8/9/2019 Risks in Financial Decision Making Process
1/75
Rik in Finncial Deciion Making Proce
8/9/2019 Risks in Financial Decision Making Process
2/75
Abtact
n rgnization trategy mut be appropriate fr it reource, environmental
circumtnce, nd cre objective. The proce involve matching the compny'
internal reource nd capabilitie to the external buine environment the rgnization
face. trategy frmulation involve doing a ituation nalyi: both internal nd external;
objective are et viion, miion tatement, overall crprate objective. The pln
provide the detail of how to achieve thee objective. Thi trategy will determining
where you are now, determining where you wnt to go, nd then determining how to get
there . Buine trategie mnagement involve: mnaging reource eg:-finncial,
peronnel, time, nd infrmation technology. trategic mnagement i actually a olid
foundation r a framewrk within which all the functionning mnagerial operation are
bundled together. Thi i the highet level crprate activity that et the term nd goal
fr a compny that it hould follow.
8/9/2019 Risks in Financial Decision Making Process
3/75
Table of Content
Finncial Rik Mnagement .......................................................................................... 19
Deciion Criteria ............................................................................................................ 20Mnagement Of Wrking Capital ..................................................................................21
The Finncing Deciion ................................................................................................. 22Capital Invetment Deciion ........................................................................................ 23
Methodology ..................................................................................................................33
Data Collection .............................................................................................................35
emi-tructured Data Collection .................................................................................. 35Untructured Data Collection ....................................................................................... 36
Dicuion ......................................................................................................................39
Managerial Implication ............................................................................................... 63
8/9/2019 Risks in Financial Decision Making Process
4/75
Chapter One: Introduction
The imprtnce of mnaging knowledge nd intellectual aet a increaing
rgnization value i mnagement of humn reource. Humn reource (HR) practice
have greater impact rgnization productivity. Mnaging humn reource men
integrating deciion about people with deciion about the reult n rgnization i
trying to obtain . By integrating humn reource mnagement (HRM) into the agency
plnning proce, emphaizing humn reource activitie that upprt broad agency
miion goal, nd building a trong relationhip between HR nd mnagement, agencie
are able to enure that the mnagement of humn reource contribute to miion
accomplihment nd that mnager are held accountable fr their HRM deciion. Thi i
epecially imprtnt puh to align all agency activitie, including HRM, toward achieving
defined agency trategic goal nd miion. (Kanen nd Trigergi, 2003, 294-309)
Finncial mnagement i imprtnce to provide the neceary finncial reource
to enable the agency afer, nd to enure a high tndard in the mnagement of finnce.
Finnce nd finncial mnagement encompa numerou buine nd governmental
activitie. In today' buine environment, crprate finnce addree iue relating to
individual firm. pecifically, the field of crprate finnce eek to determine the
optimal invetment that firm hould make, the bet method of paying fr thoe
invetment, nd the bet way of mnaging daily finncial activitie to enure that firm
have adequate cah flow. Finncial mnagement influence all egment of crprate
activity,. Through the acquiition of fund, the allocation of reource, nd the tracking of
finncial perfrmnce, finncial mnagement provide a vital function fr ny
rgnization' activitie. (Kanen nd Trigergi, 2003, 294-309)
8/9/2019 Risks in Financial Decision Making Process
5/75
In today' economy, the peed of infrmation acce r delivery often pell the
difference between ucce nd failure. Infrmation i often locked up in multiple
ytem, making it hard fr uer to acce the data they need when they need it. To
unlock thi infrmation, rgnization hould conider uing Infrmation nd Technology
that incrprate buine proce. With IT achieved buine infrmation by query data
acro multiple department: warehoue, operational, web, nd external data ource in
real time. The value of infrmation chnge with the timele of it deliver to deciion
maker. Mot rgnization deliver reprt that ummarize pat activity. Thi hitrical
help mnager nd executive undertnd the effectivene prir trategie, pln nd
initiative nd alo identify emerging pattern nd trend that could affect future pln.
While hitrical infrmation i critical, it doent help rgnization identify problem r
opprtunitie a they occur, r take immediate action to optimize the reult. With the
pace of buine quickening, compny cnt alway affrd to wait until the next day, next
week, next month to review progre. They need mre timely infrmation to monitr,
mnage, nd optimize operational procee that affect button line reult. Depite the
imprtnt of data nd infrmation a n aet nd a reource in providing competitive
advntage nd utaining their ucce . (Kanen nd Trigergi, 2003, 294-309)
By integrating nd conideration the humn reource, people nd infrmation nd
technology mnagement in the buine trategy i imprtnce to enable long run of
uccee buine operation.
Three Fundamental Concept
8/9/2019 Risks in Financial Decision Making Process
6/75
There are three fundamental concept that underlie the mot imprtnt finncial
deciion making tool nd procee. They are the three crnertone of making
deciion that maximize the firm economic value. They are alo the three fundamental
concept that are ued to value ecuritie, project, nd entire firm. Thee three concept
are the Time Value of Money, the Rik-Return Relationhip, nd Cah Flow. In general,
cah flow are dicounted to preent value uing time value of money calculation nd
ome type of rik adjutment proce. The reulting preent value are interpreted a the
intrinic value (r economic value) of the aet generating the cah flow.
Finncial Aet
Finncial aet are invetment in a broad rnge of ecuritie uch a common
tock, preferred tock, bond, nd other finncial aet uch a lon, nnuitie, mutual
fund hare nd derivative ecuritie. Fr ecuritie uch a tock nd bond, mny
valuation model are baed on dicounted cah flow valuation approache that rely on
thee three fundamental concept identified above. Thi men that the dicounted cah
flow to the invetr repreent a fair market value fr the ecurity. (Kanen nd
Trigergi, 2003, 294-309)
trong, embedded relationhip hift actor' motivation away from the puruit of
immediate economic gain toward the enrichment of relationhip through trut and
reciprocity (Powell, 1990; mitka, 1991). The importance of etablihing trut (or
confidence) in the bank-firm relationhip ha been dicued in the bank marketing
8/9/2019 Risks in Financial Decision Making Process
7/75
literature (e.g. Gill et al., 2006; Hawke and Heffernan, 2006). Uzzi and Gillepie (1998)
howed that ocial tructure and relationhip baed on trut play an important role in the
capital tructure of ME and the bank-firm relationhip. They determined that the
quality of the relationhip between an organiation and it lender affect the ME'
financial deciion making. Firm will alter their level of borrowing if the bank-firm
relationhip i rich in trut and reciprocity. The rationale for thi i that if the bank trut
the firm, the bank can lower it monitoring cot, which in turn enable the bank to offer
capital at price that are more competitive than would have been poible in the abence
of an embedded relationhip.
Reearch ha hown that identity i alo an important component in the formation
of relationhip and ocial tructure becaue it aign value to the tranaction and
enriche the exchange of ocial capital between partner in the network (Porte and
enbrenner, 1993). Organiational identity i a key intangible apect of any organiation.
It affect not only how organiation define themelve but alo how problem are
defined and reolved (e.g. Dutton et al., 1994; Dutton, 1997). Dicrete identity field, et
of actor clutered around ocially contructed identitie, affect the contruction of an
organiation' reource and core capabilitie (Hunt et al., 1994). Porac et al. (1999)
define identity contruction a an explicit claim that the organiation i of a particular
type. Intitutional theorit have ued the term field to denote the grouping of
organiation that are imilar, have common practice or hare a certain focu of
attention, uch a a market. DiMaggio and Powell (1983) define organiational field a
thoe organization that, in the aggregate, contitute a recognized area of intitutional
8/9/2019 Risks in Financial Decision Making Process
8/75
life: key upplier, reource and product conumer, regulatory agencie, and other
organization that produce imilar ervice or product. According to DiMaggio and
Powell (1983), mutual information proceing within a group of organiation i a vital
ign of field formation. Laron (1992) and Helper (1990) reported that thicker
information on trategy, profit margin and production know-how i tranferred through
embedded tie. Uzzi (1996, 1997) refer to uch information a fine-grained information.
Exchange of thicker, or fine-grained, information i unlikely in the abence of trut
becaue information could be ued opportunitically (Helper, 1990; Laron, 1992).
Baed on previou reearch, there i reaon to believe that identity field may
have an impact on the formation of embedded relationhip. Previou reearch ha hown
that the quality of firm-financier relationhip affect the financial behaviour of ME
(Uzzi and Gillepie, 1998). Therefore, it i poible that identity field may influence the
financial deciion making of ME, an iue that ha not previouly been addreed.
