Introduction to Management Finance
Management of finance is necessary is a very necessary task that every organisation needs to perform. Because every firm has limited source and amount of finance in respect of its proposed future projects. Management of finance includes planning and implementing such financial tools which can be helpful in generating better returns from such investments. This report contains nature of various investments like stock further this report also contains a detailed comparison between cash flow from stock and cash flow generated from bonds. Readers can get acknowledged about various growth rate models which are helpful in valuation of stock. On the other hand this report also contains various tools through which it can be easier for cited entity to manage its available finance and to get better return by employing that finance in projects of cited entity. Financial management act as a tool to achieve predetermined financial and non financial goals and objectives.
Evaluation of nature of stock as an investment and analysis of most stockholders play large roles in the management of the firms in which they invest?
Basically stock can be defined as the security which offers ownership to the stockholder in cited entity. Which bears a share in entity's assets and its earnings. Stock in a corporation can be divided into two categories i.e. common stock and preferred stock. Common stock is usually known as equity stocks these type of stock posses ownership, voting rights and dividend. On the other hand preferred stocks possesses some preferential rights, as the person who has preferred stock of any company covers preferential rights over those who have common stock of cited entity. When company pay off dividend to its share holder then at that time they requires to give dividend to the preference shareholders. Cited entity or firm can also purchase or invest in the stock of any other company. Through which an entity can generate money through such investment. Through such investment shareholders can become owner of cited entity. Through which such shareholder can make vital impact over the financial management of cited entity. As they have invested in the company hence they want a certain return so that opportunity cost of their money can be generated and met easily. For giving better return to shareholders management of cited entity need to make such strategies through planning tools of financial management so that they can generate better returns on their investment in various organisational projects.
Shareholders and their expectations from cited entity affects the organisational structure of any organisation. For better management of available finance an entity can use financial planning tools like ratio analysis, variance analysis , cash flow and fund flow analysis. Through these tools an organisation can prepare budget for the forecasting of proposed project. They need to estimate level of expenses so that they can invest a certain estimated amount in the project further through it they can also estimate the level of return which can be generated out of such projects(Peirson and et. al., 2014). Hence it can be ascertained easily that the the expectations of shareholders from a company affects such entities financial management.
Compare and contrast the nature of cash flows stemming from an investment in stock with those coming from bonds
Stock and bonds are two different thing through which a person can invest in a company. Stocks provide right to vote, ownership and in return shareholders also get dividend on a certain rate which is declared by company and its board of directors. Stock are of two types i.e. equity stocks and preference stocks. Equity stock holders will get ownership rights and preference share holders will get preferential rights over the dividend. On the other hand Bonds can be classified as Debt investment through which investor invest his money in cited entity. This can be defined as investment in terms of loan as money is invested by investor through bonds is utilized for the projects of cited entity hence this can be treated as loan. A firm borrows the funds for a defined time period. Bonds has both variable and fixed rate of interest. Bond functions in term of loan amount between the investor and corporation. Entity needs to pay a fixed or variable amount of interest which depends on the type of bonds.
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Stocks are a bit riskier than bonds. If a person invest in bonds then he can be considered on a safer side. This can be considered as understandable oversimplification of the real fact. Persons holding ownership over the stocks are known as the shareholders or stock holders. If a company in which shareholders have invested their funds, gets bankrupt then such shareholders are also considered as bankrupt. Shareholders are not personally held liable for the liabilities of cited entity in which they have invested their money. But in case the liabilities of a firm get increased then the excess of liabilities over the assets of entity can be considered as the negative net worth.
On the other hand the bond holders are considered not as the owners of company but they actually are the long term creditors of company. Bondholder get priority over other creditors of the company as in case of winding up of company and its business then at that time company needs to discharge the liability bond holders preferably.
