Financial Decision Making and Theory

Abstract

The aim of this research is to provide an overview of financial decision making and theory and practise according to which the decision has been taken. In this research the risks faced by any person or company in financial decision making and the strategies adopted by companies will be discussed.

Decision making is plays an important role in progress of any company. Basically there are some set goals and objectives according to which company make their strategies and take financial decisions. Intelligent decisions put company on a progressive way and all this depends on the financial manager that how to make the strategy, how to follow a set plan of strategies and how much will be the success.

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Making right decision at the right time will lead a company to success, for this purpose one have to analyze the resources and then define some goals. Different strategies will be brought in to action to achieve those objectives and goals. Afterwards what will be the impact of investment for the company and how much profitable it will be also the role of taxation will be discussed.

Chapter 1: Background and Introduction

Introduction:

Decision making is an important and necessary part of everyone’s life. When it comes to making business decisions i.e. where huge money is involved, and loss and profit make a big difference then financial decisions will be more risky, and difficult, however there will be certain rules and procedures by which risk of financial decision can be reduced or minimize the loss.

The process of corporate decision making is the most important decision for effective management. Decision making process is based on expert’s knowledge and experience. The good financial decisions help the organization to generate profit effectively, if the decision is accurate, business in specific time will be successful, and however poor decision could lead to failure of business (Mind tools 2007).

Every firm have some objective and goals because if there are no objectives and goals, then there is no point to struggle and hard work and therefore no development and success. According to those goals and objectives there will be a vision and mission of company and then some strategies will be defined to achieve those objectives. Profitability is the basic aim behind every strategy because it will help the company to forecast their profits, revenues and profits according to each strategy.(Lumby,S 2004)

When deciding on an investment opportunity, one has to consider the risks involved. As an investor or manager makes decisions on which project to invest, consideration must be given for the Net Present Value (NPV) of the different projects from which to choose. Afterward, a good investor should conduct sensitivity and scenario analysis as well as a risk analysis. Sensitivity analysis shows NPV under varying assumptions, giving managers a better feel for the project’s risks (Ross et al, 2005). In the real world, it is likely that there will be many variables affecting a project. The sensitivity analysis only modifies one variable at a time. This is where the scenario analysis comes into play. Scenario analysis examines a project’s performance under different scenarios (Ross et al, 2005). Finally, the break-even analysis helps to calculate the figure at which the project breaks even. This is useful as Company want to know how bad forecasts must be before a project loses money. All three analyses help an organization or individual understand the risks involved in a project. The goal of dissertation is to analyze the risks associated with the investment that will help to make financial decision.

Profitability index is a good tool to help determine which of the projects will give the company the highest value after investment. As a financial analyst, it is extremely difficult to eliminate bias for analysis. One has the option to adjust his or her stance and can choose to be conservative, moderate or aggressive. The value of the NPV, IRR and PI can be higher or lower based on the position that the financial analyst favours the most. This is a risk as it also poses some form of bias relating to the financial analyst’s view. The results would not show the true stance of the company, rather it would show the analyst’s view. To mitigate this risk, a strategic analyst will make decisions based on a combination of results and abstain from decisions based on his or her own stance (Ross et al, 2005).

The fact that no one can be certain as to how the economy or market will perform in the coming years also poses a major risk. As the values are selected and decided, outside factors might have a major effect in the following years that will skew the current values. In the Financial decision making, no information is given on the stability of the market. If the market is not stable, predictions could not be made to a certain extent, thereby making investment decisions risky. To mitigate this risk, the concept of forecasting needs to be applied. Although forecasting would not eliminate all risks associated with the future, it may help identify and evaluate risks, clarifying factors and reveal assumptions (Veryard Projects, 2001). Forecasting will help to identify future risks in order for the companies to create a backup plan. Environmental scanning is also another mitigation method as it will help identify external factors that might pose a threat to their decisions (Veryard Projects, 2001).

The Risk element in concept of investment decision is an imperative factor in the valuation of likely investments. Risk and risk management are at the core of an investment’s success. Risk refers to the volatility of unexpected outcomes, usually relating to the value of assets or incomes gained from them (Jorion and Khoury, 1996). In simple words, risk refers to a measure of the possibility of being ‘surprised’. A key concern for financial institutions and investors is the enormous issue of market risks. Risk can be categorised into number of types but a clear understanding of Financial Risk is beneficial in evaluation and monitoring of investments. Financial Risk is the variability in the investor’s returns. Investors can considerably reduce the variation in returns by carefully investing in two or more assets.

