Finance Zing

Understanding IRA Rollover Tax Implications

2010-11-27T04:28:00.000-08:00

Tax planning should be a crucial part of your retirement savings strategy, as simple tax mistakes can easily cut the balance of your retirement accounts in half. Let’s look at some of the most common situations that can trigger IRA rollover tax implications within your retirement plans.

IRA Rollovers from Employer-Sponsored Plans

The most common situation that triggers an IRA rollover tax is the rollover process itself, where funds are moved from an old employer-sponsored 401k or 403b account to a traditional or Roth IRA. Account holders have two major options when initiating an IRA rollover – a direct rollover or an indirect rollover.

A direct rollover occurs when the old account custodian forwards the funds directly to the new IRA account provider. The account holder never sees the money – once the necessary paperwork is complete, it’s simply a matter of waiting until the account balance is transferred to the new account. The major advantage to this option is that it does not trigger any IRA taxes, mandatory withholding or early withdrawal penalties.

In comparison, an indirect rollover involves the account holder cashing out the balance of the original employer-sponsored retirement plan before personally depositing the funds into the new IRA account. This type of transfer isn’t subject to the IRA rollover tax; however, the original custodian is required to withhold 20% of the account’s balance when closing the account. This simple distinction will leave you with only 80% of your original investment balance to deposit into your new account.

IRA Conversions – The Roth IRA Tax Penalty

The main distinction between traditional and Roth IRA accounts is how they’re taxed. Funds invested in traditional IRAs are contributed before they’re taxed, allowing them to grow tax free until they’re disbursed at retirement. Roth accounts, on the other hand, are funded with money that’s already been taxed, meaning that they will not be taxed on withdrawal once the account holder reaches retirement age.

For many investors, Roth IRAs offer significant advantages, especially if they anticipate being in a higher tax bracket upon retirement. However, funds that are invested in a traditional employer-sponsored retirement plan can’t be rolled directly into a Roth IRA without triggering the Roth IRA tax penalty, as this would prevent the account holder from ever paying taxes on the funds. Instead, the funds must first be rolled into a traditional IRA before being converted to a Roth IRA, at which point they will be subject to ordinary income tax.

Additional Issues with the Roth IRA Tax Deduction

Of course, this is the simplified version of the Roth IRA conversion process – the reality of the process may have several additional IRA tax implications that should be considered.
For example, if you’re nearing retirement age, converting a large traditional IRA balance will trigger a large Roth IRA tax penalty that you may not be able to recoup before you begin to rely on your funds. Alternatively, because Roth IRA conversions are taxed as ordinary income, performing a large conversion could make you ineligible for other valuable tax credits, such as education or child care programs.

For this reason, it’s a smart idea to sit down with a qualified financial adviser who can assist you in understand the IRA tax implications you may face depending on the retirement investment options you choose. Although financial adviser fees may seem high, they can be a bargain if they save you thousands in IRA taxes!

Avoid the IRA Rollover Tax with a Direct Transfer

2010-10-27T04:27:00.000-07:00

Moving your money from an old employer-sponsored retirement plan – like a 401k or a 403b – to an IRA can be a smart move financially, as these accounts typically offer a wider range of investment opportunity and higher returns overall. However, if you aren’t careful, you could wind up on the hook for a serious IRA tax penalty. Let’s look more closely at how you can avoid this situation.

Transferring Funds Out of an Old Retirement Plan

The first step in understanding how to avoid the IRA rollover tax is to become familiar with the options available to you for moving your retirement funds out of an old employer’s account. Typically, you have three options:

1. Cash out your old account. When you close your old employer-sponsored account, you do have the option to take your invested funds as cash. However, this choice comes with some pretty stiff tax implications – plan to pay at least ordinary income taxes plus early withdrawal penalties unless you deposit your funds into a new IRA within 60 days.

2. Move the funds to your new employer’s retirement account. In most cases, this doesn’t make much sense – remember; you’re moving your funds out of the old 401k or 403b to take advantage of new opportunities and higher rates of return. Simply rolling your funds into a new employer account offers neither of these benefits.

3. Transfer your balance directly into an IRA. In this scenario, you instruct your current account holder to move the money directly into your new account. You never see the money and you’re never subject to IRA rollover taxes.

Understanding the IRA Tax Implications of These Options

For the purposes of this article, let’s assume that you plan to transfer your funds to an IRA account and look at the advantages and disadvantages of the first and third scenarios from an IRA tax standpoint.

In scenario one, you take a cash distribution of the entire balance of your old 401k or 403b account. If you want, you can simply keep the cash, although this is rarely a smart move. At a minimum, you’ll pay income tax on the money, plus the mandatory 20% withholding tax your employer is required to withdraw and any other IRA rollover tax penalties that may apply. After all is said and done, you could be out as much as 50% of the balance of your former account.

Of course, if you do take the cash distribution, you can avoid some of these IRA rollover taxes by depositing the funds into a new IRA account within 60 days. However, even if you plan to go this route, your former employer is still required to withhold the mandatory 20% IRA tax. If you want to defer tax on the total taxable portion of the transfer, you’ll need to add funds of your own to the IRA to make up for this 20%.

For this reason, the third scenario is almost always the best choice for avoiding IRA rollover tax penalties. When the funds are transferred directly from one retirement account to another, no IRA taxes are withheld and you aren’t required to pay ordinary income tax on the account balance. Your funds are able to continue to grow and enjoy the benefits of an IRA, without suffering any losses during the transfer process.

Is an IRA Direct Rollover Right for You?

2010-04-26T00:42:00.000-07:00

Depending on your financial situation, refinancing direct IRA could only be the right investment vehicle to help you secure your future. If you decide to change your place of work or actually retires, turnover Individual Retirement Account (IRA) offers a wide range of features and benefits that enhance your retirement savings - that is certainly an option worth of further consideration.

An IRA Direct Rollover is a vehicle for safe and secure investment that is supported by the government as a way to help people prepare for retirement. In the current turbulent economic environment, this investment option is very attractive. In addition, the IRA Capital offers a wide range of options and choices than the traditional 401k, and also offers significant opportunities to increase your profit margin and increase your savings.

The IRA is also running very simple account maintenance. The process involved in managing an IRA rollover is much simpler than other forms of investment for retirement. For example, the IRA rollover direct you to consolidate your money in an account and effectively monitor its performance. Retirement plans such as 401K employer controlled, can become very fragmented and confusing, if you move into different positions and businesses throughout your life. Changing jobs can be the ideal opportunity to consolidate and establish an IRA rollover.

Perhaps the biggest advantage of the direct rollover IRA is that it offers better access to your funds 401k or 403b plan of your employer. There are a number of conditions that exist that allow you to access your money without penalty, if necessary. For example, if you become ill or disabled, if you buy your first home, or if you incur expenses of higher education, you can withdraw IRA funds without penalty.

Another reason that can make a direct rollover IRA right for you is the greater range of investment choices offered by this plan. Although your 401k can not offer a yield of 3-5% annually, according to its limited investment options, a direct rollover IRA account offers a wider range of potential output because of its access to more wide range of investment choices.

If you are interested in investing and are willing to research and look for opportunities to grow your wealth, direct rollover IRA may be the perfect vehicle for you. Rather than being limited by the options in your 401k investment applied, you can really compare and find a bearing that focuses on investments you are really interested IRA. The IRA rollover can also reduce your risk of losing money in a market unsettled, as it allows you to spread your money across a wider range of investment vehicles, thus reducing your risk exposure while maximizing your profits .

If you change jobs, or if you're approaching retirement, scrutinize the features and benefits of the IRA rollover - it may just be the ideal investment choice for you. The IRA is a rollover flexibility, choice and tax advantages that can increase your retirement savings and start on the path to financial security.

Basics of depreciation

2010-01-15T10:00:00.000-08:00

Depreciation is the allocation, for accounting and tax purposes, of the purchase costs of fixed assets over a effect on the net income of the firm. Over depreciation of assets decreases the net income of the firm, and under depreciation increases it. In simple terms, then, when a company depreciates an asset at more than the normal rate, total expenses go up and lower profits are reported, There for, profits vary depending on the method of depreciation used in preparing financial statements.