Becaue current knowledge only take u thi far, exploratory reearch i neceary. In
ubequent ection, I firt decribe the exploratory approach ued to illutrate the iue.
Next, I decribe the financial deciion-making proce of a jewellery deign firm, noting
how relationhip with the bank and an invetor are affected by the firm' identity and
how the firm relate firm identity to the perceived identity of the financier. I then
ugget a framework for thinking about how identity field may affect the ME'
financial deciion making. I conclude with a dicuion of the ME' financial deciion
making and the effect on the capital tructure and ugget implication for bank.
8/9/2019 Risks in Financial Decision Making Process
9/75
mall to medium-ized enterprie (ME) and new buinee have become
increaingly important for economic development (e.g. Deni, 2004). A central concern
for thee firm i the capital tructure problem: What mix of ecuritie and financing
ource hould be ued to finance the buine? Loan financing i the mot important
ource of external financing for mot European enterprie, 99 per cent of which have
fewer than 250 employee. It ha been recognied that acce to loan financing depend
on the cloene of the relationhip between enterprie and bank (European
Commiion, 2001). The embedded finance literature i a promiing new line of reearch
that addree thi iue. It ha found that when the bank i embedded in the ocial
tructure of the ME and there i a trong bank-firm relationhip, both the ME and the
bank benefit. ME that have embedded tie with banker can overcome information
problem and accumulate ocial capital that can be ued to acce capital at price that
make bank financing more attractive to firm. By etablihing a trong, embedded
relationhip with their ME cutomer, bank alo receive many benefit, including an
enhanced ability to reduce the cot aociated with writing loan contract, to retain
client, and to decommodify financial capital (Uzzi and Gillepie, 1998; Uzzi, 1997). The
importance of developing and maintaining the bank-firm cutomer relationhip ha been
emphaied in the bank-marketing literature (e.g. Ennew and Bink, 1996; Madill et al.,
2002; Proena and de Catro, 2005). Although pat tudie in different line of reearch
have generated knowledge regarding the importance of banking relationhip, ome
quetion need further invetigation, uch a what factor may be important to the
etablihment of relationhip between ME and financier, which in turn may affect the
ME' choice of financier.
8/9/2019 Risks in Financial Decision Making Process
10/75
Adapting an embedded perpective on financial deciion-making, thi reearch
addree a quetion that ha not been dicued previouly: are there pecific
organiational formation or characteritic that are of importance to the etablihment of
embedded firm-financier relationhip? How do uch characteritic affect the formation
of embedded tie to financier, and how doe they affect the rationale behind the ME'
financial deciion making? Becaue there i little previou knowledge about thi ubject,
exploratory reearch i needed. Thi reearch preent a new framework for thinking
about how ME make financial deciion, taking into account the firm' organiational
identity. To illutrate the framework, I preent a longitudinal tudy of a jewellery deign
firm that follow it financial deciion-making proce. The firm i categoried a a
fahion deign firm. Financing ha been found to be an urgent problem for fahion firm
(undberg, 2006), which motivate further invetigation of the financial deciion-making
proce for fahion ME. Managerial practice and organiational pattern that are
typically oberved in fahion indutrie are frequently at odd with our etablihed view
of managing organiation. The main difference i that in thee organiation identity
contain contradictory element: normative artitry and utilitarian economic coexit.
The finding preented in thi paper contribute to an increaed undertanding of
firm financial deciion-making and thu provide new inight into the capital tructure
problem. In contrat to the pecking order theory of finance, which ugget that firm
follow a pecking order from mot to leat preferred internal fund, friend and family,
bank and equity market (Myer, 1984; Myer and Majluf, 1984) thi tudy offer an
8/9/2019 Risks in Financial Decision Making Process
11/75
alternative explanation to how firm may hierarchically order their dependence on
different ource of financial capital. The finding and framework uggeted in thi
reearch alo provide clue a to how bank could market themelve to tart-up firm.
Invetment Project
Fr invetment project, the focu i on incremental after-tax operating cah flow
adjuted fr the time value of money nd fr rik. The um of all dicounted cah flow
i referred to a a Net Preent Value (NPV) that repreent the intrinic value of the
project. Thi NPV i ued a the bai fr the firm deciion to invet in the project.
By accepting poitive NPV invetment opprtunitie, owner, mnager nd employee
of the firm cn maximize the firm economic value. A the economic value of the firm
i maximized, it owner nd employee cn hare in the benefit of the greater value.
The following diagram illutrate thi proce. Incremental after-tax cah flow
are identified nd ome method of rik adjutment i ued when arriving at the
dicounted, rik adjuted, net preent value of the project. If the dicounted net preent
value i poitive, the project i accepted. Acceptnce of a poitive NPV invetment
project increae the economic value of the firm. thi increaed value cn then be hared
by owner, mnager, nd employee. (Haye nd Garvin, 2002, 71-79)
8/9/2019 Risks in Financial Decision Making Process
12/75
Incremental
After-Tax
Cah Flow
Accept
Poitive
Net
Preent
Value
Economic
Value of
the Firm
Increae
Owner,
Mnager,
nd
Employee
hare
Increaed
Value
Rik
Adjutment
Valuation of the Firm
Fr entire firm, whether privately r publicly owned, the dicounted cah flow
generated by all the firm' invetment project added together repreent the intrinic
value of the entire firm. Fr public firm, if the finncial market are pricing the common
tock crrectly, the market value of the firm' equity will equal thi intrinic value. Fr
private firm, the intrinic value repreent a fair market value. (Haye nd Garvin, 2002,
71-79)
Reearch Quetion
1. How much external nd Internal fund impact on Crprate finncial deciion
nd how?
8/9/2019 Risks in Financial Decision Making Process
13/75
2. How crprate capital tructure effect the finncial deciion making?
3. Ha tax effect in crprate finncial deciion? If ye how nd how much?
Reearch Objective
1. To find out the finncial deciion making proce of a compny nd the
baic idea on which that deciion i baed.
2. To identify how taxe effect the proce of finncial deciion making
proce nd how much the effect will be?
3.To find out how different type of invetment effect the finncial deciion
making proce nd how much the effect will be?
4. To reearch how cn we reduce the rik of deciion making in the indutry
uing crprate finncial deciion, how a compny hould make it deciion nd which
apect a compny hould be concerned about while making n invetment deciion?
8/9/2019 Risks in Financial Decision Making Process
14/75
Chapter Two: Literature Review
The primary goal of every crpration i to maximize hareholder wealth,
primarily through cah dividend nd hare value appreciation. To thi end, the role of the
finncial mnager i to act in accrd with thi premie. RoWeterfieldJaffe (2004)
tated, The mot imprtnt job of a finncial mnager i to create value from the firm
capital budgeting, finncing, nd net wrking-capital activitie. Mreover, how do
finncial mnager create value? They mentioned to way to do it: Firt, the firm hould
try to buy aet that generate mre cah thn they cot. econd, the firm hould ell
bond nd tock nd other finncial intrument that raie mre cah thn they cot .
Finncial mnager overee the preparation of finncial reprt, direct invetment
activitie, nd implement cah mnagement trategie. Their dutie vary with their
pecific title, which include controller, treaurer, credit mnager, nd cah mnager.
The role of the finncial mnager, particularly in buine, i chnging in repone
to technological advnce that have ignificntly reduced the amount of time it take to
produce finncial reprt. Finncial mnager now perfrm mre data nalyi nd ue it
to offer enir mnager idea on how to maximize profit. They often wrk on team,
acting a buine advir to top mnagement. Finncial mnager need to keep abreat
of the latet computer technology in rder to increae the efficiency of their firm
finncial operation. (Haye nd Abernathy, 2003, 66-77)
BrealeyMyerAllen (2005) found the following:
The finncial mnager tnd between the firm operation nd the finncial (r
capital) market, where invetr hold the finncial aet iued by the firm. The
8/9/2019 Risks in Financial Decision Making Process
15/75
finncial mnager role i illutrated in the next figure, which trace the flow of cah
from invetr to the firm nd back to invetr again. The flow tart when the firm ell
ecuritie to raie cah (arrow 1 in the figure). The cah i ued to purchae real aet
ued in the firm operation (arrow 2). Later, if the firm doe well, the real aet
generate cah inflow which mre thn repay the initial invetment (arrow 3). Finally, the
cah i either reinveted (arrow 4a) r returned to the invetr who bought the ecuritie
(arrow 4b). Of coure, the choice between arrow 4a nd 4b i not completely free. Fr
example, if a bnk lend money at tage 1, the bnk ha to be repaid the money plu
interet at tage 4b.