Cash flow which is generated out of bonds and stocks are generally in small amounts. But they are actually followed by larger payments at they end of maturity period. Cash flow during the investment period can be generated through dividend in case of stocks and in case of bonds the cash flow is in the form of interest and final cash flow generated when bonds get matured and principal amount is received. But in case of of equity or preference stocks the final payments received when shareholder sale out its shares and gets the market price of such share. Payment of interest by company on bonds may be fixed or it may vary as per the nature of bond but in case of equity stocks, equity shareholders cant get fixed amount of dividend as their dividend is not fixed it varies every financial year and it purely based on discretion of board of directors because they need to retain a part of profit for future activities.
Growth rate model for stock valuation
Growth rate model was propounded by Gordon which is actually used to determine intrinsic value of equity stock or preferred stock. Which is entirely based on the series of dividend which is to be received in future. Such dividend grows constantly with a equal rate, as this model presumes a constant growth rate. This model is generally used by those companies which have a equal growth rate in respect of dividend.
- How Growth model can be used for the valuation of stock : This growth model can be used as a tool for the valuation of stock of any entity. The Gordon Growth model values stock of a company using its assumption of constant growth rate in dividend which they pay to its shareholders. There are three key inputs in Gordon's Growth model i.e. dividend per share, growth rate in dividend per share and rate of return. Dividend per share actually means the amount which company pay to its shareholder on a dividend. Growth rate in dividend represents a constant growth in the dividend per share. Further the required rate of return represents the required or desired return which investors invest from cited entity. Further assumption of Gordon model of growth rate is it assumes that the entity will work and exists forever. And its dividend capacity will grow with a constant rate.
- Limitations of Growth rate model : There are certain limitations of Gordon's growth rate model like its major limitation is its assumptions about constant growth rate of dividend. Because in practical life it is very tough to give dividend to shareholders with constant rate as thok mame cited entity for development needs to expand its business activities for which they need to initiate more funds and for such projects management used to retain certain amount of money for those projects hence it becomes very rare and very tough for an entity to give dividend to its shareholder with a constant rate. Hence this model is limited and useful for the valuation of shares or stocks of such companies which has stable or constant growth rate in its dividend.
Approach to valuing a stock expected to grow at more than one rate in the future
In financial market, stock valuation is used to value the company's stock. An entity can use various approaches and models for valuation of stock when there is no a constant or stable growth rate in dividend per share. The two models which can be used by the cited entity for the valuation of stock having unstable growth rate is mentioned below :
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- Dividend Discount Model : it is a very basic model of valuation stock. As per this model the true value of company can be estimated through the habit of company in payment of dividend to its shareholders. Dividend payment is used as a base for the valuation because the dividend is the actual cash flow which is received by the shareholders. Management needs to calculate present value of these cash flow by discounting those cash flow through a certain rate. After this the user can get the worth of a share. By following all the step the user can value stock of a company but it should be noted that the limitation about this model is this model can only be used when the company pays off its dividend hence in case if board members decides that dividend wont be given for a financial year then this model cant be applied on that firm for valuation of its stock.
- Discounted Cash Flow Model : In case when, board members of any organisation decides not to pay dividend for the current financial year then in this case this model can be used by the user for the valuation of the stock of cited entity. As this model uses discounted future cash flow for the valuation of stock of a company. The major advantage for using this model is that it can be used for any firm which is currently not paying of their dividends to their shareholders. This model contains several variations but two stages DCF model is mostly used for valuation of stock and firm. In this, future cash flow are forecasted for a period of five or ten years. And after this user need to calculate a terminal value which will be there at the end of specific year. Basic requirement for using this model is that the company must have a predictable cash flow so that user can use discounting factors on such cash flow for evaluating cash flow.
The above mentioned facts and figures along with concepts and approaches describes that how financial management plays a vital role in any entity. This report also mentions that how the expectations of shareholders affects the decision of management regarding the management of finance. Management needs to make such strategies through which projects of entity can give better returns to the company so that company or firm can pay better dividend to its shareholders. Further readers of this report can also get knowledge about Gordon's Growth Rate Model and they can understand how it can be used for the valuation of stock of a company. On the other hand it also includes description about the types of stocks other than this it can be ascertained that how Dividend discount model and Discounted cash flow method can be used by user for valuation of stock in case of variation in growth rate.
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