To prevent inconsistent use of depreciation methods by different companies from one year to another, the Internal Revenue Service (IRS) requires all firms to depreciate their assets based on certain procedures approved by Congress. However, firms can use different depreciation methods in various internal or external reports, or for evaluation of their own performance.

A company or individual cannot depreciate an asset more than its original price. In other words, an asset purchased for $100 can be depreciated for no inflation can sometimes raise the price of an asset above its initial price. Unfortunately, the existing depreciation laws ignore inflation and limit the total depreciation charges to the purchase price and installation cost.

Taxes on dividends received by corporations

2010-01-11T05:25:00.000-08:00

In addition to their main functions, corporations may participate as investors in the capital market. They may invest in financial securities of other corporation or institutions. Because corporations pay taxes on their income and stockholders also pay taxes on distributed dividends, the law permits an exemption of 70% of the dividends that corporations receive on their investment outside the company. In other words, corporations pay taxes on 30% of their dividend income. Because the maximum corporate tax rate is 39%, the effective highest rate in dividends is 11.7%.

Taxes on a corporation's dividend income, which is in addition to taxes a corporation pays on its earnings and that stockholders pay on their dividends, are usually called a triple tax. The rationale for a 70% tax exemption of the dividend income of corporations is basically to minimize the effects of a triple tax.

Capital gains and losses

2009-12-31T03:23:00.000-08:00

By definition, if a capital asset is sold above its book value, a capital gain is realized; if the asset is sold for less than the book value, there is a capital loss. A capital asset could be a real asset, such as real estate, or a financial asset, such as stocks and bonds. One of the most controversial provisions of the Tax Reform Act of 1986 was the elimination of the long-term capital gain deduction. Under previous tax law, a capital gain of $1,000 on an asset that an investor had owned for 6 months or longer was exempt by 60%. Because that maximum tax bracket in the previous system was 50%, the most an individual had to pay on long-term capital gains was only 20% (0.50 x (1 - 0.60)). In the existing system, there is no capital gain deduction; therefore, capital gains and ordinary income (wages, salaries, rent, etc) are taxed at the same rates. The maximum tax rate on capital tains is 28%. The highest tax rate on a net capital gain is generally 15%. There are three exceptions:

The taxable part of a gain from qualified small business stock is taxed at a maximum 28% rate.
Net capital gain from selling collectibles such as coins or art is taxed at a maximum 28% rate.
The part of any net capital gain from selling Section 1250 real property that is due to depreciation is taxed at a maximum 25% rate.

Passive income versus active income

The current tax law makes a distinction between passive income and active income. What is the difference between the two? Passive income is generated from a trade or business in which the taxpayer "does not materially participate." With certain exceptions, investments in rental properties and limited partnerships are defined as passive. Investments in which a taxpayer is continuously and rigorously involved are called active. Why does this distinction matter? The answer is that a taxpayer cannot deduct a passive loss from his/her salary, portfolio income, or business income. Passive losses are deductible to the extent that there is a new income from passive activities. A dollar loss from one limited partnership can be deducted from a dollar net income of another passive investment. If there is no income from any other passive investment, either passive losses should be carried forward to a future year or their deductible expenses should be itemized, although itemized deductions are severely limited in the current tax law. The capital gain provision does not exist, and the maxium capital gain rate is 28%. Passive losses cannot be deducted from ordinary and portfolio income. The only exception is for people hwo, on a small-scale, actively engage in owning and managing a real estate property. A maximum deductible loss in this case is $25,000 and it is proportionally phased out for people with incomes between $100,000 and $150,000 annually.

How to figure taxable income

2009-12-30T03:02:00.000-08:00

To arrive at taxable income, we must go through three steps. First, we need to determine the total income. Total income includes all kinds of income minus certain exclusions such as interest from tax-exempt securities and some Social Security benefits. Second, the total income should be reduced by certain adjustments such as IRA deductions (if eligible), contributions to other acceptable retirements plans, alimony payments, and penalties in early withdrawals of savings. The balance is called the adjusted gross income. Third, subtract the standard deductions or the itemized deductions (whichever is higher) and the total exemptions from the adjusted gross income; the remaining figure is taxable income on which we must pay taxes.

Standard deductions versus itemized deductions

Once the adjusted gross income is computeed, a taxpayer has the choice of taking a fixed amount of deductions as stated by the law or reporting a detailed and itemized list of deductions. As a rational person, the taxpayer should compute and compare both amounts and claim the higher amount. The itemized deductions, subject to limits, include medical and dental expenses, state and local income taxes, real estate taxes, home mortgage interest, some other interest expenses, gifts to charity, casualty and theft losses, job-related expenses, and a broad category of miscellaneous expenses.

Itemized deductions have been severely limited. For instance, medical expenses that are not reimbursed by insurance companies may be deductible to the extent that they exceed 7.5% of the adjusted gross income. For instance, a taxpayer with an adjusted gross income of $60,000 is not entitled to any medical deduction before he/she pays $4,500 of medical expenses ($60,000 x 0.075). If total expenses are $6,000 deductions would be $1,500 ($6,000 - $4,500); assuming a marginal tax rate of 25%, the tax benefit of this deduction is only $375 ($1,500 x 0.25). Stated differently, a taxpayer in a 28% tax bracket, with an adjusted gross income of $60,000 who pays $4,500 for medical expenses, receives only $375 in the form of a tax benefit. Interest expenses, except interest expenses on home mortgage, are nondeductible. An exception to this rule is the interest on one's principal residence or a second residence; the deduction however is limited to the interest on a mortgage no greater than the home's purchase price plus the cost of home improvement. If the extra debt of the principal or second residence is used for educational or medical purposes, interest expenses may also be considered deductible.

Marginal versus average tax rate

2009-12-28T02:43:00.000-08:00

The distinction between marginal and average tax rates is important in financial decision making. Suppose you are a single taxpayer and report $60,000 as taxable income. You pay 15% on the first $30,650 and 25% on the remaining income. In this case, your marginal tax rate (the highest rate you pay on additional income) is 25%. To calculate the average tax rate precisely, let's see how much tax you owe on the entire income:

25% x ($60,000 - $30,650) = $7,337.50
Total taxes = $4,220 + $7,337.50 = $11,557.50
Average tax rate = $11,557.50 /$60,000 = 0.1926 or 19.26%

As you see, the average tax rate is the percentage of total taxes paid on total taxable income. The marginal tax rate is the only relevant tax rate in financial decision making. Suppose Bob and Betty are married; they file their tax forms separately, and each earns a taxable income of $125,000. The marginal tax rate for each spouse is 33%. In other words, for every $100 worth of extra income, each pays $33 income taxes excluding state and other taxes.

What are the implications of the marginal tax rate? Bob and Betty may argue that with a federal tax rate of almost 33%, and assuming 10% state taxes, they have to pay nearly half of their new earnings (43%) to the federal and state governments. This 43% rate (federal plus state) ignores other possible deductions. Therefore, Bob and Betty may reconsider any offers that may bring them additional income. This is true because in a progressive taxable income system, the higher the marginal tax rate, the less will remain as a disposable income to the person. One way in which you can reduce the negative impact of a higher marginal tax rate is through tax planning for more legitimate and substantiated tax deductions so that a person can lower his/her average tax rate. The following schematic shows an interaction of the income level, marginal tax rate, legitimate deductions, and the average tax rate:

Higher income > Higher marginal tax rate > More legitimate deductions needed > Lower average tax rate

Federal income tax for individuals

2009-12-26T02:29:00.000-08:00

Prior to the Tax Reform Act of 1986, individuals were taxed at 15 progressive tax rates from 11% to 50%. In 1986 the tax structure was reduced to two basic brackets. 15% and 28% with an intermittent rate of 33% for a certain mid-level income. For example, a single return taxpayer would pay 33% on the income between $17,851 and $43,150; beyond that level a lower rate of 28% would be in effect. Because of the intermittent rate of 33%, the previous tax system was called progressive-and-regressive in the sense that mid-level incomes were taxed at the highest rate of 33%. The progressive-regressive aspect of the tax system turned into a progressive system (higher rates for higher income) in 1993 following a series of amendments based on the Omnibus Budget Reconciliation Act of 1993.