The dutie of finncial mnager vary with their pecific title. A finncial
plnner wrk under the direction of a mnager, perfrming variou finncial r budget
nalye. The enir finncial plnner upervie the taff in perfrming
finncial/economic nalye of new project nd nalye of merger nd crprate
growth policie. The mnager of finncial plnning direct the taff reponible fr
perfrming nalye in everal functional area including profit plnning, capital
expenditure, acquiition, nd budgeting. The Chief Finncial Officer (CFO) advie the
preident of the rgnization with repect to finncial reprting, finncial tability nd
liquidity, nd finncial growth. The CFO alo direct nd upervie the wrk of the
Controller, Treaurer, nd ometime the Internal Auditing Mnager. Other dutie may
8/9/2019 Risks in Financial Decision Making Process
16/75
include trengthening relationhip with tockholder, finncial intitution, nd the
invetment community. Frequently, the CFO i a member of the Board of Directr
nd/r the Executive Committee nd a uch, contribute to overall rgnization
plnning, policy development, nd implementation. (Haye nd Abernathy, 2003, 66-77)
In addition, finncial mnager perfrm tak unique to their rgnization r
indutry. Fr example, government finncial mnager mut be expert on the
government appropriation nd budgeting procee, wherea healthcare finncial
mnager mut be knowledgeable about iue urrounding healthcare finncing.
Furthermre, finncial mnager mut be aware of pecial tax law nd regulation that
affect their indutry.
Although the tockholder own the crpration, they do not mnage it. Intead,
they vote to elect a board of directr. In thery, when the finncial mnager act in
accrd with maximizing hareholder wealth, the hareholder benefit through cah
dividend nd hare price gain. With repect to employee, however, maximizing
hareholder wealth i not alway in their bet, peronal interet. Fr example, when a
compny nnounce a layoff to cut cot (which, fr illutration, I aume i with the
intent of maximizing hareholder wealth), tock hare price often increae, a the
econdary market react to the new a n appropriate nd proactive approach to reducing
cot nd increaing cah flow fr other pririty project. From n employee'
perpective, it' a lo of job nd income. (Haye nd Abernathy, 2003, 66-77)
However, it i alo in the bet interet of the compny to attract nd retain a
killed wrkfrce. If a compny ha a reputation fr paying porly, implementing
exceive round of layoff, r other unattractive humn reource policie, retaining a
8/9/2019 Risks in Financial Decision Making Process
17/75
killed wrkfrce will be difficult, nd will have a negative effect on hareholder value a
operational efficiencie, product quality, nd peed to market decline. Here, finncial
mnager (wrking in combination with HR) may conider benefit uch a employee
tock grnt nd dicount tock purchae pln (r tock option) (Online, Finncial
Mnager). In thi way, the rgnization cn align the priritie of the employee mre
cloely with thoe of the tockholder.
Mot of the reponibilitie of the finncial mnager are not traightfrward
deciion with repect to maximizing hareholder wealth. Beyond maximizing
hareholder wealth, finncial mnager alo have the reponibility of acting ethically,
particularly in today' finncial market with increaing media coverage nd regulatry
crutiny over crprate finncial cndal, like ENRON nd MCI WrldCom. When
Enron nd WrldCom went belly-up in 2002two of the larget bnkruptcie everno
one demnded that their tockholder put up mre money to cover the compnie debt.
tockholder cn loe their entire invetment, but no mre. (Haye nd Abernathy, 2003,
66-77)
BrealeyMyerAllen (2005) found the following:
Conflict between hareholder nd mnager are not the only principalagent
problem that the finncial mnager i likely to encounter. Fr example, jut a
hareholder need to encourage mnager to wrk fr the hareholder interet, o
enir mnagement need to think about how to motivate everyone ele in the compny.
In thi cae enir mnagement are the principal nd junir mnagement nd other
employee are their agent.
There are ome incentive to preure mnager to maximize tock price:
8/9/2019 Risks in Financial Decision Making Process
18/75
1. Threat of firing mnager. But tockholder uually jut ell their tock rather
thn try to chnge mnagement. Recently intitution collectively holding large block of
tock have been known to out mnager (at nnual tockholder meeting where board
of directr are elected).
2. Threat of hotile takeover. If a compny i taken over in a hotile takeover, the
mnager uually loe their job. Hotile takeover are probable only if the common tock
price i undervalued. Therefre, mnager cn dicourage hotile takeover by
maximizing the common tock price.
3. Poitive incentive. Compenation of the mnager cn be tied to the
perfrmnce of the crpration nd it common tock: executive tock option,
perfrmnce hare award, profit-baed alary nd bonue, etc.
In ummary, the tak of the finncial mnager cn be broken down into (1) the
invetment, r capital budgeting, deciion nd (2) the finncing deciion. In other wrd,
the firm ha to decide (1) what real aet to buy nd (2) how to raie the neceary cah.
hareholder wnt mnager to increae the value of the compny tock., they are the
owner of the crpration; the mnager wrk fr the owner. (Gillin, 2006, 38-39)
The goal fr the finncial mnager i to maximize hareholder (owner) wealth,
not jut increaing it r not jut profit. How?: by urviving, avoiding ditre nd
bnkruptcy, beating the competition, maximizing ale r market hare, minimizing cot,
maximizing profit, nd maintaining teady earning growth.
The uual method of maximizing the wealth of the tockholder i to maximize
the price of the crpration common tock. However, neither mnager nr
tockholder cn et the price of the common tock; the market determine the price.
8/9/2019 Risks in Financial Decision Making Process
19/75
Crprate finnce i related to the crpration nd the finncial deciion that
are taken by the crpration. There are everal imprtnt concept of crprate finnce
nd everal other finncial tool that are behind all thee crprate deciion. All thee
imprtnt concept of crprate finnce are ued to minimize the finncial rik to which
the crprate ectr i expoed. At the ame time, thee concept are ued to increae the
profitability of the crpration. Thee imprtnt concept of crprate finnce cn be
ued to identify, nalyze nd olve the finncial problem of almot every firm.
Finncial Rik Mnagement
Rik mnagement i the proce of meauring rik nd then developing nd
implementing trategie to mnage that rik. Finncial rik mnagement focue on rik
that cn be mnaged ("hedged") uing traded finncial intrument (typically chnge in
commodity price, interet rate, freign exchnge rate nd tock price). Finncial rik
mnagement will alo play n imprtnt role in cah mnagement.
Thi area i related to crprate finnce in two way. Firtly, firm expoure to
buine rik i a direct reult of previou Invetment nd Finncing deciion. econdly,
both dicipline hare the goal of creating, r enhncing, firm value. All large
crpration have rik mnagement team, nd mall firm practice infrmal, if not
frmal, rik mnagement.
Derivative are the intrument mot commonly ued in Finncial rik
mnagement. Becaue unique derivative contract tend to be cotly to create nd monitr,
the mot cot-effective finncial rik mnagement method uually involve derivative
8/9/2019 Risks in Financial Decision Making Process
20/75
that trade on well-etablihed finncial market. Thee tndard derivative intrument
include option, future contract, frward contract, nd wap.
Deciion relating to wrking capital nd hrt term finncing are referred to a
wrking capital mnagement. Thee involve mnaging the relationhip between a firm'
hrt-term aet nd it hrt-term liabilitie. The goal of Wrking capital mnagement
i to enure that the firm i able to continue it operation nd that it ha ufficient cah
flow to atify both maturing hrt-term debt nd upcoming operational expene.
Deciion Criteria
Wrking capital i the amount of capital which i readily available to n
rgnization. That i, wrking capital i the difference between reource in cah r
readily convertible into cah (Current Aet) nd cah requirement (Current Liabilitie).
o the deciion relating to wrking capital are alway current deciion, i.e., hrt term
deciion.
The hrt term deciion of the firm are imilar to thoe of long term in term of
rik nd return, but they differ in mny other way like time factr, dicounting
conideration, liquidity etc. o thee deciion are not taken on the ame bai a long
term deciion. Thee deciion have different criteria like cah flow nd profitability.
