Making Rational Investment and Financing Decisions: The Case of Fortune 1000 Corporation Proposal

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Introduction

Business corporations need to make decisions that will have pecuniary implications hence risking their current financial position (Porter & Horton, 2011). In real practice, business owners often delegate this vital role of decision-making to a group of professionals who are discharged with managing the entity on behalf of the owners. Fundamentally, the objective of business management is to increase the shareholder’s wealth through increased share prices and a continuous stream of high dividends. In the recent past, this objective has changed due to the increased level of awareness among the many stakeholders who have different interests in the business. Nonetheless, the firm’s management cannot dispense with the crucial role of making rational decisions that ensure the firm continues to operate as a going concern.

Business managers are faced with decisions of varied nature in their day-to-day operations. These decisions can either be classified as either investment decisions or financing decisions. An investment decision can also be referred to as the capital budget decision and entails committing the firm’s current funds to long-term assets with an expectation of a continuous stream of benefits over a long period. Consequently, the aspect of risk and return analysis arises in the choice of the investment to be pursued. On the other hand, a financing decision involves the evaluation of the sources of finances to fund the projects chosen by the management. As rational entities, firms will prefer a low cost of capital to fund their investments.

In the case of Fortune 1000 corporations, the capital budgeting decisions at hand are twofold: First is the decision on whether to produce or outsource the improved (X57) widget; and, the decision whether to acquire an overseas firm that will produce the new product. Each of these two decisions entails a degree of risk-taking due to various uncertainties involved. Additionally, the decisions must be accompanied by the financial decision because the new ventures must be funded.

The following part of this paper will seek to address crucial considerations that are paramount in the understanding of the best decisions that Fortune 1000 corporations could make to succeed in the new venture. The addressing of these issues will also bring a better understanding of the US reporting standards (GAAPs) vis-à-vis the International Financial Reporting Standards.

Financial information needed in appraising an Investment

Based on the nature of the decisions that Fortune 1000 Corporation needs to make, that is, investing and financing, the project viability needs to be evaluated carefully vis-à-vis the sources of finances. Various facts must be investigated to make rational decisions. First, regarding investing decisions, some of the following facts may be helpful to the management: The expected cash flows from the manufacture of the new widget (X57). The production of the new gadgets entails the expansion of the plant capacity and the hiring of more staff. As such, the management should seek to approximate with much certainty the initial capital outlay that will be required. The inflows of the project should also be estimated so that they can be matched with the outflows.

Secondly, the management should also possess information about other alternative investments at their disposal for comparison purposes. Firms are often faced with the dilemma of choosing the best project appraisal method especially in instances of mutually exclusive projects. Hence, for the management to be able to compare the different methods, it should have all the facts such as the expected duration of the project and the cost of capital for obtaining financing. Various sources of financing exist for the business. However, these sources are tagged with different costs and as a matter of importance, the management should be in a position to compare the various costs of financing and choose the cheapest.

Steps to follow in Evaluating a Financial Project

First, the management needs to understand the type of decision that is at hand to be guided in their appraisal. For instance, in the case of Fortune 1000 Corporation, the management is faced with a replacement decision. The proposed new widget necessitates plant adjustment. Also, they are faced with a “make or acquire” decision coupled with an option of acquiring another plant to manufacture overseas. Various methods of appraising financial projects exist including the traditional methods and the modern methods.

The traditional techniques are also known as non-discounted methods because they do not recognize the time value of money brought by the long-term nature of financial projects. These methods include the Payback Period and the Accounting Rate of Return (ARR). Under the payback method, the management sets the acceptable payback period, and projects that have a shorter project in comparison to this benchmark are accepted. The payback period is the duration that a project takes to recoup the initial capital outlay; hence, the shorter the periods are preferred. The ARR is an expression of the project’s income as a fraction of the funds invested and is calculated as shown: Projects with high ARR are ranked higher hence preferred.

The modern methods of appraising financial projects take into account the time value of money hence they are also referred to as the discounted methods. These methods include the Net Present Value (NPV), the Internal Rate of Return (IRR), and the Profitability Index (PI) method. The NPV method uses the rate of return to discount the project’s cash flows. Projects with a positive NPV are chosen because they will result in increased value.