Since 1993 a number of changes in tax law have affected the tax brackets on different individual taxpayers. In the area of federal income taxation, following is a list of the major tax components (tax variables) that often divide policymakers' views on how individuals should be taxed; therefore, the tax variables change from one year to another.

Inflation-adjusted tax brackets: These adjustments revise the low and high boundaries of different tax brackets.
Basic standard deductions: The basic standard deduction amounts for 2006 were as follows - head of household ($7,550), married taxpayers filing jointly & qualifying widow(er)s ($10,300), married taxpayers filing separately ($5,150) & single ($5,150). The standard deduction amount for an individual who may be claimed as a dependent by another taxpayer may not exceed the greater of $850 or the sum of $300 and the individual's earned income.
Personal exemptions: The amount one can deduct for each exemption has increased by $100 from $3,200 in 2005 to $3,300 in 2006. One begins to lose all or part of the benefit of exemptions if the adjusted gross income is above a certain amount. The amount at which the phase-out begins depends on the taxpayer's filing status. For 2006, the phase-out began at: $112,875 for married persons filing separately, $150,500 for single individuals, $188,150 for heads of household and $225,750 for marred persons filing jointly or qualifying widow(er)s.

Basics of taxation

2009-12-24T02:09:00.000-08:00

The US tax law has been revised many times in the last 20 years. The current tax system is the outcome of many revisions including the Economic Recovery Act of 1981, the Tax Equity and Fiscal Responsibility Act of 1982, the Tax Reform Act of 1984, the Tax Reform Act of 1986, the Omnibus Budget Reconciliation Act of 1993, and the Tax Reform Act of 1996. A number of other revisions and amendments after the year 2000 have affected the existing laws with different economic reasons behind each amendment. A basic knowledge of taxation is needed for a financial analyst to measure the impact of tax rates on financial decisions. Without a good understanding of taxation, we may not be able to arrive at correct decisions in evaluating non-mutually exclusive projects, deciding on leasing versus buying, determining dividend policy, identifying alternative sources of financing, and analyzing other cases related to finance and investment.

Determining the amount of taxable income

Problem: Alice and Larry have a total income of $60,000. They have made a $5,000 contribution fo an acceptable self-employed retirement plan and have also paid a $500 penalty of an early withdrawal of a certificate of deposit from their bank. Including their children, they are entitled to four personal exemptions (assuming $3,250). Their total itemized deductions are $12,500. What is the taxable income of Mary and John?

Solution: Adjusted gross income = Total income - Adjustments
= $60,000 - 5,000 - 500
= $54,500

Taxable income = Adjusted gross income - Deductions - Exemptions
= $54,000 - 12,500 - (3,250 x 4)
= $29,000

In this example, Alice and Larry will pay taxes on $29,000.

Various tax reform acts in the last 10 years made significant changes in the tax law for individuals. The Omnibus Reconciliation Act of 1993 was followed by other tax amendments in 1996 and 2000. There are five progressive rates of 15%, 25%, 28%, 33%, and 35% for individuals. The marginal tax rate (the tax rate in additional income) is the only relevant factor to consider for calculations of after-tax benefits of new investments. Taxpayers may elect a standard deduction or itemize their deductible expenses. Itemized deductions have been severely limited for the purpose of computing personal tax liabilities.

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Corporation

2009-12-22T01:57:00.000-08:00

The third form of organization is the corporation, which, in terms of dollars, dominates today's business world. A corporation can be formed by a person or a group of persons. The "personality" of the corporation, under the law, is totally separate from its owners. Precisely speaking, a corporation, is a "legal entity"; therefore, the corporation, rather than the owners, is responsible for paying all debts.

Because of the legal status of a corporation, the owners have limited liability and can't lose more than their invested money. Unlike a proprietor, the owners of a corporation do not have to withdraw from their personal savings or sell their personal belongings to satisfy creditors if the corporation goes bankrupt. An owner of a corporation is called a stockholder or shareholder.

The purpose of a corporation is to increase the wealth of stockholders, who elect a board of directors from among themselves and from people outside the corporation to set general guidelines for the corporation. If the corporation is relatively large, the board hires managers to work as agents of the stockholders. Managers have a responsibility to set long-range corporate strategy, which specifies the objectives that the corporation must achieve in the future. Managers have other responsibilities, including hiring employees, purchasing assets, borrowing money, issuing stock, controlling the work of other employees, and reporting the status of the corporation to the board of directors and stockholders on a periodic basis. The above picture illustrates the basic organization of a corporation.

Partnership

2009-12-21T01:34:00.000-08:00

A partnership is a form of business organization in which two or more individuals are the owners. A partnership can be viewed as a proprietorship with more than one owner.

There are two kinds of partners: general partners and limited partners. General partners have unlimited liability in running a business, but limited partners are liable only up to the amount of their investments or for a specified amount of money. In a general partnership all partners have unlimited liability. In a limited partnership there is at least one limited partner in the business.

Business publications such as the Wall Street Journal often contain advertisements for limited partners in real estate businesses. In such a case, an individual typically invests a certain amount of money in a partnership for the purpose of building a shopping center, buying or leasing a rental property, or purchasing land. The profits of the partnership are divided among the limited and general partners according to predetermined ratios. Since the risk of a limited partner is confined to the loss of the investment, his or her portion of the total profit is usually less than that of a general partner. In order to bring more capital to some undertakings, particularly lucrative real estate ventures, existing general partners may sometimes offer nearly equal shares of profits to new limited partners.

Proprietorship

2009-12-20T01:26:00.000-08:00

A proprietorship is the oldest form of organization for a business owned by only one individual. Anyone with money can buy basic working tools and start a proprietorship to produce goods or offer services thought to be marketable.

A main advantage of a proprietorship is its easy formation process. The formation of a proprietorship doesn't require the approval of any regulatory agency. Once the working conditions of the business are present the sole proprietorship is in existence. (The only exception is that certain professions require a license in order to practice.) Another advantage is the straightforward taxation method used for proprietorships: The proprietor's income is simply included on the owner's individual tax return each year.

A main disadvantage of this form of organization is that the owner is responsible for the entire liability of the proprietorship. Since the owner has unlimited liability, personal properties that are not used in the business may be lost to creditors.

Another disadvantage is that a proprietorship can't use organized capital markets - such as stock and bond markets - to raise needed capital. A proprietorship therefore has limited opportunities for growth, because its capital can be expanded only so far. Capital, in the form of either debt or equity, is the means to buy assets and expand a company. Since a proprietorship cannot raise equity capital by outside means, it cannot enjoy the benefits of continuous growth.

Although more than 80% of the businesses in the United States are proprietorships, they represent only 10% of the total sales in the marketplace! The reason? Proprietorships are small businesses with limited means to finance operations and limited resources to compete and survive in the market.

Forms of business organizations

2009-12-19T01:14:00.000-08:00

There are three main types of business organizations in the United States - proprietorship, partnership, and corporations. An owner of a proprietorship or a general partnership has unlimited liability, but the liabilities of shareholders in a limited partnership or a corporation do not exceed the value of their investments. Unlike a proprietorship or a partnership, a business corporation is a "legal entity" separate from its owners.

Proprietorships and partnerships are small firms with very limited ways to raise capital and to expand operations. While more than 80% of US business firms are either proprietorships and partnerships, they have a market share of only 10% of the national economy.

Finance terms #2

2009-12-17T01:08:00.000-08:00

Active income: Income generated from a trade or business in which an investor actively and materially participates; otherwise, called passive income.

Capital gain: Profit from the resale of an asset (selling price minus book value).

Capital asset: A real and tangible asset such as real estate or machinery.

Cash flow: A measure of a company's liquidity, consisting of net income plus noncash expenditures (such as depreciation charges).

Financial asset: Assets that are not real on their own; for example, bonds, stocks, certificates of deposit.