The mot imprtnt criterion fr making hrt term deciion i cah flow. nd
the bet meaure of cah flow i net operating cycle r cah converion cycle. It
repreent the time difference between cah payment fr raw material nd cah
collection fr ale. nother apect of cah converion cycle i gro operating
cycle which i ame a net operating cycle except the fact that it doe not take into
8/9/2019 Risks in Financial Decision Making Process
21/75
account the creditr deferral period. Cah converion cycle indicate the firm'
ability to convert it reource into cah. Becaue thi number effectively
crrepond to the time that the firm' cah i tied up in operation nd
unavailable fr other activitie, mnagement generally aim at a low net count.
In thi context, the mot ueful meaure of profitability i Return on capital
(ROC). The reult i hown a a percentage, determined by dividing relevnt
income fr the 12 month by capital employed; Return on equity (ROE) how
thi reult fr the firm' hareholder. Firm value i enhnced when, nd if, the
return on capital, which reult from wrking capital mnagement, exceed the
cot of capital, which reult from capital invetment deciion a above. ROC
meaure are therefre ueful a a mnagement tool, in that they link hrt-term
policy with long-term deciion making. ee Economic value added (EVA).
Mnagement Of Wrking Capital
Guided by the above criteria, mnagement will ue a combination of policie nd
technique fr the mnagement of wrking capital. Thee policie aim at mnaging the
current aet (generally cah nd cah equivalent, inventrie nd debtr) nd the
hrt term finncing, uch that cah flow nd return are acceptable.
Cah mnagement. Identify the cah balnce which allow fr the buine to
meet day to day expene, but reduce cah holding cot.
Inventry mnagement. Identify the level of inventry which allow fr
uninterrupted production but reduce the invetment in raw material - nd
minimize rerdering cot - nd hence increae cah flow; ee upply chain
8/9/2019 Risks in Financial Decision Making Process
22/75
mnagement; Jut In Time (JIT); Economic rder quntity (EOQ); Economic
production quntity (EPQ).
Debtr mnagement. Identify the appropriate credit policy, i.e. credit term
which will attract cutomer, uch that ny impact on cah flow nd the cah
converion cycle will be offet by increaed revenue nd hence Return on Capital
(rvice vera); ee Dicount nd allownce.
hrt term finncing. Identify the appropriate ource of finncing, given the
cah converion cycle: the inventry i ideally finnced by credit grnted by the
upplier; however, it may be neceary to utilize a bnk lon (r overdraft), r to
"convert debtr to cah" through "factring".
The Finncing Deciion
Achieving the goal of crprate finnce require that ny crprate invetment
be finnced appropriately. A above, ince both hurdle rate nd cah flow (nd hence the
rikine of the firm) will be affected, the finncing mix cn impact the valuation.
Mnagement mut therefre identify the "optimal mix" of finncingthe capital
tructure that reult in maximum value.
The ource of finncing will, generically, comprie ome combination of debt
nd equity. Finncing a project through debt reult in a liability that mut be erviced
nd hence there are cah flow implication regardle of the project' ucce. Equity
finncing i le riky in the ene of cah flow commitment, but reult in a dilution of
ownerhip nd earning. The cot of equity i alo typically higher thn the cot of debt,
8/9/2019 Risks in Financial Decision Making Process
23/75
nd o equity finncing may reult in n increaed hurdle rate which may offet ny
reduction in cah flow rik.
Mnagement mut alo attempt to match the finncing mix to the aet being
finnced a cloely a poible, in term of both timing nd cah flow.
One of the main therie of how firm make their finncing deciion i the Pecking
rder Thery, which ugget that firm avoid external finncing while they have
internal finncing available nd avoid new equity finncing while they cn engage in new
debt finncing at reaonably low interet rate. nother majr thery i the Trade-Off
Thery in which firm are aumed to trade-off the Tax Benefit of debt with the
Bnkruptcy Cot of debt when making their deciion. n emerging area in finnce
thery i Right-finncing whereby invetment bnk nd crpration cn enhnce
invetment return nd compny value over time by determining the right invetment
objective, policy framewrk, intitutional tructure, ource of finncing (debt r equity)
nd expenditure framewrk within a given economy nd under given market condition.
One lat thery about thi deciion i the Market timing hypothei which tate that
firm look fr the cheaper type of finncing regardle of their current level of internal
reource, debt nd equity.
Capital Invetment Deciion
Capital invetment deciion are long-term crprate finnce deciion relating to
fixed aet nd capital tructure. Deciion are baed on everal inter-related criteria.
Crprate mnagement eek to maximize the value of the firm by inveting in project
which yield a poitive net preent value when valued uing n appropriate dicount rate.
8/9/2019 Risks in Financial Decision Making Process
24/75
Thee project mut alo be finnced appropriately. If no uch opprtunitie exit,
maximizing hareholder value dictate that mnagement return exce cah to
hareholder. Capital invetment deciion thu comprie n invetment deciion, a
finncing deciion, nd a dividend deciion.
The cae
In thi ection, the firm' financial deciion-making proce i analyed. In
addition to the two founder of the firm, the actor involved in thi proce included the
two banker repreenting the bank where the firm i a cutomer and the invetor who
entered after the firm wa granted debt financing and offered equity financing. The
chronology of the financial deciion-making proce i decribed in Figure 1.
The firm' decription of it buine and it need for finance
According to one of the two deigner, their buine idea wa to create high
qualitative jewellery, with a mix of fahion, art, and craft, and to launch two collection a
year, following the product life cycle of the fahion indutry. The objective for etting
up the buine wa to be able to freely expre their artitic viion. Early on, the firm
received a great deal of attention in the media, in newpaper, in magazine and on
televiion, where it wa portrayed a an example of the recent hype and ucce of
wedih fahion deign.
The deigner' rhetoric invoked their alignment with the artitic world. For
example, they launched their firt collection in an art gallery to demontrate their artitic
ambition. With their rhetoric, the deigner claimed their artitic identity whilt
downplaying their economic identity, and commenurate with their identity claim, they
8/9/2019 Risks in Financial Decision Making Process
25/75
defined core capabilitie in term of intangible, uch a artitic talent. The deigner,
however, alo expreed a different et of claim about the identity of their firm, which
wa to generate profit. In a newpaper reearch, they expreed their viion in the
following way: By founding a profitable company we are trying to create our own pace
in the commercial market. Thu, they were aware of the neceity to negotiate a balance
between an idealitic, artitic-viion driven perpective and the revenue-driven realitic
view.
The deigner expreed an intention for the firm to grow and to cover market
in New York and Tokyo. External financing would be needed to achieve thi goal. To
finance their firt collection, they each made a private invetment of EK 10,000 and a
family member granted the firm a loan of EK 40,000, with interet, that hould be
reimbured in two year. Their poue covered their private expene. The univerity
where they had tudied aigned a mentor to the firm. Thi mentor gave them a mall
loan (EK 20,000) when they opened their hop. Encouraged by their mentor, the
deigner decided to apply for bank financing: He told u we needed financing to grow.
The firm' perception of the meeting with the bank
The firm initially applied for and wa granted a bank overdraft of EK 50,000 and
a bank loan of EK 150,000. The deigner accepted the overdraft but decided to
potpone the bank loan becaue of perceived unfavourable interet rate. In thee
meeting, they alo voiced a problem they faced in their buine: they needed to find a
uitable upplier becaue the upplier they were currently uing wa too cotly.
In converation with the banker, the deigner emphaied how their artitically
driven core capabilitie were perceived by other actor and expreed the firm'
8/9/2019 Risks in Financial Decision Making Process
26/75
capabilitie in term of intangible: the deign and artitic edge. The banker were
informed of recent event and activitie uch a participation in magazine and TV
interview. The deigner alo mentioned that the firm wa one of three nominee for a
pretigiou fahion award. Thee tactic eemed to imply manifetation of firm identity
and an intention to emphaie ucce in the deign community.
Their intention had been to communicate their intangible artitic core capabilitie.
However, they believed thee artitic capabilitie were not acknowledged a key or
unique reource by the banker. One deigner commented that We mention[ed] our
appearance in magazine and the attention our deign ha achieved, but the banker are
more intereted in the figure. The deigner did decribe the banker a profeional
and a having good intention: We do think they want u to ucceed.
At a later tage, the deigner wanted to extend the bank overdraft and apply for a
larger bank loan. Financing wa needed to arrange the upcoming fahion how that would
launch their third and, o far, mot important collection. The how would take place
during Fahion Week in Augut, and in thi week the winner of the previouly mentioned
award would be announced. Becaue of an increaed demand from tore, they alo
wanted to build up a tock and, hence, place a large order with their upplier for which
they needed financing to make a required advance payment. The deigner alo wanted a
mall financial buffer. Thi application wa rejected; however, the initial bank loan
offer and bank overdraft remained.