Secondly, the IRR is the interest rate that equates the present value of outflows to the present value of inflows, that is, a zero NPV. As such, the project with a rate of return higher than the cost of capital is accepted. Finally, the PI expresses the present value of a projected income as a per dollar value of the investment. The financial project acceptance criterion endorses investments with a GPI that is equal to or more than 1. The PI is usually expressed using the Gross Profitability index (GPI) which is calculated as shown:

A new entity could adopt various forms of organizations to better adapt to the market situations. Many forms of business organizations exist in the economic world. These organizations include mergers, amalgamations, joint ventures, and acquisitions. The new widget (X57) is manufactured with some parts made from China and Mexico. Hence, the widgets operation cycle begins with the acquisition of the raw materials in the different countries. The different parts are then shipped to the US for assembly and the finished product is finally sold in the market.

IFRS vs. US GAAP concepts in financial reporting

Globalization is slowly but steadily turning the world into a global village. This has necessitated the adoption of global financial reporting standards which enhance comparability of business results. As such, nations have continued to adopt the IFRS en masse, with more than 110 nations using them by the year 2009 (Austin & Tschakert, 2009). International Financial Reporting Standards (IFRS) are prepared and issued by the International Accounting Standards Board (IASB). In using the IFRS in financial reporting, when a standard specifically applies to a transaction or a situation, the accounting policy applied to that item is established by applying the standard and also following the application guidance if the IASB (Thornton, 2007).

The IFRS and the US GAAPs differ in many ways. First, the latter is applied in the US economy while the latter is universal. Some of the areas of difference in these two standards are in the treatment of Intangible assets and revenue recognition.

Under the US GAAPs, the acquired intangible assets are recognized at their fair value (Austin & Tschakert, 2009). The cost of acquiring the intangible assets is allocated to the assets and amortized over a specified period. On the other hand, under the IFRS, intangible assets are only recognized if they have any future financial benefit (SEC, 2011). Secondly, intangible assets are recognized when they can be measured reliably and they are also revalued regularly.

Retained earnings are the profits of a business that have not been distributed to the owners of the company in form of dividends. Retained earnings could be treated as a form of an internal source of financing of the business and are cost-free in the case of ordinary stock. Qualitative qualities in a financial statement are the non-measurable aspects of an organization that are reported in financial statements. However, the firm needs to report on these aspects of an organization say using the chairman’s statement.

Business entities raise finances for funding their projects from varied sources. In case of a purchase or building decision for a Fortune 1000 corporation, the management could raise finances through Issuing shares in the stock market either through a public offer or private placing; the firm could also use debt financing by issuing bonds to the public; and finally, the firm could also use its retained earnings to finance its investments. Any form of capital advanced by a firm is recorded in the balance sheet under the ‘Financed By’ category. The body that is responsible for overseeing the financial statements in the US economy is the Financial Accounting Standards Board (FASB). The body’s standards guide the preparation of the financial reports and teaching of the public, auditors, and users of financial information (Thornton, 2007).

An external event is an event that is beyond the control of an individual firm. Hence, an external event is a threat to an entity and exposes the firm to uncertainties. Piracy, theft of goods under transportation is likely to bring to existence additional costs to a firm in form of the costs of insurance for goods on transit. Likewise, the economic crashes in Greece could be signified by the lack of value of their currency, high-interest rates, low value of exports, and an increase in the level of inflation. As such, Fortune 1000 corporation is likely to lose its markets to such countries due to the reduced purchasing power of the people.

Conclusion

Business managers will always be faced with various decisions that they need to make every day. These investment and financing decisions demand that firms’ management understands their environment adequately to be able to take advantage of the opportunities at their disposal. The uncertain nature of investments decisions carries some risk-return aspects that firms must appreciate. Though the risk is an inherent aspect of investments, it must always be tempered with a careful analysis of the market situation stemming from the managements’ expertise for the firm to maintain the going concern status.

References

Austin, S. G., & Tschakert, N. (2009). Major Differences in U.S. GAAP & IFRS and Latest Developments. Accounting Day Town & Country Convention Center, pp 5, 53-55.

Porter, G. A., & Horton, C. L. (2011). Using Financial Information: The alternative to Debits and Credits (7th ed.). OH: South-Western Cengage Learning: Mason.

SEC. (2011). A Comparison of U.S. GAAP and IFRS. Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers , p 16.

Thornton, G. (2007). Comparison between U.S. GAAP and International Financial Reporting Standards (1.1 ed.).

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