Inflation-adjusted tax brackets: Annual income tax brackets that increase by an assumed rate of inflation. The ratio was 1.7% from 1998 to 1999.

Marginal tax rate: A rate a taxpayer pays on his or her last unit of income.

Modified Accelerated Cost Recovery System (MACRS): A depreciation method in which assets are classified according to their specifications and to the number of years over which they can be depreciated.

S Corporation: Small business with a corporate form but in which all profits (and losses) are passed through to the shareholders, as in a partnership.

Triple tax: A situation where taxes are paid three times: income tax on corporate income, tax on stockholders' dividends, and tax on dividend income of the firm from its outside investment.

Finance FAQs #2

2009-12-15T00:16:00.000-08:00

Q: What three accounting statements help the manager monitor a firm's performance? What can the balance sheet tell the firm about its assets and financial structure?
A: The income statement, the balance sheet, and the statement of cash flows. The balance sheet tells the firm how it is allocating its funds to various assets and how the firm generates funds from internal and external sources. The income statement is concerned with sales, costs, and profits. The statement of cash flows traces cash inflows and outflows for operating, investing, and financing purposes.

Q: In what ways can statistics be used to help managers succeed?
A: Statistics provide the tools for comparing the financial status of the firm with that of other companies and of its own industry. Statistical techniques are invaluable for projecting the returns and relative risks of different investments. They can be used to simulate the outcome of investments, given different assumptions. Statistics can help managers to monitor operations and to time borrowing, purchase of goods, and capacity expansion.

Q: What are some of the nonfinancial aspects of the manager's role in society, such as responsibility toward workers, treatment of minorities, and dealing with gender problems?
A: Financial managers must be ethical and seek to interact with the community. They must conform to environmental, legal, health, and safety standards. In this connection, they should avoid investments in ventures that transgress democratic principles and should seek to hire minorities. In other words, a balance should be struck between attempts to maximize wealth and the attainment of social betterment. A firm should also establish rules to prevent sexual harassment and to eliminate salary differentials based on gender or race.

Q: What happens when the firm issues either too much debt or too much common stock?
A: Risk increases and the firm fails to take full advantage of the various sources of funds. In this case, the cost of issuing debt or stock will eventually increase.

Q: Does knowledge of financial theory and statistical appraoches give a manager all the answers in solving financial problems? Explain.
A: Financial theory is a starting point. It merely provides some tools which cannot substitute for experience and judgment. However, despite its limitations, theory helps to explain the financial process and shows how to avoid pitfalls in making investment decisions.

Q: Besides maximizing the wealth of the firm, what are some of the other goals of financial management?
A: Besides having the responsibility of maximizing the price of a company's shares at the least risk possible, a manager must adopt flexible financing methods in order to control costs. Furthermore, when implementing a plan, constant monitoring is required, and when the plan fails to achieve the desired goal, a new staretegy should be adopted.

Q: Why do firms seek global exposure?
A: Firms seek global exposure because they wish to increase growth, diversify risk, gain from new technology exchanges, lower costs of labor, and benefit from cheap imports. However, they must be aware of certain risks such as exchange rate devaluations, expropriations, and the potential losses in the value of assets.

Q: What kinds of different decisions are faced by a global firm?
A: Managers have to be aware of the different tax laws and legal aspects in foreign countries. They should take advantage of lower interest rates when borrowing abroad. It is also important to consider differences in discount rates between domestic and foreign projects involving similar projects. Strategies should be adopted to protect against losses in current assets and liabilities. The interpretation of the D/E ratio can differ significantly in various countriess calling for a different attitude toward debt risk and insolvency. Managers must learn to employ financial derivatives as hedges against currency rate changes. Among the most popular derivatives are futures and swaps. Also, because managers face an exchange rate risk, they have to adjust the projected cash flows of a foreign project for expected changes in currency values and they must adopt strategies to protect the values of working capital assets.

Repatriation of earnings is not simple because of losses that a firm can incur in currency translations. Furthermore, managers cannot employ the same standards of accounting. They should be cognizant of the differences in capital structure interpretations because abroad, high D/E ratios are more acceptable than in the domestic market. Although there are many benefits in globalizing, a prudent policy is advised to avoid overexposure in weak currency countries.

Q: What are some of the advantages of outsourcing? What are some of the problems it creates for the firm?
A: By outsourcing a firm can avoid technological obsolescence. The firm does not have to incur the costs of pollution control and worker safety. If the existing capacity mix fails to match changing demand, outsourcing can fill the deficiency gap. Above all, the firm benefits from low labor and other costs. In contrast, the firm is faced with new risks such as adverse changes in exchange rates. Loss of depreciation cash flows is a real possibility. Foreign investments may be subject to expropriation.

Finance FAQs

2009-12-13T23:31:00.000-08:00

Q: What do financial managers try to maximize, and what is their second objective?
A: The primary objective of financial managers is to maximize the wealth of the firm or the price of the firm's stock. A secondary objective is to maximize earnings per share.

Q: In trying to achieve optimum profits, what may a firm ignore?
A: In striving for optimum profits, a firm may overlook risk. In other words, investment decisions based on high profits can cause profits to disappear or fluctuate excessively; this could lead to insolvency, a great deal of uncertainty, and a decline in the price of the firm's stock.

Q: State the kinds of assurances that investors and creditors seek from a firm.
A: Investors are looking for the highest returns at the lowest risk. Creditors want to be assured that the firm maintains a sound financial structure and that its policies ensure payment of interest and repayment of principal. Creditors don't want the firm to take unnecessary chances, which could lead to insolvency.

Q: What environmental considerations prevent the firm from achieving the best resutls in terms of cost control and profitability? Explain what this means.
A: Firms must try to minimize such environmental hazards as air and water pollution. By buying pollution equipment, a firm allocates funds to unproductive and unprofitable equipment. In doing so, it cannot achieve the highest financial returns but it will enhance its image.

Q: What are some of the micro- and macro-economic factors what influence the decisions of a firm?
A: Firm related micro factors are mainly supply, demand, and prices. Macro factors are external in nature and include the business cycle, the rate of inflation, trends in the financial field, and changes in foreign exchange rates. Correct timing and forecasting of these macro factors are essential.

Q: What kinds of conflicts confront the financial manager as an agent of the firm? How can a firm attract the best managers?
A: By acting as agents, managers may adopt conservative approaches to avoid making big mistakes. They may be forced to reconcile the different aims of stockholders and creditors. In trying to meet the constraints imposed on the firm by creditors, agents may not be able to devote enough time and effort to achieve maximization of the firm's wealth. Agents may not be willing to assume the added risks of certain projects even though such investments may more than adequately compensate the firm for the risks incurred.

The best managers can be attracted to the firm in two ways: first, by offering them attractive compensation and, second, by giving them options to buy stock in the firm as an incentive to make decisions that will raise the market value of shares.

Goals of financial planning

2009-12-11T23:06:00.000-08:00

A good manager knows how to use the factors just discussed in arriving at final decisions. Financial managers are charged with the primary responsibility of maximizing the price of the firm's shares while holding risk at the lowest level possible. In order to achieve these goals, a manager must determine which investments will provide the highest profits at least risk. Once this decision is reached, the next step involves the selection of optimal ways to finance these investments.

Planning to achieve the best results should be flexible, allowing for alternative strategies to replace existing plans should financial and economic developments diverge from an expected pattern. Furthermore, financial planning involves proper timing of investments in order to avoid overexpansion and inefficient use of resources. Optimal use of available funds means exploring different options and selecting those that provide the greatest overall value. It also means adopting effective ways of determining how much to borrow in order to reduce financing risks. The financing used to raise funds should include safety features that will allow managers to refinance when market conditions become favorable.

After a financial decision has been made, there must be constant vigilance and monitoring of developments. If the original plan falls short of expectations, early recognition and remedial action become necessary. Those who delay in taking appropriate action pay the price for poor management. This price is exacted by the market (and the investment community), which in the aggregate represents a highly efficient judge of performance. Poor or inflexible managers are accountable to competitive forces and to the marketplace, where valuation becomes the ultimate determinant of successful or unsuccessful financial management.