8/9/2019 Risks in Financial Decision Making Process
27/75
The Bank' Perception Of Meeting With The Firm
The banker' perception of the firm wa that the deigner acted very
profeionally. They decribed the meeting a open and tranparent: The firm brought
their buine plan and budget and hared information, for example on their trategy and
profit margin.
The banker defined the core capabilitie and reource of the firm in different
term to thoe ued by the deigner. Their rhetoric invoked utilitarian economic
reource. One of the banker tated, The deigner how economic thinking, in term of
being careful with their carce reource. Thi i important when etablihing trut in a
firm. Beide being capable of running a buine they are kilful in PR and marketing.
Another banker explained, I do not know much about the firm' market but from the
bank' perpective it i the people behind the tart-up that are the mot important when
evaluating a company.
The banker emphaied that normally the bank would not grant an overdraft or a
loan to a buine like the firm becaue it had not yet generated a profit, it had not been in
buine long enough to how atifying ale figure, and it had no ecurity in term of
fixed aet. The reaon for not extending the bank overdraft and bank loan wa that the
banker were concerned about the uneven cah flow, and they cautioned that artitic
talent alone would not overcome economic iue: cah flow wa the mot important
factor, one of the banker tated. The deigner explained that large fluctuation in cah
flow are common in the fahion indutry. However, the banker decided that the exiting
line of credit and the ize of the bank loan would remain fixed. The bank had already
8/9/2019 Risks in Financial Decision Making Process
28/75
tretched the criteria for what would normally be accepted a ground for a poitive
finance deciion.
Financial Deciion Making Take A New Turn Enter The Invetor
hortly after the firm wa denied the extended bank overdraft and bank loan, the
firm won the award. Commenurate with the contradictory identity element of fahion
firm, the jury explained, The firm i appointed the newcomer of the year becaue they
have in a hort period of time managed to balance unique deign, high quality, and a
ditinguihed buine thinking. The award meant increaed interet from the pre, both
national and international. For example, the firm received a one-page reearch in the top
wedih buine newpaper, where it emphaied it need for financing and buine
expertie. In the reearch, one of the deigner commented that We are looking for a
partner with experience and finance that want to grow with u into a profitable
company. The award reulted in an increae in ale volume and an increaed number of
retailer. hortly after winning the award, the firm received two large order from two
department tore, but the problem of finding a uitable upplier remained.
After learning that the firm had won the award, an auction houe pecialiing in
high-quality jewellery, contacted the firm. The firm and the auction houe et up a
meeting to dicu poible form of cooperation. The deigner explained their buine
ituation and tated what they aw a their mot urgent problem: To obtain external
finance in order to invet in growth-promoting activitie, uch a participating in
international trade how and being able to make the advance payment to the upplier.
They alo needed to find a uitable upplier who wa le cotly but who could maintain
8/9/2019 Risks in Financial Decision Making Process
29/75
atifactory quality. The repreentative from the auction houe declared that hi firm
admired the firm' artitic qualitie; hence, he voiced what the firm had portrayed a their
core capability. However, he admitted that he wa not able to give the firm the name of a
pecific upplier right away. The auction houe' main objective wa to become a private
invetor in the firm; in exchange for a 30 per cent hare of the company, it wa willing to
give the firm EK 200,000 and help the firm in it operation and in expanding it
buine.
The Firm' Financial Deciion
The bank overdraft and the bank loan would have covered the expene and
invetment for which the firm needed external financing; however, the firm choe not to
accept the bank' offer. Intead, the firm accepted the invetor' offer and wa content
with the term of the agreement. The deigner decribed their deciion a motivated by a
perception of haring imilar value, uch a the appreciation of high-quality deign.
Furthermore, the deigner oberved that We are in the ame buine, which make it
eaier to undertand each other. The bank only eemed intereted in how much we ell
each day or month. Another rationale for the financial deciion wa that the auction
houe might be able to ait the firm in it operation and in finding olution to market-
oriented problem, uch a finding uitable upplier. One of the deigner explained that
Even though they could not recommend a upplier immediately, they would probably
know how to find a upplier becaue of their experience in the buine. Thu, alluding
to artitic identity attribute legitimized the private invetor in the mind of the deigner.
In contrat to the bank, the auction houe focued on the firm' deign capabilitie and
8/9/2019 Risks in Financial Decision Making Process
30/75
what the firm identified a it core capability it artitic talent. Another factor that had
influenced their financial deciion wa the notion of being diimilar to the bank: In
contrat [to the auction houe], we do not feel that we have much in common with the
banker. It hould be noted that the initial loan offer and bank overdraft would have
covered the expene for the how and advance upplier payment.
Theory Development Identity Field-Embedded Financial Deciion
In thi tudy, the rationale for preferring equity intead of bank financing i
explained by the notion of being cloer or more imilar to the invetor than to the
banker and the bank. In the bank marketing literature, it ha been found that perceived
imilaritie between cutomer and banker do play an important role in building an
initial relationhip and can contribute toward the etablihment of trut (Gill et al.,
2006). For the firm, the perception of cloene or imilarity i derived from the notion of
belonging to the ame field, of haring identity attribute and value. It can be
anticipated that when actor cluter around ocially contructed identitie, there i a
void between group of actor. Weber (1946) ued the term phere to ditinguih
different group of actor. Fahion deigner may be conidered member of what Weber
referred to a the aethetic phere, which i characteried by the importance put on
aethetic value. Weber wa one of the firt to write about the clahe between the
economic and aethetic phere. According to Weber, the firm conidered the bank to be
a member of the economic phere, which may explain the perceived ditance from the
banker. The invetor, on the other hand, could be conidered a a member of the ame
phere. Applying bank marketing terminology, the firm perceived the invetor to be
8/9/2019 Risks in Financial Decision Making Process
31/75
imilar, wherea the banker wa perceived a diimilar. The invetor wa perceived to be
embedded in the ame aethetic phere, wherea the banker were not.
Organiation tend to incorporate organiational form, tructure and practice
that are ocially legitimate that i, iomorphic or conitent with intitution operating
in that environment (Meyer and Rowan, 1977; DiMaggio and Powell, 1983). Kotova
(1996) invetigated the effect of a country' pecific intitutional environment on
organiational practice. Organiation operating in different countrie may experience
intitutional ditance a a conequence of the difference/imilarity between countrie'
intitutional environment. Hence, organiational practice reflect the intitutional
environment of the country where they have been developed and etablihed. Thi
intitutional ditance between countrie can be identified by a et of quantifiable
meaure. Applying the notion of intitutional ditance to the concept of identity field
may help identify a quantifiable meaure of the ditance between different field. Hence,
thi quantifiable meaure can verify that firm operating within the ame intitutional
environment or field form embedded tie more eaily than firm operating in different
intitutional environment.
The notion of haring the ame identity attribute eem to promote not only
actual but alo perceived component of embeddedne. In parallel to Glynn (2000), I
found that information proceing, field formation and perception of imilarity are
mutually reinforced through ocial interaction and the language of the profeion. The
fact that the firm and the invetor are in the ame indutry facilitated communication
between the partie becaue the ocial relationhip permeated information with meaning
beyond it face value. uch information i time-aving becaue educating potential
8/9/2019 Risks in Financial Decision Making Process
32/75
invetor take time, energy and money (tiglitz and Wei, 1981). Furthermore, thi
tudy indicated that the notion of belonging to the ame identity field conveyed the
perception that the invetor could provide the firm with valuable information. For
example, the deigner expreed an expectation that the invetor would be able to
ugget a upplier to uit the firm' pecific requirement. imilar identitie alo convey a
perception, on the part of the firm, that the invetor could conider the firm from a more
holitic perpective than the bank could. In addition to providing the firm with external
financing, the invetor could addre other problem. Thi notion could alo be expreed
a a higher degree of what eal (1998) refer to a competence trut in the invetor than
in the banker in relation to the ability to ait the firm in it buine development.
Previou reearch ha found that embedded tie develop primarily from third-
party referral and previou peronal relationhip (Uzzi, 1996). The evidence from thi
tudy ugget, however, that the perception of belonging to the ame identity field et
expectation of trut and tranfer of private information between the newly introduced
partie. Therefore, field identification facilitate the formation of embedded relationhip
between the ME and the invetor.