Finally it is concluded that decision making is all about compare possible options and alternatives and financial decision is totally based on the theory of valuation because company valuation is necessary in order to make multiple alternatives and in all types of decisions there are same essential concepts involved which has exclusive features in the valuation and later on decision making process (Lumby, S 2004).

These strategies help in making intelligent decisions by analyzing the given or required information. These strategies also help in selecting the best possible action based upon the consequences of decisions and also work out the significance of individual aspects (Mind tools 2007).

Aims and Objectives

The aim of this dissertation is to reduce the risk of financial decision making. To define a way for the managers by which they can reduce the risk of uncertainty and they can identify that whether to invest in this business is profitable or is there any risk of loss. There will be certain processes and procedures. By following them financial decision making will not very difficult and after investing these process will also make an estimation of the profit or loss. The main objectives of this dissertation will be as follows:-

Identify the risks in financial decision making process.

Define the methods and procedures to minimize the risk.

To calculate that after investing in certain project what will be the impact of that investment i.e. Profitable or not.

What will be the taxation effect?

These objectives will be addressed in the different sections and then based on the research and findings a conclusion will be defined at the end.

Chapter summaries

This dissertation consists of an Abstract and five further chapters. In first chapter will be a thorough introduction of dissertation and about the aims and objectives

In second chapter the literature review will highlight different areas of research and about the objectives to be achieved.

Research methodology will be described in the third chapter and in this chapter different methods using during the research will be explained and also the collection of data.

Chapter four will be about the outcomes of the research and there comparison with literature.

Chapter five will be about the conclusion and recommendation by analyzing the objectives through different methodologies that what the final outcome of the dissertation is.

Chapter 2: Literature Review

Responsibilities of Financial manager in investment decision making

The financial manager is the person whom primary responsibility for financial management in a firm. The financial manager must act as an intermediary standing among financial markets and the firm’s operations, where the firm’s securities are traded. The role of financial manager is very complicated it’s a two way process. Firstly, maintain a cash flow from shareholders to company and secondly from company to shareholders. This cash is for the purpose to acquire real assets used in and by the company operations and expanses. Later on if the performance of company is good and progressive these real assets generate profits for the company which works as cash inflows and finally this profit is returned to the shareholders who have earlier made the investment (BusinessCreditInfo.com, 2006). This shows that the financial manager has to deal with capital markets as well as the firm’s operations. Therefore, the financial manager must understand how capital markets work.

The financial manager must undertake certain specific duties to carry out the responsibilities satisfactorily. Some of the main duties are summarized by the following;

1. The financial manager is continuously involved in financial analysis to monitor the financial performance of a firm. For example, financial manager has to ensure and provide adequate financial control such that funds are allocated in an efficient manner.

2. The financial manager must ensure that the firm meets its day-to-day cash requirements.

3. The financial manager advises on the acquisition of fixed assets such as cash, market securities, accounts receivable and inventories.

4. The current and fixed assets of a firm are usually financed through a combination of current and long-term liabilities, and equity, or shareholders’ money. The financial manager must ensure that a firm invests in the types and amounts of fixed assets needed for efficient operation.

5. The financial manager must pay attention to the welfare of the firm’s shareholders. In this regard, financial manager needs to develop and implement a dividend policy which is acceptable to these shareholders.

The fundamental financial goal of any organization is to maximize the stockholder’s value. In general, an increase in stockholders wealth means that value has been added to firm assets and wealth of society has generally increased. In addition, stockholders are satisfy to contribute cash only if the decisions made to generate at least equal to the returns that stockholders could earn by investing in financial markets. Otherwise, shareholders might be wanted their money back. (Ardalan, K 2003)

According to Van Horne J., (2007) stated that maximization of profits is regarded as the proper objective of the firm; however, maximization of profits is not as inclusive a goal as that of maximizing shareholder wealth. For one thing, total profits are not as important as earnings per share. A firm could always raise total profits by issuing shares and using the proceeds to invest in Treasury bills.

The viewpoint of financial manager and stockholder regarding to maximizing share value are as following (Arcas, 2007);

1. The viewpoint of financial managers is creating high retained earning or profit to the company. Whereas, Shareholders consider to dividend and stock price of the company so the aim of the management is always to make the company profitable and progressive to maximize shareholder’s value. The makeup of the shareholders can change without affecting the operation of the corporation whereas the decision from financial manager could imply the trend of shareholder’s wealth.