That is why it is important to keep abreast of new advances in the modern theory of finance as well as of developments taking place in the financial markets. Finance has emerged as an important discipline that requires constant updating of old and refining of new concepts. The latest advances in valuation methods can help to make better decisions. The emergence of new financial instruments, such as financial futures, options, and other contingency liability claims, provides managers with more sophisticated and effective methods for evaluating and, when necessary, altering financial decisions.

Benefits & obligations to the firm

2009-12-09T22:52:00.000-08:00

Within this framework, financial managers have certain obligations to those who entrust them with the running of the firm. They must have a clear sense of ethics and must avoid payoffs or other forms of personal gain. Managers should not engage in practices that can damage the image of the firm, but should participate as much as possible in social activities to demonstrate that they are cognizant of the importance of the community and those who buy their products or services. Financial managers should also ensure that all environmental and legal standards necessary to ensure the health and safety of the community and of the workers are met.

The gender issue should also be a concern of the corporation. This calls for setting up guidelines on the treatment of women and how to avoid sexual harassment. Although it is a known fact that many women are paid less than men for doing the same jobs, there is little justification for this differential treatment. A firm has the responsibility to address the gender issue and strive to remedy inequities of this kind.

More specifically, if financial managers work in a vacuum and are concerned only with monetary gains, they may overlook other equally important aspects necessary for maintaining a high public opinion of their firms. By allocating funds for the social betterment of employees and the community, managers will attract customers and a more stable shareholder following. Obviously, the costs of social programs must be tempered by the financial ability of the firm to engage in these less-profitable endeavors. Certain socially desirable policies - hiring minorities, providing for worker safety, and refusing to invest in specific profitable ventures because they fail to meet democratic principles - should be part of the financial decision process. Although there may be a conflict between promoting socially responsible programs and the profit motive, maintaining some concern for social needs when pursuing the goal of maximizing the wealth of the firm is a prime responsibility of a firm.

You should remember

Financial managers must reconcile social and environmental requirements with profit-making motives. Adherence to social values may not produce the most efficient use of assets or the lowest costs, but it will enhance the image of the firm. Looking after the interests of minorities, setting up training facilities, caring for the safety and the welfare of workers, and dealing effectively with gender issues, can produce long-term benefits in the form of higher productivity and more harmonious relationships between labor and management.

Public responsibility and financial management

2009-12-07T22:39:00.000-08:00

Finance is a very challenging and rewarding field. It is an exciting area because financial managers are given the responsibility to plan the future growth and direction of a firm - which can greatly affect the community in which it is based. Many of the tools and techniques for solving financial problems will be discussed later in this blog. One must bear in mind, however, that these models and methods provide only a starting point. The decisions reached by a financial manager ultimately represent a blend of theoretical, technical, and judgmental matters that must reflect the concerns of society.

Benefits and obligations to society

All of us grumble occasionally about government regulations, but as good citizens we abide by the law. Voting on election day may take some of our time, but it a civic duty and right that citizens exercise for the good of society. We go on jury duty even though it takes us away from more productive business endeavors, because we know this is a necessary function if our legal system is to work.

Business firms are faced by similar obligations to society. Though they search for ways to be profitable and achieve the highest wealth, financial managers must accept certain compromises that may impede them from obtaining the highest wealth possible. For example, a firm may be prevented from selecting certain production methods because the government says they cause too much pollution. In other words, firms have obligations to society than can interfere with their profit motives. Social, moral, environmental and ethical considerations are part of the investment decision process and cannot be ignored by financial planners.

The burdens of these costs fall unevenly on different firms. Some firms, especially large corporations, have more resources to deal with these problems. And it seems logical to assume that the most profitable and financially strong corporations should incur a greater share of these social costs. Pollution abatement, enforcement of safety standards, and improved sanitary conditions can reduce employee absences and raise labor productivity. Therefore, a firm can deal with social and legal constraints satisfactorily without critically impairing its ability to maximize the price of its stock.

Implications of outsourcing

2009-12-05T22:20:00.000-08:00

Outsourcing occurs when domestic firms invest and produce goods in foreign countries or when these firms choose to rely on imports rather than build domestic plants and produe these goods domestically. Low-labor-cost countries, like China, open up new investment opportunities for American corporations. Growing competitive pressures are forcing domestic firms to invest abroad or to import cheap foreign products. These developments have altered the decision-making process.

One major factor responsible for outsourcing is the ease with which technology can be transferred abroad. China and other Asian countries can claim technological parity while enjoying low costs of production. No wonder American companies have a difficult time competing. That is why outsourcing is such an attractive investment option. When evaluating the merits of outsourcing, a corporate manager is forced to make several decisions:

Invest and produce domestically or move a plant overseas.
Import cheaper foreign goods to take advantage of low labor and other costs or shift to more capital-intensive and technologically advanced operations.
Invest abroad in order to gain access to new rapidly growing foreign markets.

Decisions to invest domestically are justified when the firm has a technological advantage or the goods it produces are capital-intensive. However, substituting imports for domestic investments in plant and equipment means that the firm may forfeit the cash flows it would generate from depreciation. In this case a firm must compare the benefits from low-cost imports against the loss of cash flows originating in depreciation charge offs. The firm may also have to weigh the probable benefits derived from internal research efforts as opposed to the benefits obtained from outsourcing. Learning how to work with probability models will help a manager to evaluate the relative merits of outsourcing compared to domestic investments.

Outsourcing relieves managers from having to purchase raw materials or to hedge against the risk that the prices of these raw materials will increase. An outsourcing firm does not have to incur the high costs of pension plans, health benefits, pollution control, and worker safety. Some risks such as technological obsolescence and unforeseen changes in demand become less important with outsourcing. These and other advantages make outsourcing an attractive option.

Let's examine the case of a US manufacturer who has a domestic subsidiary that supplies it with parts. The firm can either upgrade the facilities of the subsidiary, cut costs and increase productivity, or move the plant overseas. The costs of moving abroad must take into account the cost of abandoning the plant of the subsidiary. Given these choices, what options are available to the firm? One course of action would be to increase research spending for the development of new products and to raise the efficiency of the subsidiary's plant. But even if research efforts are successful, the benefits may be ephemeral because foreign manufacturers are good copiers and tend to ignore patent protection rules. Another alternative is to invest and shift production to new facilities that are highly capital-intensive. The cost of this move may be too high. Staying in the forefront of technology should help the firm to remain competitive. Don't overlook the fact that rapid growth abroad, in the long run, will put upward pressure on the cost structure of other countries, which should help to level the competitive playing field. Meanwhile, given global cost disparities among countries, outsourcing will continue to play an important role in business decision making.

You should remember

2009-12-03T22:00:00.000-08:00

Firms expand globally to improve profits, increase their growth potential, and gain from an exchange of technology. Globalization can mean diversification and less risk. There are risks, such as currency devaluations and global crises; however, in the long run, foreign operations can provide lower costs of production and sometimes lower costs of borrowing. The closer link between countries has caused firms to become more sensitive to financial and fiscal crises. That is why managers must not overextend themselves abroad.

Globalization means developing plans to protect assets from deterioration in value, and it means knowing how to hedge against foreign risks by employing futures and swaps. Obviously, managers should make adjustments for differences in discount rates in capital budgeting, and efforts should be made to determine how unequal tax laws, legal rules, and accounting standards can affect performance. It should be recognized that domestic standards involving capital structure, cost of capital, and dividend policies require different treatment abroad than they do domestically. While foreign investments can be attractive, managers should not ignore the new set of risks associated with expanding on a global basis.

Decision making challenges

2009-12-01T21:54:00.000-08:00

Globalization means that managers are faced with new challenges in decision making. What works in the domestic market may not work in foreign countries. Foreign subsidiaries are called on to seek ways to protect asset values by employing hedges and instruments, such as futures, options, and swaps, which may not enter into the domestic equation. More specifically, the managements for foreign subsidiaries and operations should institute policies to protect the value of inventories and account receivables. Safeguarding earnings against exchange rate risk should be a continuous concern. That means constant vigilance and keeping abreast with economic and financial trends as they affect the earnings of a multinational firm.

