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Financial Decisions for Managers: Financial Ratios and Types of FinancingResearch Paper

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Financial Decisions for Managers: Financial Ratios and Types of Financing

a) If a "typical" firm reports $10 million of retained earnings on its balance sheet, could its directors declare a $10 million cash dividend without any qualms whatsoever?

Retained earnings are those earnings made by a company and have not yet been distributed. According to Gibson (2009), a company may be unable to pay cash dividends even with enough retained earnings unless it has enough cash or it is in a position to raise enough cash and has fulfilled all legal obligation of the state in which it is incorporated. What this implies is that, a company has to have a substantial amount of cash on top of the retained earnings before they can be distributed as cash dividends. It is highly unlikely that the retained earnings themselves will be held as cash, as they represent investments of the assets of the firm. However, the directors may distribute dividends if they so wish although it would not be appropriate. Their major responsibility is to increase shareholder wealth and to make this possible, one portion of the total annual profit has to go to dividend payment and another has to be reinvested into the business. Only then can the directors be said to have acted in the best interest of the shareholders as they put the company's future expansion in mind.

b) Explain how the federal income tax structure affects the choice of financing (use of debt vs. equity) of U.S. firms. If financing with debt is better, why doesn't everyone finance almost entirely with debt?

Federal income tax is advantageous in debt financing because the interest payments reduce the amount of taxable income to be paid, unlike equity financing. It may not be advisable to finance almost entirely with debt because debt will finally have to be repaid. The interest payable, in relation to debt financing, raises the breakeven point, making the company prone to bankruptcy in times of financial difficulty. The risk with equity financing is less as equity investments may or may not be returned. Debt financing is also disadvantageous because it has too many conditions tied to it and investors and lenders are also put off by a large debt-to-equity ratio -- an indicator of financial risk.

Question two

Financial ratio analysis is conducted by four groups of analysts: managers, equity investors, long-term creditors, and short-term creditors.

a) What is the primary emphasis of each of these groups in evaluating ratios?

Managers- Managers of a company are mainly interested in its performance, since they are responsible for the daily duties carried out. They will, thus, be more interested in operating performance and turnover ratios, which enable them to compare the company's performance across different periods and against competitor companies.

Equity investors- Profitability is the main concern of equity investors. They aim to get maximum returns on their investments. They also seek to find out the ability of a company to pay them dividends. Essentially, they mostly use profitability ratios to find out how capable a company is in generating a good income (Schmidgall, 2003).

Long-term creditors- Since long-term creditors have long-term interest in the finances of a particular company; they hold solvency ratios in high regard (Schmidgall, 2003). Solvency ratios gauge an entity's ability to pay long-term debts and show the financial risks of the company, which make them useful to lenders as they require their long-term debts to be repaid in time.

Short-term creditors- These creditors are more concerned with the ability of the company to pay off the amounts that were lent to them. They are, therefore, more interested in the liquidity of the company. They emphasize on liquidity ratios, which gauge an entity's ability to meet its short-term obligations.

b) Why would the inventory turnover ratio be more important when analyzing a grocery chain than an insurance company?

The success of a grocery store largely depends on its inventory management. This is because it uses a lot of inventory, some of which may be perishable and could potentially lead to numerous losses. Inventory turnover ratios help managers determine the ratio of costs of the goods sold against the particular average inventory, hence they will be able to avoid wastage and keep track of every item of stock. An insurance company primarily deals with the sale of insurance policies and inventory is not one of the major assets that will largely influence its performance.

c) What does it mean when a company's return on assets (ROA) is equal to return on equity (ROE)? What implications does it carry?

Sometimes, a company's ROA is equal to its ROE, which means that the company did not use any debt. If no debt is used, it may imply that owners catered for the company's financial needs themselves. This implies that the company may have to hold highly liquid short-term assets or utilize cash in order to fund investments. They have to deal with more tax liability and they also resort to financing options that dilute ownership of the firm.

Question three

a) What happens to the length of time it takes you to become a millionaire when you increase your savings per month?

When monthly savings are increased, the amount of time it takes to be a millionaire is scaled downwards. It is not easy to determine what future investments will give back - it is better to increase the amount of savings in order to be a millionaire within a shorter time.

b) What happens when you increase the expected rate of return?

The higher the rate of return the higher the ending balance achieved.

c) How do taxes impact your accumulation? Why are marginal tax rates important instead of average?

The higher the tax rate, the less the amount of savings and consequently the less the ending balance displayed. The average tax rate calculates the total taxes paid on income. It is calculated as a percentage of the income, as opposed to the marginal tax rate, which is the highest rate that an individual can be taxed. Marginal rates are important because they show the true amount of the taxes that should be paid.

d) What rate should you use for an expected return?

Since the savings plan starts at a young age, 7% is a suitable rate of return that will accommodate the total spending and savings. The rate also allows a young individual to accommodate a small amount of risk.

e) What should you do if you want to become a millionaire sooner than the calculator indicates?

To become a millionaire sooner, one should increase the amount of savings and use a high rate of return. The key is for the savings to increase as the amount of income increases, and to minimize expenditure accordingly.

f) What is the difference between EAR (effective annual rate) and APR (annualized percentage rate)

The EAR is an interest rate that produces the same figure of future value of a given loan if annual compounding is applied. The APR shows the particular cost incurred in borrowing money for different purchases, and is often calculated as the periodic rate multiplied by the number of periods in a year. According to Laopodis (2013), the APR uses the simple interest rate to calculate the cost incurred in borrowing, which makes it better - it is the rate often used by banks. However, it gives rise to an understatement of the EAR.

For example:

Ann has a credit card with an APR amount of 1%. She pays off the balance in installments and continues to earn a charge till she clears the balance. Her APR will be 12% (1%*5), while her EAR will be 12.68% (1+12%/12)12-1 (Laopodis, 2013). The actual interest amount 12.68 is higher.

Question four: Merck Company

a) Why did Merck's price fall so significantly?

Stock market prices are greatly influenced by human psychology, company performance, and major news about a company's products, which provide a basis for the stock market reaction. According to Flynn et al. (2009), the financial impact of such an unexpected event in an efficient market will be reflected in the stock prices instantly. News of Vioxx's negative effects on human health gave the company a bad reputation and investors lost confidence in the management and performance of the company. Consequently, Merck's stock price fell significantly because the demand of the stocks went down as people could not risk their health after reports of heart attacks and strokes. Most people would also avoid the product, as legal battles are expected to carry on for a long period of time -- which will definitely lead to less shareholder wealth.

b) As CEO of Merck, Raymond Gilmartin made the decision to stop sales of Vioxx. Should he have withheld this information since it would have a clear negative effect on share price and he had an obligation to maximize the value of these shares?

It was right for the CEO to stop the sales of Vioxx as the… [END OF PREVIEW]

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