2. Long-term and Short-term; financial managers: good financial managers will have a long-term plan to increase share value along with the current market situation. Meanwhile stakeholders and shareholders may desire to get the higher return with short-time period. Therefore, they may change and move around to find more profits.

3. Ethics in management; unethical financial manager may attempt to find the short-term prosperity and give him/herself a return in many kinds from company compensation. Meanwhile stakeholders: the inappropriate practice may lead to the unacceptable image and may relate to the industry wealth. In addition, shareholders: the unethical decision from manager could pull down the share value and may result in bankrupt if the owners are not promptly action to solve the issue.

4. Different Opinion in a type of investment to increase the shareholder wealth between financial manager and Shareholders because each person may see the high return from different perspective and the best decision can not be concluded. For example, stockholders may not think about risk of the possible earnings stream. Stockholders want to increase stock price by increasing the risk. On the other hand, financial manager who looks at the overall pictures for long-term goal, financial manager want to accelerate good performances of the company by limiting the risk that the company should take.

Market price is the performance indicator for any company. It tells that how much company is earning and also the management performance on their shareholder’s behalf. The management is under continuous review. If a shareholder is dissatisfied with management’s performance, he/she may sell his/her shares and invest in others company. This action, if taken by other unsatisfied shareholders, will put downward pressure on the market price per share. Therefore, the company cannot survive and raise the fund on as favorable terms as possible in the market which impact directly to the financial manager.

In short, financial manager has important roles in managing financial in the firm, dealing with conflictions either boards of director, employees or shareholders, which made financial manager requires short-term and long-term viewpoint to increase financial status and to maximize shareholder value.

Techniques used in financial decision making and risks involved

Researches show that investment decisions which are made, no matter in large or small businesses are mostly dependant on Capital Budgeting techniques. According to Jones and Smith (1982), an American engineer has first use the present value calculations to calculate non financial investments back in 1887 who were really concerned with the railway construction economies (Jones and Smith, 1982). It is also seen that Fisher’s (1907) seminal work called ‘The Rate of Interest’ is first discussed by an American economist evaluating in finding net present value.(Fisher, 1907). Capital Budgeting, frankly speaking is the process of generating, evaluating, selecting and following up on capital expenditures (Study Finance, 2007), or in other words the planning process used to determine a firm’s long term investment.

According to Maccarrone (1996), in the last few years capital investment has boost in decision making and further believes that most of the theories about capital investment’s behavioural aspects and about the association between investment decision. (Maccarrone, 1996). Also looking at the research paper by Fourcans (1987), where he says that, in the success of all big names and multinational companies’ capital budgeting is the most popular strategy and plays very important role in the development of any organization. As other techniques there are some drawbacks, ambiguity and risks involved in using capital budgeting as Fourcans (1987) focused that when you use certain strategies in business, a certain risk level is associated with each technique (Fourcans, 1987).

As mentioned before, majority of investment decision which take place are mostly backed up by capital budgeting techniques, but in real life, not all companies follow the same type of techniques. The type of techniques they use sometimes depends on their size or on the position of the business in the market. In this report wewill be looking at different business positions and list the type of techniques they use based on research.

Also there will be a discussion on looking at the risks and uncertainty involved in capital budgeting techniques because theories and researches suggest that quite a lot of time the results from capital budgeting are inefficient and in-accurate.

Technically speaking, every investment project is worth the go if the net present value (NPV) is positive, but according to Holmén (2005) this is not always the case. For the calculation of NPV, different cash flows of a project required and then discount them at a given discount rate. Discount rate is the risk of cash flow for which the price is charged by capital markets.

The formula for NPV is

Where

t is Time of the cash flow.

r is The discount rate.

Ct is the net cash flow.

The stockholders from big organizations think that discount rate is a risk according to the strategy that affects the project value. During capital budgeting, the deficiency of capital markets, bankruptcy costs were mostly ignored when there is capital market imperfection (Holmén, 2005). This reason is also backed up by Stulz (1999) who believes that there are certain aspects which are neglected while making decisions based on NPV (Stulz 1999). There is no doubt that NPV is the most commonly used technique, but there are also other alternates like payback period etc. The payback method used is consider the most imperfect method because firstly it overlooks cash flows and secondly time value of money; this factor is ignored. According to Graham and Harvey (2001), which is also a surprising fact that 57% of Corporate Finance Organizations (CFo) apply payback method for capital budgeting decisions and 76% use NPV method (Graham and Harvey, 2001). Koedik et al (2004) says that the method of payback is widely used not only in Europe but also in UK, Germany and France. It is second largely popular technique in Netherlands subsequent to NPV (Koedjik et al, 2004, pg 71-101).