The question arises whether a foreign subsidiary should pay dividends to the parent company. In the US, intercorporate dividends are partially exempt from taxation but repatriated dividends are fully taxed. There are also important cost of capital considerations. Sometimes the costs of borrowing in foreign countries is lower than in the US. Some foreign governments subsidize loans used for direct investment purposes. In addition, the debt of a foreign subsidiary is often guaranteed by the parent company. Therefore, the attitude toward debt financing differs abroad. Because of these protective measures, the debt-to-equity ratio abroad is higher than in the US. As a result, there is less concern with financial distress and a better chance for taking advantage of financial leverage. Currency depreciation is an ever-present danger and can play havoc with the value of assets. That is why managers must consider selling assets when faced by a probable foreign currency depreciation, and hold back payment of liabilities in this situation.

Expanding abroad requires that managers learn hedging techniques to minimize exchange rate risks. Also, when employing capital budgeting procedures to measure the relative risk/return merits of foreign projects, managers should keep in mind the need to adjust cash flows for changes in exchange rates. Don't forget the role of the Internet, which serves as a useful vehicle for matching buyers and sellers involved in forward contracts and swap agreements.

It is evident that managers of multinational corporations face many more challenges when they consider investing abroad. Although the opportunities are still attractive, more attention must be given to the risk/return trade-off principle when assessing the merits of foreign investments. Globalization of the firm will continue to provide highly profitable opportunities to domestic firms, but this movement requires careful decision making and highly skillful financial management.

Globalization of the firm

2009-11-29T21:39:00.001-08:00

Most large corporations operate on a global basis and with good reason: investing abroad has proven to be highly profitable. Decisions to build plants and produce goods abroad are also motivated by the lure of low-cost labor and the easy transfer of highly efficient technology that gives competitive price advantages to foreign operations.

As domestic demand reaches maturation, the search for new markets leads corporations to invest and sell abroad. The trend to develop a presence abroad is also motivated by a desire to hedge against risks. Because economic activity diverges from one country to the next, diversification abroad tends to dampen the overall fluctuations of sales and earnings, thus reducing the risk exposure of a corporation. Unfortunately, the advantages of this covariance principle are not as great as they were in the past. Fortunately, the advent of new financial instruments, including financial derivatives, such as figures and swap agreements, provide managers with new tools for hedging and minimizing foreign risks.

The emergence of foreign industrial powers, like Japan, South Korea, and China, has intensified competition while it opens new opportunities for American firms to import lower-priced goods for sale in the domestic market. This not only saves the domestic firm the need to invest n new capacity, but it also allows it to share in the technological advances of that country.

Importance of accounting

2009-11-25T04:20:00.000-08:00

Financial managers rely on accountants to prepare income and balance sheet statements that provide information on the profitability and the financial status of a firm. The Financial Accounting Standards Board's statement number 95 now requires firms to report a current Statement of Cash Flows. This statement provides a detailed analysis of the way cash is generated and traces how cash is utilized in the conduct of all phases of a business. As a result, this statement supplies another important financial tool to managers who seek to control and understand the external factors and internal policies that can influence the cash flows of the firm.

Financial statements help managers to make business decisions involving the best use of cash, the attainment of efficient operations, the optimal allocation of funds among assets, and the effective financing of investment and operations. The interpretation of financial statements is achieved partly by using financial ratios, pro forma statements, sources and uses of funds and cash budgets.

It should be pointed out that the managers of a firm are supplied with more detailed statistical information than appears in published financial statements. These data are especially important in developing cash flow concepts for evaluating the relative merits of different investment projects. This information permits managers to determine incremental cash flows (an approach that looks at the net returns a given project generates in comparison with alternative investments), thus enabling them to make more accurate assessments of the profitabilities of specific investments. It is the responsibility of managers to direct their accountants to prepare internal statements that include this information so that they can make the best investment decisions possible.

You should remember
Managers should learn how to time and forecast, as accurately as possible, changes in basic micro- and macroeconomic factors. They should make good use of accountants, who supply the financial statements that enable managers to monitor the performance of the film. In other words, the best managers know how to use all available tools and how to piece together different sources of information to achieve the most effective investment strategies and objectives for the firm.

Understanding economic factors #2

2009-11-24T03:44:00.000-08:00

Macroeconomic factors
People's decisions are influenced by changing economic conditions. By reading the newspapers and listening, people develop a sense about the economic climate. If it seems to be deteriorating, consumers tend to cut spending and become more conservative in their buying habits. Conversely, when conditions improve, people are likely to loosen their purse strings. These reactions to changing external economic (macro) forces, such as rising or declining business activity and changes in tax laws, influence the decisions mady by a firm.

When business is expanding, a firm increases its investment and production. It pulls in its horns when faced by a business contraction. the important thing is to be able to detect when these changes in activity are likely to occur. This is why financial management relies on internal and external models that forecast expected business activity in future months and years. A firm must also develop a flexible strategy to deal with major shifts in demographic, changes in legislation or tax laws, and new technological breakthroughs. It behooves managers to engage in financial planning so that they can be armed with different alternatives under different economic conditions.

Failure - or success - in dealing with macroeonomic problems can have an impact on the price of the firm's shares.

Timing of economic decisions
Most consumers know that one can get a good buy on a product once the demand for it fades. This kind of timing can pay off handsomely. Christmas greeting cards, for example, sell for half-price right after the holidays.

In the same way, the successful manager instinctively knows how to react in a timely fashion to changes in supply, demand, and price conditions. Buying raw materials at low prices can give a cost advantage to a firm. Conversely, if investments are undertaken and demand does not increase as expected, a firm may expand too early, getting stuck with large inventories and an underutilized capacity. The way financial managers time their decisions with respect to changing microeconomic factors can be reflected in higher or lower prices of the company's stock.

Equally valued is the ability to time decisions dealing with changing macro-economic factors properly. Knowledgeable managers have the judgment to be able to take full advantage of profitable opportunities at reasonable risks when general business activity is expanding. It is important, therefore, for financial managers not only to forecast levels of business and related activities accurately, but also to make sound judgments with respect to expected changes in the direction of related macro and micro factors.

Financial managers must make sure that their decisions to invest or not to invest, to raise capital or not to raise capital, are justified. To do this they must judge the future direction of interest rates, the behavior of stock prices, the expected changes in overall business activity, the anticipated rate of inflation, the status of financial markets, and even the trend of foreign exchange rates. Wrong timing in regard to any of these factors can mean higher costs of generating funds in financial markets. If corporate managers misjudge the business cycle at the peak, they may get stuck with unwanted and costly inventories. A decision to increase capital expenditures and to produce more at the peak of a business cycle could lead to excess inventory once demand contracts. By correctly timing a rise in the rate of inflation, managers can make better judgments about purchasing raw materials at low prices, building inventories, buying equipment at the most advantageous terms, and raising funds at the right time.

Proper timing of the economic factors also reduces volatility and the undertainty of future profits.

Understanding economic factors #1

2009-11-23T03:13:00.000-08:00

Almost everyone applies some economic principles on one occasion or another. Take the case of a flea market. Most of us have either gone to one or have been vendors at these markets. Whether one is buying or selling, it is obvious that the vendors displaying the items most in demand usually wind up with the biggest sales. Price is another important consideration. If it is too high, few customers will buy. Some of these simple economic principles are useful in making the right sell/buy decisions in any market.

Similarly, financial managers can make better decisions if they apply these basic economic principles. For example, economic theory teaches us to seek the best allocation of resources. To this end, financial managers are given the responsibility to find the best and least expensive sources of funds and to invest these funds into the best and most efficient mix of assets. In doing so, they try to find the mix of available resources that will achieve the highest return at the least risk within the confines of an expected change in the economic climate. Good financial management has a sound grasp of the way economic and financial principles impact the profitability of the firm.

Micro-economic factors
Financial managers do a better job when they understand how to respond effectively to changes in supply, demand, and prices (firm-related micro factors), as well as to the more general and overall economic factors (macro factors). Learning to deal with these factors provides important tools for effective financial planning.

