is known as agency problem because owners are concerned with driving the long-term performance whereas manager can focus on taking such actions that can result in improving their own performance. Thus, in the event of occurrence of conflict it should be resolved quickly for reaching to the ultimate goal of wealth maximization. Thus, it is extremely important for manager to align their personal objective with the braid objective of the company for driving the maximization of wealth for current shareholders. On the other hand, the notion of profit maximization for shareholders is a short-term objective of the financial management. This is because it does not take into account the concept of risk and return as that in the wealth maximization. The emphasis given by the business managers only on increasing profits will not promote the sustainable growth and development of a business company (Chiu, 2012). However, the focus on wealth maximization for shareholders will ultimately lead to increase in profits for the shareholders. Therefore the notion of profit maximization is covered under the concept of wealth maximization and so the business managers should prioritize wealth maximization. For example, an increase in price-earning ratio is an indicator of wealth maximization for companies whereas profitability ratios such as gross profit indicates the short-term growth potential of a company. For example, if a Company A has higher stock price than B even if it has lower profitability ratios, the also investor should select the company A for investment purpose. This is because price-earning ratio indicates the potential for future growth earning of the company and thus indicates its long-term performance (Shim and Siegel, 2008). Evaluation of Mutually Exclusive Projects using the IRR and NPV Approaches The mutually exclusive projects refer to set of projects out of which only one project can be selected for the investment purpose and thus the acceptance of one indicates the rejection of other. The feasibility of a project can be assessed through the use of capital budgeting techniques such as NPV and IRR. Thus, if there are two potential projects present for investing purpose, them the project manager should assess the feasibility of each project through the use of capital budgeting techniques. The project managers often incorporates the use of Net Present Value (NPV) and Internal Rate of Return (IRR) are the most common methods that are used for ranking projects in relation to the present value and future cash flows. The Net Present Value (NPPV) method is regarded as the method of ranking the projects for investment purpose through calculating the present value of future net cash flows. The method takes into account the concept of time value of money discounted at the marginal cos t of capital. Therefore, if the NPV of the project is zero, then the cash flows are adequate for meeting the required rate of return and if it is positive them there is sufficient cash flows to pay back the investment incurred and return to the shareholders. However if the NPV is negative, then the project must be rejected because it is not regarded to be profitable in the future context (Heitger, Maryanne and Hansen, 2007). On the other hand, the method of Internal Rate of Return (IRR) is a method of ranking the projects on the basis of calculating the discount rate at which the present value of the future cash flows equates the project cost. For a project to be acceptable on the basis of IRR method, the discount rate must exceed the cost of capital of the project. However, it is regarded that the methods of NPV and IRR provides contradictory results in evaluation of the feasibility of mutually exclusive projects that varies in terms of size and differences in the time of cash flows. NPV provides absolute measure and therefore it will rank the mutually exclusive projects on the basis of adding more profits irrespective of the original investment. However, IRR is a relative measure that ranks the projects on the basis of realizing higher return on investment irrespective of the total value gained. NPV is attributed to be a better method for evaluating them mutually exclusive projects as provides more rea listic results on the basis of profitability and wealth maximization of shareholders. On the other hand, IRR method does not provide realistic results which limit its use during selection of mutually exclusive projects (Brigham and Houston, 2012). For example, a company having a budget of $50,000 and has options of selecting either project A, B and C. If the projects A and B cost $40,000 and project C costs $10,000then project A and B are regarded to be mutually exclusive. Thus, as such, the project managers is recommend to adopt the use of NPV method for ranking the project and accept the project having higher NPV. If roger earn $10000 per year up to 10 years Years Cash inflow PVF @ 8% PV 1 $ 10,000.00 0.926 $ 9,259.26 2 $ 10,000.00 0.857 $ 8,573.39 3 $ 10,000.00 0.794 $ 7,938.32 4 $ 10,000.00 0.735 $ 7,350.30 5 $ 10,000.00 0.681 $ 6,805.83 6 $ 10,000.00 0.630 $ 6,301.70 7 $ 10,000.00 0.583 $ 5,834.90 8 $ 10,000.00 0.540 $ 5,402.69 9 $ 10,000.00 0.500 $ 5,002.49 10 $ 10,000.00 0.463 $ 4,631.93 Present of cash flows $ 67,100.81 It is better that Roger receives $100000 today as if he earns $10000 per year up to 10 years it will provide him loss of $32899.19 Debra wins $200,000 in a lottery. She takes only $20,000 in cash and invests the balance at a rate of interest of 10% pa with the understanding that she will receive 160 equal monthly payments with the first one to be made in 2 years. Find the size of the payments. Solution B: Value of total investment at year 0 (current time) = $180000 Value of total investment at the end of year 2 = $216000 (calculated on simple interest basis) Size of payment = (0.0833*$216000) /[1-(1+0.0833)-160] (Shim Siegel, 2008) = $1442.18 Nominal Rate of Firm A 10% per annum It is compounded quarterly Number of times compounding 4 times Effectives interest rate of firm A Firm A Nominal interest rate = 12 % p.a. EAR = (1+12%/4)4 -1 EAR = (1.125) -1 EAR = 0.125 EAR = 12.5 % p.a. So Firm B needs 12.5 % Effective interest rate to match the Firm A Effective rate for firm B =12.5% Compounded monthly Number of times compounding = 12 times Nominal interest rate: 12 *[(1+0.125)1/12 - 1] =11.83% References Brigham, E. Houston, J. (2012). Fundamentals of Financial Management. Cengage Learning. Chiu, P. (2012). Looking Beyond Profit: Small Shareholders and the Values Imperative Corporate Social Responsibility. Gower Publishing, Ltd. Heitger, D., Maryanne, M. Hansen, D. (2007). Fundamental Cornerstones of Managerial Accounting. Cengage Learning. Shim, J. Siegel, J. (2008). Financial Management. Barron's Educational Series.