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Business Financing and the Capital Structure

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Business Financing and the Capital Structure
Table of Contents
  1. Estimating Asset Investment Requirements
  2. Debt and Equity Options
  3. Seeking Capital from Foreign Investors
  4. Relationship between Risk and Return
  5. References

Estimating Asset Investment Requirements

The concept of working capital management focuses on evaluating the relationship between short-term liabilities and short-term assets to sustain organizational expenses and debts, both in the short-term and in the long-term (Abuzayed, 2012). Efficient working capital management improves an organization’s operations through the improvement of an organization’s earnings. Efficient working capital management depends on the flow of marketable securities. Marketable securities include assets that easily convert to cash. These securities are often liquid because they have a high demand. Some common examples of marketable securities include stocks and bonds, but any equity or debt instrument also classifies as a marketable security (Abuzayed, 2012). Similarly, government bonds also suffice as common examples of marketable securities. These marketable securities are often beneficial to investors because they provide returns even when the assets are dormant.

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Investors use marketable securities to park excess cash whenever they have not identified any ready investments. Financial instruments, such as mutual funds and money market accounts, serve this purpose. Albeit both types of financial instruments serve the same purpose, they originate from different entities. For example, mutual funds originate from mutual fund companies and financial instruments originate from financial brokerage firms. Both sets of investments use money market instruments to provide a return for their investments. However, the interests derived from such investments are relatively lower than other types of investments (Abuzayed, 2012). Even though these investments provide a low return, they are relatively safe investments when they compare to other types of investments.

Debt and Equity Options

The process of raising business capital is often a complex issue because many entrepreneurs face different financial options when raising business capital. The right type of financing option is however not very apparent to most of these entrepreneurs, more so, because every financial option has a special set of implications for the business. It is therefore important for businesses to choose the right type of financing option for their businesses. The two most common types of financial options are debt and equity financing. Considering the uncertain economic times we live in today, as a financial advisor, I recommend that new businesses should not use debt financing. Instead, new businesses should go for equity financing. Equity financing is different from debt financing because equity financing does not require regular payments from the business (Keown, 2003). Instead, this type of investment only erodes the control of the business owner by buying business stakes. Comparatively, debt financing does not involve buying into the business. Investors only loan the money to the business owner, in return for regular payments (including interest) (Keown, 2003).

In today’s uncertain economic times, it is riskier to take debt financing because it may lead to bankruptcy if the business fails. Unfortunately, uncertain economic times only seek to affirm the high failure rate of new businesses. Comparatively, business owners who seek equity financing do not have to worry much about business failure because equity investors normally understand that when the business fails, they are not entitled to compensation (Keown, 2003). It is therefore safer to seek equity investments in today’s uncertain business environment as opposed to debt financing.

Seeking Capital from Foreign Investors

Foreign investors play an instrumental role in improving the economic health of different countries. At the micro-economic level, foreign investors are equally beneficial to small investors as they provide the necessary capital that small business owners need to undertake their activities. This is the reason some business owners seek capital from foreign investors (Abuzayed, 2012). However, while foreign investors are crucial for small and large businesses, their involvement in local businesses poses several risks and rewards. One reward that may motivate business owners to seek capital from a foreign investor is the need for foreign reserves. More specifically, business owners who need foreign reserves for their businesses may find it very beneficial to seek foreign participation in their businesses. However, the greatest risk for such a decision is that the foreign money is only “hot” money. In other words, the foreign investors may withdraw their money at a moment’s notice. If this happens, the business may suffer from low capital.

Foreign investors may also increase the capital reserve for new businesses by injecting “new money” into the business. Business owners may use the increased capital reserve to expand the business, or start it (if it is a start up business). However, the involvement of foreign investors may create a false representation of the business because the “new money” is not “concrete,” as it originates foreign investors who may not have a close attachment to the business. Stated differently, the increased capital reserve may decrease at the same speed it increased, if the foreign investors have a second thought regarding their investments in the business. Comprehensively, even though foreign investors may provide the necessary boost for business owners to start or expand their businesses, their involvement also poses several risks for the business.

Relationship between Risk and Return

Risk and return share a positive relationship, which demonstrates that high risk equals to high return and low risk equals to low return. Keown (2003) says common bond is the least risky investment, while common stock is the riskiest investment. Even though common stock is riskier than corporate bond, it provides the best hedge for inflation (Keown, 2003). Moreover, the risk profile of common stocks may reduce if the investors are more patient with their investments.

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Based on the diversity of risk and return, diversification is the best way to improve the relationship between risk and return. To understand how diversification affects the level of risk and return, it is important to understand the concepts of non-diversifiable risk and diversifiable risk. By understanding the relationship between the two forms of risk, it is similarly crucial to say that the only relevant risk, given the opportunity to diversify risk, is non-diversifiable risk (Keown, 2003). In other words, by having a risk that is non-diversifiable, an investor suffers “real” risk.

Diversifiable risk is irrelevant because diversification reduces the risk. For example, if an investor had $50,000 and invested it by buying the Shares in Widgets Inc. Australia, which eventually posts an average rate of return of -3%, the investor would make a loss on his investment because his investment would decrease to $42,937 (97% of $50,000). However, if the investor diversified his portfolio by investing $5,000 in Widgets Inc. Australia, $15,000 in Widgets International, $10,000 in Computing America, $5,000 in a fixed interest account, $10,000 in property shares, and $5,000 in cash, he would make a 2.6% profit if all portfolios increased by -3%, 12%, -2%, 6%, 10%, and 5% respectively. From the above illustration, we see that diversification reduces the level of risk.

References

Abuzayed, B. (2012). Working capital management and firms’ performance in emerging markets: the case of Jordan. International Journal of Managerial Finance, 8(2), 155 – 179.

Keown, A. (2003). Foundations of Finance: The Logic and Practice of Financial Management. New York: Prentice Hall.

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