When making investment decisions, financial managers consider the effects of changing supply, demand, and price conditions on the firm's performance. Understanding the nature of these factors helps managers make the most advantageous operating decisions. Also, managers should determine when it is best to issue stock, bonds, or other financial instruments.

The sale of products at a profit depends heavily on how well managers are able to analyze and interpret supply and demand conditions. Supply considerations relate specifically to the control of production costs, where the key element is to hold costs down so that prices can be set at competitive levels. The best machinery must be bought; and the most productive workers available msut be hired. The goal is to squeeze out the biggest possible profit under given supply conditions. Maintaining a low-cost operation will enable the firm to charge competitive prices for its products and maintain its market share while still obtaining a reasonable return.

Knowledge of economic principles can be useful in generating the highest sales possible. Understanding and appropriately responding to changes in demand allows financial managers to take full advantage of market conditions. To accomplish this, the best managers develop and adopt reliable, workable statistical techniques that forecast demand and pinpoint when directional changes in sales take place.

This task, however, is not an easy one. Economic factors cannot be forecast with any degree of accuracy, and many projections are subject to large errors. Good managers, however, can modify forecasts of supply and demand to make them come reasonably close to the actual results. In other words, good financial managers know when to raise and/or lower prices. If demand estimates are high, they institute actions to avoid overproduction and excessive inventories. Therefore, while all managers are faced with forecasting problems, the good ones can deal effectively with difficult situations.

Assuming that demand and prices can be forecast fairly accurately, the next step is to make a decision on the kind of plant and equipment needed to produce goods at the cheapest cost. Obviously, this decision calls for a great deal of judgment regarding the efficiency of different types of equipment and whether or not - or when - this equipment might become outdated. The choice of one machine over another involves considering the risks associated with each machine and how fast it is likely to become obsolete. This risk decision must also consider that future shifts in demand can make a particular machine useless. These are some of the important micro-economic questions which financial managers must answer.

The long-range view

2009-10-30T00:28:00.000-07:00

Management can, in the short run, gain high profits by buying inferior materials and hiring poorly trained or unskilled workers. This decision may temporarily yield lower costs and lower prices than those charged by competitors. The first results may be higher profits. These short-sighted policies, however, tend to produce long-range problems. Inferior machinery produces more than the usual number of rejects. Machinery breakdowns become more frequent, costs of repairs mount, and fewer products meet quality standards. The outcome is likely to damage the image of the firm, affecting the price of the firm's stock adversely. The better course of action is to occur the added expense of maintainging quality control, thereby reducing the potential risk of unfavorable feedback from investors.

High profits gained at the expense of increased risk generally produce unsatisfactory reaction by stockholders and investors in the long run. Investors generally give more value to earnings generated by a firm with a steady profit record than to the same level of earnings generated by a firm in highly risky investments with a widely fluctuating earnings record.

As a result, the objective of profit maximization may conflict with that of the maximization of wealth. Attempts to increase profits beyond a certain level may mean the taking of greater than necessary risks and may also impair, to some extent, the ability of the firm to maintain solvency. Wealth maximization implies a constant concern with risk. This goal may not be achieved if the firm pursues a policy of short-term profit maximization.

There are many tools for accomplishing the maximization of wealth, among them the understanding and application of the principles of economics, accounting, finance and related disciplines.

You Should Remember
The primary goal of a financial manager is to maximize the wealth of stockholders. Maximizing profits is a short-term goal that does not address itself to some key factors, one of which is an acceptable risk level. The goal to maximize wealth may conflict with the aim to optimize profits in the short run, but wealth maximization should always be the primary consideration. When striving for this goal, we should apply the risk/return trade-off principle.

Risk versus Profits

2009-10-29T10:06:00.000-07:00

Profit maximization is a short-term objective and is less important than maximizing the wealth of the firm. A firm can achieve high profits in the short run simply by cutting corners. In other words, managers can delay charging off some expenses, they can defer buying expensive albeit cost effective equipment, and they can layoff some of their most productive high-salaried workers. These short-sighted decisions can lower costs and raise profits temporarily. Furthermore, high profits may be obtained by investing in highly uncertain and risky projects. In the long run, these chancy projects can weaken the competitive position of a firm and lower the value of its stock. Therefore, attempts to maximize profits may prove inconsistent with the goal to maximize the wealth of the firm, which calls for attaining the highest expected return at the lowest risk level.

In finance, higher risks are generally associated with higher possible gains - but there is also a greater chance of loss. The same principle applies to Aunt Jane or John Doe. Both would like to strike it rich, but they know that to do so they must be willing to face the dangers of heavy losses. Aunt Jane or John Doe are aware that it is safer to purchase a US Treasury bill than to buy pork belly contracts. The chances of incurring losses from owning a treasury bill are slim indeed, while pork belly contracts could mean high gains or large losses.

Managers are faced with a similar dilemma. Some projects may be more profitable than others, but the risk associated with them could be too high and might jeopardize the solvency of the firm. This situation is analogous to gamblers who insist on betting on long-shot horses. Although the payout is great if the long-shot wins, the chances are that these gamblers will be consistent losers. Bettors who play to "show" or put their money on the favorite horse have a better chance of winning, but their gains will be lower. The same applies to the policies adopted by managers. There is a constant conflict between engaging in highly profitable ventures and maintaining a sound financial status. These managerial decisions involve a compromise between taking excessive risks to maximize profits and making investments that will probably result in lower risk and lower profitability - but will lead to a sound financial posture for the firm.

Let's elaborate on these points. Investment decisions involve comparing the future projected returns, generated by investments, with the risk faced by these undertakings. This fundamental decision rests on the well known risk/ return trade-off principle. Basically, A decision to invest in a low risk project (A) will yield a low return (A'), and a high-risk project (B) should produce a higher return (B') to justify its implementation.

The only way to evaluate the contribution of various investments to the wealth of the firm is to adjust the future returns of each investment for risk. For example, suppose you have two projects, A and B. Both projects generate the same series of future returns, but project A is less risky than project B. Which is the best project and which will increase the wealth of the firm most? Obviously, it is project A.

Therefore, the goal of a manager is to maximize the value of the firm or its stock. This is accomplished by investing in those projects that have the best risk/return trade-off.

You Should Remember

2009-10-28T09:50:00.000-07:00

If there is one problem that enters into the decision-making process, it is the uncertainty and the risk aspects of investments. When a firm makes investment decisions, it automatically attempts to put together (invest in) the best asset mix. This means utilizing the best quality assets in the most efficient way so that they will yield the fastest and least risky returns in the future. In addition, the firm must be concerned with the way it generates internal and external funds, since too much outstanding stock can cause earnings-per-share dilution, and too much debt can increase the financial riskiness and fixed loan commitments of the firm. Proper utilization of these factors, however, can produce a higher valuation for the firm. Consequently, it is important for financial managers to adopt a balanced financing policy so that investors can be assured that their invested funds are well managed and safe.

The Manager as an agent

2009-10-27T09:48:00.000-07:00

At one time or another, most people have had occasion to hire agents to take care of a specific matter. In doing so, responsibility is delegated to another person. For example, when suing for damages, individuals may represent themselves or may hire a lawyer to plead their case in court. As an agent, the lawyer is given the assignment to get the highest possible award. And so it is with stockholders when they delegate the task of running a firm to a financial manager, who, though not strictly correct, legally may be thought of as an agent of the company. Obviously, the goal is to achieve the highest value of a share of stock for the firm's owners. But there are no standard rules that indicate which course of action should be followed by managers to achieve this. The ultimate guideline is how investors perceive the actions of managers. A good way to motivate managers is to offer them lucrative stock options linked to performance.

Policy conflicts
In general, managers should seek to use sound investment policies that minimize risk. However, some managers interpret their mission differently. As agents, they envision their role as one of avoiding big mistakes. As a result, these agents may overlook good opportunities with acceptable levels of risk. This conflict between agent and stockholders is unlikely to produce the best results.

There is no guarantee that managers, acting as agents, will make the appropriate decisions and take the best course of action. For example, in assessing the risks of different project against their expected returns, managers may concentrate on only certain investments, failing to diversify the assets of the firm to achieve a lower risk level.