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As stated previously in the report, most of the organization use capital budgeting in different ways and techniques depending on the size and growth because if a company is bigger in size and position is stable then they have higher expectations and they will use more complex techniques because they have extra shares in the markets and they have got enough time to achieve what they have budgeted. As mentioned in the research done by Holmén (2005), large and growing organization, the majority of them use NPV more willingly then other techniques (Holmén, 2005).

Even Ryan AND Ryan (2002) states in his research that NPV and IRR is most popular capital budgeted technique in progressed organization. Patricia and Glenn’s research was done on 1000 companies and the outcome was, about 49.8% big organizations use NPV and on the other hand 44.6% use IRR with the possibility of using each more commonly being 85.1% and 76.7% respectively (Ryan and Ryan, 2002).

Collis and Jarvis (2000) say that in small companies financial decision is all depends on owners and managers that how they use their resources and information to manage and control their process (Collis and Jarvis, 2000). Consequently, According to Peel and Wilson (1996), if financial management practices in the small firm sector could be improved significantly, then fewer firms would fail economic welfare would be increased substantially (Peel and Wilson, 1996).

Normally in practise small companies tend to follow the criterion of big financial names but according to their size and growth they make their own policies and strategies with clear intention keeping in mind their objects and goals and are quite similar like the big organizations are following. These can be explained critically as follows. First, the financial management practices of large firms are neither conclusive nor indisputable. On the contrary, they are controversial and continually changing (Johnson and Kaplan, 1987). Second, the larger companies themselves, even with highly skilled and experienced staff, do not always stick strictly to standards defined by them so could not avoid the serious failure in real practise of financial decision making (Jarvis et al., 1996).Third, many research studies have demonstrated that because of the structure small companies do not function in the circumstances as large organizations because of the different environment, economy and financial restrictions (Curran, 1990).

According to McMahon and Stanger (1995), because of different size and growth there is a difference in operation environment and so in the level of risk and uncertainty (McMahon and Stanger, 1995). So it can be said that uniqueness of small firms required financial strategies which suits to its requirements and which are designed to fulfil its requirement according to their scale and quite similar to the strategies of big successful organizations (Jarvis et al., 1996). Small organizations have limited resources to manage the strategies in the real world as compare to the big organization (Jennings and Beaver, 1997). So the fact is that small companies have different environment and conditions as compare to large organizations because the decisions making capability of small firms is often unstable by success point of view which big organizations don’t face many times.

According to Taylor III (1998) research, when assess the investment management there are two perspective namely local and global. In local perspective company performance can be calculated by its smaller units and then combine them on a local level. If performance of the company at the local level is good then it will maximize the performance of the organization as a smaller component. Local measures include usually Pay back method, IRR (Internal Rate of Return) and NPV (Net Present Value). On the other hand global measures assess any company performance as complete unit. If the performance of company as complete unit is fine it will maximize the performance of the organization completely. In global measures ROI (Return on Investment) net profit and cash flow techniques are being used (Taylor, 1998).

As above explained that the difference of capital budgeting techniques in small and big organizations. Now see that do these techniques make any difference in public and private sector. According to Habib et al (1997) tells how financial decisions made. In his paper he said, Recent developments, such as privatization and the private finance initiative, have raised the issue of which assets should be owned by the public sector and whether assets have different values in the public and private sectors (Habib et al 1997). The research shows that there is a difference between capital investment in each sector and in different organizations depending upon their size, capabilities and growth and how well establish companies maximize shareholder’s value and how finance managers take decisions for the benefit of shareholders.

As the research continues it tells us that NPV (Net Present Value) is used to calculate shareholders value but calculation by NPV shows a risk in the financial market and more research shows that calculation by NPV calculation in evaluating the risk factor is efficient or not. Further research shows that projects using NPV in most of the public sectors are quite similar so the outcome is also similar which will help in getting the profitability and maximize the shareholders wealth (Habib et al,1997).