The finding made in thi tudy ugget that other factor in addition to purely
monetary one need to be conidered in the context of ME' financial deciion making.
The notion that cutomer of financial bank ervice make their choice of ervice upplier
baed on factor other than price ha alo been recognied in the bank marketing
literature (e.g. Molina et al., 2007).
8/9/2019 Risks in Financial Decision Making Process
33/75
Chapter Three: Reearch Methodology
Thi reearch aim
How much external and Internal fund impact on Corporate financial deciion
and how?
How corporate capital tructure effect the financial deciion making?
Ha tax effect in corporate financial deciion? If ye how and how much?
To find out the financial deciion making proce of a company and the baic
idea on which that deciion i baed.
To identify how effect the proce of financial deciion making proce and how
much the effect will be?
To find out how different type of invetment effect the financial deciion making
proce and how much the effect will be?
To reearch how can we reduce the rik of deciion making in the indutry uing
corporate financial deciion, how a company hould make it deciion and which
apect a company hould be concerned about while making an invetment
deciion?
Methodology
The tudy wa conducted a longitudinal, ingle embedded cae tudy (Yin,
2003). The puret form of a longitudinal field tudy, daily participant obervation, wa
not feaible. I could viit the reearch ite only once or ometime twice a week.
Therefore, ome data were obtained through retropective report gathered hortly after
event occurred. However, a longitudinal tudy involving a erie of multiple interview
8/9/2019 Risks in Financial Decision Making Process
34/75
about recent event offered the obviou benefit of proxy in time to current event,
thereby increaing the likelihood that I could determine the equence and nature of event
accurately. Wherea multiple retropective tudie increae the external validity of a
reearch deign, a longitudinal, real-time tudy can increae internal validity by enabling
the reearcher to track caue and effect (Leonard-Barton, 1990). A cae tudy
methodology i a preferred method when how or why quetion are being poed,
when the invetigator ha little control over event, and when the focu i on a
contemporary phenomenon within ome real-life context. The rationale for conducting a
ingle cae tudy wa that the firm contituted a cae of deviation from the pecking order
(Yin, 2003). According to iggelkow (2007), it i often deirable to chooe a particular
organiation preciely becaue it allow one to gain certain inight that other
organiation would not be able to provide. Although individual cae cannot prove a
theory, they can ufficiently point to poible omiion in the theory.
Time et a frame of reference for what change are een and how thoe change
are explained. The reearcher' theoretical framework ugget jutification for the
beginning and ending of data collection (Pettigrew, 1990). The framework may focu on
major ocial drama or breakpoint in a firm' hitory, which indicate the beginning of
period of continuity and change (Pettigrew, 1985). The time frame of thi tudy covered
the critical period beginning when the firm recognied the need for external finance and
continuing through the deciion-making proce.
8/9/2019 Risks in Financial Decision Making Process
35/75
Data Collection
For a period of 13 month, during which I followed the firm in their financial
deciion-making proce, I gathered data addreing archival ource through both emi-
tructured and untructured method. Public information about the firm wa reviewed,
including pre account and material generated by the firm (e.g. promotional material).
emi-tructured Data Collection
emi-tructured data collection included a number of emi-tructured interview
eion with the deigner and their banker. I conducted even emi-tructured
interview with the two deigner and two eparate interview with their two banker.
Interview averaged from one to two hour in duration, were tape-recorded and
trancribed within 24 hour with my own reflection added. Data collection from
interview with the deigner provided a equence of event for the hitory of the firm,
inight into how they had reaoned during pat deciion concerning the financing of the
buine and how they reaoned during the time period when I tudied the firm, a well a
inight into future goal and viion of the buine. The objective of thee interview
wa to undertand why certain deciion and choice were made and how thee deciion
were related to the deigner' decription of their buine, miion, and objective. The
interview conducted with the banker were intended to provide inight into how the
banker perceived the deigner and their buine, and how thi influenced their deciion
to offer financing to the firm.
8/9/2019 Risks in Financial Decision Making Process
36/75
Untructured Data Collection
Untructured data collection included note taken a part of obervation at the
firm during it daily operation, including meeting with partner, economic conultant,
and their mentor. Obervation at the firm normally lated from one to three hour. The
objective of thee obervation wa to gain an undertanding of the identity of the firm
and how thi influenced deciion about and relation with the bank. Obervation were
alo made during meeting between the firm and the bank. Thee obervation allowed an
encompaing view of the dynamic of buine-financier relationhip and aimed to
capture the interplay between the firm and the bank. The obervation of meeting
between the bank and the firm were tape-recorded, trancribed and complemented by my
own reflection. After the firm' meeting with the bank, I conducted interview with the
deigner to invetigate their reaoning and perception of the meeting. A compilation of
the interview and obervation are preented in Table I.
There are two main approache to data collection: quantitative and qualitative and
each comprie of advantage and diadvantage. One of the main advantage of
quantitative approach to data collection i the relative eae and peed with which the
reearch collection can be accomplihed. However the ytematic and analytical
influence which can be gained from tatitical analyi mut be et againt the iue of
ample repreentativene, error in meaurement and quantification (Collin and Huey
162:2005)
Qualitative data collection method provide a more real bai for analyi and
interpretation. It can be extenive and time conuming. Moreover qualitative approach
preent problem relating to inflexibility and ubjectivity.
8/9/2019 Risks in Financial Decision Making Process
37/75
Company webite, financial market webite uch Bloomberg, financial time,
company report would be ome of my major ource of data.
Interview are the bet method to interact with the conumer. It i the mot appropriate
method when a topic i confidential and enitive and it i the bet and appropriate
method to pick conumer brain (Hoyer 2004:27).
In thi reearch reearcher will record interview o that afterward it will be eay
to examine the reult for quantitative and qualitative analyi. The reearcher planned to
conduct 10-12 in-depth interview containing both one-to-one and
Likewie, interview involve direct contact with conumer. Interview are
generally conidered to be more appropriated than focu group when the topic i
enitive, embarraing, confidential, or emotionally charged. They are more appropriate
when the reearcher want to pick conumer brain (Hoyer 2004:27). Reearcher
often record interview for alter trancription o they can examine the reult uing
qualitative or quantitative analyi (ibid.). In thi project, the reearcher plan to carry 5-
10 in-depth interview. Thi will be done on telephone interview and one-to-one
interview through which reearcher can get more information about the topic.
The data collected will be preented in table, chart by uing P (tatitical
Package for ocial cience). The reearcher decide to ue thi ytem becaue P i a
comprehenive ytem for analyzing data. It can take data from almot any type of file
and ue them to generate tabulated report, chart, and plot of ditribution and trend,
decriptive tatitic, and complex tatitical analyi (www.p.com 2007). The
reearcher hope to gain a clear, detailed undertanding of the cutomer involved in
reponding to the interview, what they think about making financial deciion and how
8/9/2019 Risks in Financial Decision Making Process
38/75
much tax and invetment made an impact on their buine and what point they
conider before making the deciion. In addition, the reearcher hope to provide valid,
reliable, and applicable information for related or intereted future to make the right
deciion at the right time doing the right thing at right place whether to make that
invetment deciion on the bai of certain point or after inveting what will be the tax
ratio and how much etimated profit he can achieve with appropriate channel.
With regard to the third phae which concern the diviion of theory teting and
theory forming. Thi reearch would fall into a deductive approach norm, that i, a theory
teting reearch. The reearcher i going to rely on econdary information and literature
earch, undertand the baic conumer behaviour theory and eential model ued in
interpreting conumer proce of purchae, ue and dipoing product and ervice,
deign quetionnaire under the reearch philoophy guideline, carry a few in-depth
interview if poible, analyze the data, and finally deductively and qualitatively tet the
ene of the deciion bai on particular point.
8/9/2019 Risks in Financial Decision Making Process
39/75
Chapter Four: Analyi and Dicuion
Dicuion
According to financial economic, debt convey le tranaction cot than equity.