Agents are often caught in the middle by trying to satisfy two major factions: the creditors and the stockholders. This consideration is especially important when debt becomes an important source of financing. Creditors impose certain constraints on the firm, such as limiting dividend payments when profits are too low, and otherwise force the managers to maintain the liquidity of the firm at a given level to ensure repayment of loans. In trying to satisfy the claims and restrictions imposed by these creditors, financial managers may have to devote too much attention to creditors and not enough attention to stockholders. This conflict can make managers less efficient and prevent them from taking advantage of the best opportunities.

There are no easy answers to ensure compatibility between agents and their stockholders. It is up to the stockholders - acting through the board of directors - to hire the right managers and to make sure they are properly compensated. This means meeting the market price to attract the right talent. Offering stock to these managers also helps ensure that they will seek to maximize the value of the firm's shares.

In any event, capable managers have the right judgement and instincts to know what policies to implement and when to implement them. They know when to raise funds and how to control assets. These correct decisions are translated into favorable signals to investors, usually resulting in a higher valuation of the firm's common stock.

Building an image

2009-10-26T04:16:00.000-07:00

Many times the most successful financial plans do not receive the attention they should get mainly because managers fail to publicize them or "blow their own horns." In the past, this information was conveyed to security analysts who, in turn, advised investors of new developments taking place in a firm. But this approach was too selective and reached only a few investors. Usually, company officials propagated this information through the newspapers, television and quarterly and annual reports. At best, this information was sporadic and lacked immediacy.

The aim should be to disseminate new information as quickly as possible, reaching a large number of investors. The Internet has and will become an effective vehicle for achieving this goal. The firm should seek to make investments in those fields that investors associate with growth, glamour and having great potential. Unfortunately, many good, financially sound companies are identified with low valuation areas. Good producers do not receive the recognition they deserve. The idea would be to direct investors' attention to the most attractive areas of the firm to ensure a better valuation. The firm may want investors to know that it is shifting to more attractive areas of growth and profitability. The firm's responsibility to stockholders is to create the best image possible. Recently, a succcessful strategy has been to employ "trading stocks." This strategy consists of issuing new stock to represent that part of the firm's assets that have the best financial outlook. In this way, investors can identify the stock with similar high valuation areas and will give the price of a trading stock the full valuation it deserves.

Managers should give this concept of image building more attention when acquiring new companies, adding new product lines, or giving research new direction. This part of investment strategy, whether it is real or illusory, should be ever present in the minds of managers when they expect to change the investor's perception of the investments' potential of the firm's stock.

Adapting to changes

2009-10-25T04:01:00.000-07:00

Finance is part science, part art. Financial analysis provides a means of making flexible and correct investment decisions at the appropriate and most advantageous time. When financial managers succeed, they help improve the value of the firm's shares.

A manager gives favorable signals to investors by establishing a record of sound financial statements with returns that are growing rapidly and steadily at a minimum level of risk. Why are the right signals so necessary? Because stockholders (investors) ultimately determine the market value of the firm as reflected in the prices of the securities it issues. If the firm has a good record, and these people believe that its record will continue, valuation will be high. Conversely, a poor record, with expectations of unfavorable returns and high risk levels, will produce a low valuation.

To be successful, financial mangers have to deal with the changes constantly occurring in the field of finance. They must adopt more sophisticated methods so they can plan better in an increasingly competitive climate. They need to deal effectively with constant change inside and outside the company. In short, financial managers are responsible for recognizing and responding to the changing factors in the private, public and financial environments.

There is a growing need for timing new product introductions correctly, for delivering products and services that meet current and developing needs, and for ensuring that decisions are backed up by alternative plans. Changes in research efforts and production are sometimes called for to ensure that new products can meet the challenges of an increasingly competitive marketplace.

What is finance all about?

2009-10-24T03:45:00.000-07:00

Finance is the application of a number of financial and economic principles to maximize the wealth or overall value of a business. More specifically, by employing net present value (time discounted cash flows minus the original costs) to measure profitability, a firm maximizes wealth by investing in projects and acquiring assets whose combined returns yield the highest possible profits at the least risk. No one really knows when maximum wealth is achieved, though it is assumed to be the ultimate goal of every firm. One way of finding out the wealth of a firm is through the price of its common stock. When the price of a firm's shares increases, it is said that the wealth of the firm's shareholders has increased. Why do stock prices reflect a firm's ability to create and increase wealth? Because the stock market is a very efficient mechanism. Therefore, stock prices capture very quickly all available information as well as the outlook for future changes in the wealth of the firm. The market is even more efficient today because investors are better informed and managers use better methods and more effective strategies to telegraph their performance. The proliferation of computers has provided a platform for selecting the best investment alternatives. Of course, the advent of the Internet has revolutionized ways to search, gather, and disseminate information upon which sounder business decisions are made.

Today, financial managers have available many sophisticated tools to solve difficult business problems. That was not always the case in the past. Before 1970, the emphasis was on new ways of achieving effective working capital management, improving methods for maintaining financial records, and interpreting balance sheets and income statements. Finance has extended its horizons since that time, and the emphasis is now on ways to budget scarce resources effectively and to invest funds in the assets or projects that yield the best risk/return trade-offs. Attention has been drawn to the study of different alternatives and the effect of each alternative on the value of the firm. Greater focus is on options to hedge against risk through the use of financial derivatives. More advance methods are currently available to assess the risks and returns of investments and to similate the outcomes of different decisions before limited and scarce funds are invested. The need to develop long-term plans, to take advantage of new financial instruments, and to understand multinational finance principles is becoming increasingly evident.

Knowledge of finance should not be limited to treasures, controllers, and financial planners. In any firm, if the accountants, statisticians and marketers have an appreciation and understanding of the principles of finance. They will be able to participate more effectively in the decision making process. Different departments should participate in the final plans made by the finance division.

Key terms in the world of finance

2009-10-23T03:43:00.000-07:00

Agency Costs
Costs incurred to resolve conflicts between managers, stockholders and bond holders
Finance
The application of a series of financial and economic principles to maximize a firm's wealth and the value of its stock
Financial Planning
Projecting cash requirements, setting up guidelines to control costs, establishing future sales and profit targets, deciding the best allocation of scarce funds, and developing alternative strategies in case existing plans do not work out
Global Firm
A firm with asset investments and operations on a worldwide basis
Macro Factors
Broad economic and financial developments that impact the sales & profits of the firm
Micro Decisions
Internal decisions by a firm that influence the outcome of sales, help control costs, and determine pricing policies
Risk/return trade off
The required rate of return that justifies making an investment, given a level of risk
Wealth maximization
Contribution to the value of a firm by selecting those investments that have the best risk/return trade-off

Finance news: 23-Oct-2009

2009-10-23T03:17:00.000-07:00

Top financial headlines for the day are:

ANZ to Add up to 600 Bankers in Asia in 12 Months
California's Push for Electric Cars May Make Residents Pay More for Power
Euro gains against dollar
Facebook Fuels Growth With Games as Users Flood `Farmville,' `Mafia Wars'
Genting’s Progress at Singapore Casino Presses Sands
Galleon's Rajaratnam Is Said to Have Planned Sri Lanka Fund Before Arrest
German Business Confidence Rises to 13-Month High as Recovery Accelerates
GM Said to Boost CEO Henderson's Pay to $5.45 Million Under Feinberg Plan
New Jersey Pays Goldman Sachs for Interest-Rate Swaps on Nonexistent Bonds
Obama Gets `Incomplete' as Decisions on Afghanistan War, Joblessness Loom
Stocks Rise in Europe, Asia as Yen Falls; Pound Plunges on U.K. Recession
UK Economy Unexpectedly Contracts by 0.4% in the Longest Slump on Record
US 30-Year Fixed Mortgage Rates Climb to 5% in Second Weekly Increase
Wall Street Reacts With Skepticism, Anger on Moves to Reduce Executive Pay
Wellink, ABN Amro CEO Zalm Tarnished by Collapse of Netherlands' DSB Bank