Capital budgeting techniques which are frequently used these days in every organization do involve certain amount of risk. In investment decisions the techniques involved not always give perfect outcome. Drury andTalyes (1997) in their research say that for a long time capital budgeting techniques in UK and USA and using all four techniques of capital budgeting i.e. NPV, IRR, ARR and PBP. Further says despite the increased usage of the more theoretically sound discounting techniques, several writers in both the UK and USA have claimed that companies are under investing because they misapply or misinterpret discounted cash flow techniques(Drury and Tayles, 1997). Other writers like Finnie (1988), Hodder and Riggs (1985) and Kaplan (1986) say that firms are guilty of rejecting worthwhile investments because the improper treatment of inflation in the financial appraisal; inflation affects both future cash flows and the cost of capital that is used to discount the cash flows (Finnie, 1988; Hodder and Riggs, 1985; Kaplan 1986).

Amongst the risk involved in the investment appraisal techniques is the use of excessive discount rates. Dimson and Marsh (1994) say that many UK companies may be using excessively high discount rates to appraise investments and, as a result, these companies are in danger of under investing (Dimson and Marsh, 1994). Porter (1992) says that in the USA it has also been alleged that firms used discount rates to evaluate investment projects that are higher than their estimated cost of capital (Porter, 1992)

Ehrhardt and Daves (1999), in their research for unusual and extraordinary cash flows, say that by ignoring cash flows, capital budgeting results are incorrect which are

Quite large

From normal operating cash flows risk are quite different

Not part of companies normal operating cash flows.

There are some risk avoidance methods which can be used to get more accuracy in investment decisions. These methods and techniques can be used for the future purposes in taking financial decisions (Ehrhardt and Daves, 1999).

Take right decision at the right time is important so to get good outcome from capital budgeting it is essential to use right technique at the right time. (Pollet et al, 2006). Research shows that there is a difficulty in calculating the theory of capital budgeting and find different opportunities of investment and when making investment decisions the market should be consider positive. Further it is observed that organization using complex budgeting techniques to achieve their high standard goals and objectives for short term and in order to gain maximum market share, but on the other side companies with high goals for long term use target oriented strategies which are not very difficult to achieve (Della Vigna and Pollet, 2006).

Chapter 3: Research Objectives

Research questions

How much external and Internal funds impact on Corporate financial decisions and how?

How corporate capital structures effect the financial decision making?

Has tax effect in corporate financial decisions? If yes how and how much?

Objectives

To find out the financial decision making process of a company and the basic ideas on which that decision is based.

To identify how taxes affect the process of financial decision making process and how much the effect will be?

To find out how different type of investments effect the financial decision making process and how much the effect will be?

To research how can we reduce the risk of decision making in the industry using corporate financial decision, how a company should make its decision and which aspects a company should be concerned about while making an investment decision?

Chapter 4: Methodology

Research Philosophy

According to Remenyi et al (2003, p.32) positivistic philosophy aims at the derivation of laws or law-like generality which are related in natural and physical sciences. In quantitative research the researchers are allowed to understand the concept of the problem which is under observation. Facts and the causes of behaviour is the major emphasis area(Bogdan and Biklen 1988), in which the numeric information can be calculated, and summarized using a mathematical process and then the final outcome which is in statistical terminology is formulated (Charles 1995).

There are two features common in realistic philosophy and positivism philosophy: a belief that for data collection in social and natural sciences the approach is almost same and for explanation and assurance to the view that scientists normally pay attention to the external reality (Bryman 2001).

The interprevistic philosophy in contrast, emphasize that the suppositions of both philosophies are unnecessary; especially in cases where many factors manipulate the objective of the study, very complex to separate and control in experimental laboratory settings (Hirschheim and Klein 1994). Qualitative research, generally defined, means any kind of research that generates result not arrived at through quantification (Strauss and Corbin 1990, p.17) and which take place from real-world circumstances (Patton 2001, p.39).

In this situation this study is using interprevistic approach because the findings i.e. how to make investment decisions and how much will be the risk in that decision and how much will be the impact of that investment afterwards is really difficult to calculate exactly and also is a complex collection in real-world scenario, so it will not appropriate to use positivistic approach.

Research approach

Inductive reasoning implement to the situations where measurements or some particular observations are formed towards formulating broader conclusions, generalizations and theories (Saunders et al. 2003, p.87-88). The deductive reasoning is the approach in which one start thinking about generalizations, and then continues towards the particulars of how to implement the generalizations (Saunders et al. 2003, p.86-87), mostly applicable in disciplines where agreed facts and established theories are available (Remenyi et al. 2000, p.75)

From the following table will tells the major differences among inductive and deductive approaches and in this research, inductive approach will be used as it is best suitable for an interpretivistic research.