Firt, the lender require a lower rate of return than ordinary hareholder becaue debt
financial ecuritie preent a lower rik than hare for the finance provider becaue they
have prior claim on annual income and in liquidation. In addition, ecurity i often
provided. econd, the tranaction cot aociated with raiing and ervicing debt i
generally le than for ordinary hare. For ME, the rationale for preferring debt to
equity i primarily motivated by a notion of loing control of the firm (e.g. ogorb-Mira,
2005). Applying the cot of capital a a rationale for preferring one certain ource of
financing to another, firm generally prefer retained earning to debt finance. However,
reearch ha indicated that thi order of preference can be reviited a a conequence of a
trong embedded bank-firm tie that convey debt financing at lower price than in the
abence of embedded bank-firm relationhip, thu making the firm more prone to debt
financing (Uzzi and Gillepie, 1998). A evidenced in thi tudy, factor other than the
cot of capital or lo of control may affect the firm' financial deciion making and
influence the ME toward equity rather than debt financing. The perceived imilarity of
identity field wa an important prerequiite for the etablihment of embedded
relationhip between the ME and the financier, which in turn affected the firm'
financial deciion making.
Why did the firm in thi reearch prefer equity financing to debt financing? Did
the bank fail in it marketing effort in thi cae? Relationhip marketing ha become a
prominent theory in reearch focuing on the marketing of financial ervice to both retail
8/9/2019 Risks in Financial Decision Making Process
40/75
and buine market (e.g. Ennew and Bink, 1996). The analyi put forth in the preent
paper ugget that the perception of belonging to the ame identity field a the invetor
induced an embedded relationhip and et expectation of trut and fine-grained
information tranfer, which made the invetor a more adequate financier than the bank.
The framework preented in thi paper offer an alternative and complementary
explanation for the ME' financing tructure. In parallel to the embedded finance
literature, I offer an alternative explanation to financial theory, uggeting that the quality
of the relationhip between an organiation and the upplier of capital affect the pecking
order of ME. The framework offer a complement to the embedded finance literature
by propoing a way of thinking about the context in which embedded relationhip
between ME and upplier of equity are formed. It alo offer inight into the bank
marketing perpective, in term of what factor may influence the bank-firm relationhip.
In thi tudy, I have focued on the demand ide of finance. Addreing the upply
ide of capital to ME, variou tudie have hown that the availability and cot of
financing, epecially long-term invetment capital, are ome of the mot important
contraint on the formation and development of ME (e.g. Bink et al., 1992). A
confirmed in thi tudy, bank uually conider firm without fixed aet and atifying
cah flow to be too riky. Therefore, buine angel or private invetor are often the
only ource of early tage capital for buinee that have exhauted peronal and family
ource. Normally, the firm would not be in a poition to make a financial deciion baed
on it own preference. The cae preented in thi reearch i unique, however, in the way
the firm had the opportunity to chooe which upplier of finance to employ.
8/9/2019 Risks in Financial Decision Making Process
41/75
In addition to the rik of loing property or control of the firm, one argument for
preferring private invetor to bank financing could be to avoid the requirement to pay
interet to the bank regardle of the cah flow of the buine. Another argument in
favour of a private invetor could be acce to the private invetor' buine network and
entrepreneurial experience. Paul et al. (2007) found that for tart-up firm, rather than
equity being viewed a expenive, it i viewed a good value becaue a well-choen
invetor can add buine kill and ocial capital in the form of commercial contact and
acce to relevant network. In the cae preented in thi reearch, however, the firm wa
promied neither private information nor network connection. The deigner' rationale
wa explained by expectation of fine-grained, holitic, private information tranfer. uch
expectation may be explained by the fact that the owner of mall firm often control all
firm activitie, and therefore do not eparate problem poed to their buine. There are
numerou tudie on how firm earch for olution to problem (e.g. Cyert and March,
1963; DiMaggio and Powell, 1983). The framework uggeted in thi reearch indicate
that the proce of earching for olution to financing problem may affect, and be
affected by, the earch for non-financing information, uch a finding uitable upplier.
The goal of thi tudy wa to outline a new framework for explaining the financial
deciion-making proce of ME and to ue an in-depth cae analyi a an illutration.
Clearly, more empirical work need to be done to dicover how embeddedne affect the
financial deciion-making proce of ME. For example, the correlation between
financial and non-financial benefit, uch a cultural capital generated by embeddedne
in an identity field, need further invetigation.
8/9/2019 Risks in Financial Decision Making Process
42/75
Analytical Tool
Depending on the type of invetment that i owned or under conideration by an
invetor, variou tool may be ued to meaure and evaluate the return or value of that
8/9/2019 Risks in Financial Decision Making Process
43/75
invetment.
8/9/2019 Risks in Financial Decision Making Process
44/75
Net preent value (NPV) i a method ued in evaluating and ranking invetment,
whereby the net preent value of all cah outflow (uch a the cot of the invetment)
and cah inflow (uch a the invetment' return) are calculated uing a given dicount or
hurdle rate. An invetment i conidered acceptable if the NPV i poitive. NPV i ued
to rank different invetment option, from the highet NPV to the lowet NPV. An
invetment i rejected if the NPV i negative ince thi indicate that the invetment doe
not improve the invetor' current net worth.
Internal rate of return (IRR) i the dicount or hurdle rate at which the preent
value (PV) of all of the future cah flow of an invetment exactly equal the total cot of
the invetment. The IRR i a pecial cae of the net preent value calculation becaue the
IRR i the rate of return at which the NPV of an invetment equal zero. An invetor
hould compute both the NPV and the IRR for each potential invetment in order to
8/9/2019 Risks in Financial Decision Making Process
45/75
verify, or in order to provide additional inight into, the merit of a particular invetment
choice. Without the ue of a computer or financial calculator the calculation of the IRR i
done by a proce known a iteration, which can be extremely time-conuming and
frutrating.
IRR rank variou invetment differently than NPV if:
1) Two project have different initial invetment, and when
2) The timing of the cah flow from the invetment i different.
Capitalization (Cap) rate can be referred to a the capitalization rate of an aet.
The Cap rate i the interet rate ued to convert a erie of future payment into a ingle
preent value (PV) and i mot commonly ued in valuing real etate.
Payback period i the length of time required to recover an initial invetment. The
payback period i calculated a the original invetment divided by annual cah flow. It
can alo be referred to a a cah recovery period.
Dividend dicount model (DDM) i a valuation technique ued for etimating the
intrinic value of a tock. DDM model calculate the dicounted preent value of all
future dividend or future earning. DDM decribe the relationhip between a tock'
current price and the preent value of all future dividend payment or earning. Thi
model can be ued to determine the value of a common tock.
The Gordon growth model (alo known a the contant growth DDM)
where
P0 = current market tock price
8/9/2019 Risks in Financial Decision Making Process
46/75
D0 = current dividend jut paid
D1 = dividend paid 1 year from now
k = required rate of return on a tock invetment
g = long term utainable growth rate of the tock
Return on equity (ROE) i the after-tax profit earned by a company compared to
the total cot of it equity hare. Return on aet (ROA) i the after-tax profit compared
to the firm total tangible aet.
Return on invetment (ROI) or return on inveted capital can be defined a the
after-tax profit earned by a corporation compared to the firm total inveted capital. Total
inveted capital include common and preferred equity plu all funded debt.
Keeping core: Type Of Return
Invetment return are the reward for inveting. Return include both realized
current income (interet, dividend, rent, realized capital gain or loe) and any
unrealized capital appreciation or depreciation.
Type of return include:
Nominal return. The named or tated rate of return.
Real return. Adjut the nominal return for the effect of inflation, and it i
etimated a the rate of return minu the rate of inflation equal real rate of return.
Effective annual rate (EAR). The effective annual rate adjut the nominal interet
rate for the effect of compounding, when interet i compounded more often than
annually.
Rik-free return i the return on a rik-free aet that i earned with perfect
certainty. Thi hypothetical return i uually proxied by federal government
8/9/2019 Risks in Financial Decision Making Process
47/75
ecuritie that have the ame term to maturity a the invetor' time horizon. For
example, an invetor with a five-year time horizon would chooe a five-year
government of Canada bond a the rik-free benchmark.
After-tax real rate of return. Adjut the nominal rate of return for the effect of
inflation and income taxe and it i etimated a the nominal return le income
taxe and the effect of inflation.
Holding period return (HPR). The difference in value of an aet (current income
plu or minu capital change) that occur from the time that the aet i acquired
until ome future ubequent time, uually when the aet i dipoed of.
Realized v. non-realized gain/loe. A realized gain on an aet i one that i
actually taken and the invetor ha cah in hand. An example of a realized gain i
when a rental property purchaed for 200,000 i old for 250,000, thu realizing
a 50,000 gain. An unrealized gain on the other hand, i merely a paper profit and
might be lot if the aet' value decline. No fund are exchanged and no ale i
completed in the cae of an unrealized gain.
What i value?
Value ha a number of meaning and will be defined and ued differently by
variou financial advior. Value can be tated a the book value. Book value i an
accounting term, which employ hitoric cot a oppoed to the current cot of an aet.
Book value i typically the value hown on the balance heet of a company.
Current fair market value (FMV) i the oberved value of an aet a it trade in the
marketplace or the appraied value.
8/9/2019 Risks in Financial Decision Making Process
48/75
Liquidation value i the value that an aet would bring if it were to be old.
Intrinic value i the preent value of all future cah flow.
Although there are many type of value definition, in general, the value of an
aet i determined by three factor:
1. The amount and timing of expected future cah inflow,
2. The rikine of thee future cah flow, and
3. The invetor' required rate of return.
Quetion.
1) How can a capitalization rate (Cap rate) be ued by an invetor?
The capitalization (Cap rate) rate i typically ued when evaluating and analyzing
real etate invetment. The Cap rate i calculated by dividing net operating income
(NOI) by the property' current fair market value (FMV). Alternatively, thi formula can
alo be rearranged algebraically, and can be ued to calculate the maximum amount that
an invetor would be prepared to pay for a piece of real etate, when the Cap rate i
known.
2) Why hould an invetor ue mathematical tool when inveting?
Many individual are frightened by the thought of having to perform
mathematical calculation no doubt dredging up ditateful memorie of high chool
algebra clae. However, with the ue of technology in the form of hand-held calculator
and computer program, thi anxiety and tre i unneceary. We have included everal
8/9/2019 Risks in Financial Decision Making Process
49/75
Webite in thi book that we have found particularly ueful in aiding tudent and
invetor to overcome the dread of mathematic.
The mathematical tool are important to an invetor in everal repect. The ue of
mathematic i neceary and helpful when an invetor i etting goal and determining
the realim of thee objective. Mathematic i ued to determine the amount that i
required to be aved on a regular bai in order for an invetor to achieve the type of
retirement deired. The knowledge of mathematic alo allow the invetor to formulate
"what if" cenario. For example, the invetor may wih to know how long their
retirement net egg will lat, given a certain level of conumption in retirement, or the
interet rate that i required to achieve their retirement objective. The invetor may wih
to invetigate the effect of different interet rate on their required aving or on their
level of conumption during retirement. Employing modern portfolio theory, ince rik
and reward are related, it tand to reaon that if an invetor require an interet rate of
20%, to reach their retirement goal, then an invetor will obviouly have to conider
their rik tolerance in their choice of invetment compared with an individual who
require a 5% return in order to achieve the ame level of conumption during retirement.
Many companie provide invetor with excellent mathematical tool. However, the
invetor mut bear in mind that thee companie are not altruitic and that they have other
motive, which may not be preciely identical to objective of the invetor. If the invetor
i unaware of the method ued in a computation, then the invetor mut rely on the
aumption and method of the other party. Baic mathematic kill allow the invetor
to make their own deciion and ue their own aumption in order to arrive at
individual anwer to their own quetion. No one ha a greater take in an individual'
8/9/2019 Risks in Financial Decision Making Process
50/75
retirement plan than the individual himelf or herelf. In other word, the bet defene i a
good offene!
3) A term depoit pay 5% interet. What i the nominal rate?
The nominal rate i a named or tated rate. In thi cae, the nominal rate i 5%.
4) If a cutomer it i charged 2.75% interet rate, compounded monthly, on a department
tore credit card, how much i the annual interet rate?
An individual who doe not undertand the time value of money would imply
calculate that the annual interet rate i 12 (0.0275) which equal 33%. Thi i known
a the annual percentage rate (APR), and although it i commonly ued, it doe not take
compounding into account. In order to calculate the annual interet rate that i actually
charged the invetor mut ue the effective annual rate (EAR), which account for both
the frequency of compounding and the nominal rate. The effective annual rate i
calculated a: EAR = =
which equal 38.48% annually, a ignificant difference!
The following quetion can be anwered uing a financial calculator.
where the neceary keytroke on the calculator are a follow:
n = number of compounding period
i = interet rate per compounding period
pmt = periodic payment
PV = preent value
8/9/2019 Risks in Financial Decision Making Process
51/75
FV = future value
NPV = net preent value
CFo, CFi,CF2,CF3 = cah flow function key
IRR = internal rate of return
5) An invetor i putting 2,000 per year into a mutual fund that average a return of
9% per year. How many year will thee payment have to be made before the fund will
be worth 100,000 (rounded to the nearet whole number of year)?
i = 9%, pmt = (2,000), FV = 100,000 Compute n.
n = 20 year (rounded up to the nearet whole number)
6) The common tock of XYZ i currently elling in the market for 36.67. XYZ ha jut
paid it annual dividend 2.00, and the dividend i expected to grow at 10% per year
indefinitely. What rate of return can an invetor expect to earn on thi invetment in XYZ
tock?
Thi quetion can be anwered by algebraically manipulating the formula for the contant
growth dividend dicount model, and olving for k.
Therefore, an invetor in the tock of XYZ can expect to earn a 16% rate of return.
8/9/2019 Risks in Financial Decision Making Process
52/75
7) An inurance aleperon offer an annuity contract that will pay 100,000 after 20
year if the annuitant pay 2,000 per year with the firt payment due immediately. What
rate of return i being offered?
Note: thi quetion require the ue of an annuity due in the calculation! Be ure to witch
calculator to Begin mode.
n = 20 year, pmt = (2,000) per year, FV = 100,000, Compute i.
i = 8.10%
8) Find the Net Preent Value (NPV) of the following cah flow chedule uing a 10%
dicount rate:
Year Ca h Flow
0 (3,000)
1 (5,000)
2 2,000
3 4,000
4 6,000
5 (1,000)
Thi quetion ue the net preent value function of the financial calculator.
CFo = (3,000), CFi = (5,000), CF2 = 2,000, CF3 = 4,000, CF4 = 6,000, CF5 =
(1,000),
i = 10%, Compute NPV.
NPV = 589.86
8/9/2019 Risks in Financial Decision Making Process
53/75
9) Calculate the internal rate of return (IRR) of a 10,000 invetment that i expected to
produce the following cah flow:
Year Cah Flow
2 7,000
3 6,000
4 3,000
Thi quetion ue the internal rate of return (IRR) function of the financial calculator.
CFo = (10,000), CFi = 0, CF2 = 7,000, CF3 = 6,000, CF4 = 3,000, Compute IRR.
IRR = 19.00%
NOTE! Be ure that the firt cah flow (CFi) i entered a a 0 value.
10) The earning of the ABC Company are currently 2.00 per hare. If the earning
per hare grow over the next five year at an annual growth rate of 10%, how much
will they be at the end of that time?
n = 5 year, i = 10%, PV = 2.00, Compute FV.
FV = 3.22
11) A tock i expected to pay an annual dividend of 0, 2, and 4 per hare at the end
of each of the next three year, repectively. At the end of the third year, the tock i
expected to ell for 80 per hare. If the tock i currently elling at 50 per hare, what
i the expected return on a three-year invetment in thi tock?
Thi quetion can be olved uing the internal rate of return function of the financial
calculator.
8/9/2019 Risks in Financial Decision Making Process
54/75
CFo = (50), CFi = 0, CF2 = 2, CF3 = 4+80=84, Compute IRR.
IRR = 20.00%
NOTE. The third cah flow include the 4 dividend plu the 80 ale price of the tock.
The firt cah flow of zero dollar at the end of the firt-year mut be entered into the
calculator.
Key Term
Annual percentage rate (APR). An annualized interet rate that ignore the
effect of compounding. It i calculated by multiplying the periodic interet rate by the
number of period in a year. Bond yield are typically calculated by thi method.
Book value per common hare. Auming no preferred hare outtanding, the
book value per common hare i calculated a the total aet minu total liabilitie
divided by the average number of common hare outtanding.
Capital cot allowance (CCA). The amount an owner of an income producing
aet i allowed to deduct for income tax purpoe a a reult of owning a depreciable
aet. CCA i a tax hield that allow an invetor to deduct the cot of depreciating capital
aet from income. Under the Income Tax Act, Canada Cutom and Revenue Agency
(CCRA) regard thi a a neceary expene for producing income. Invetor calculate
CCA o that it allow a recovery over time, of the original amount inveted. Generally,
invetor may claim only 50% of the allowable CCA expene in the year of acquiition.
Capitalization or capital tructure. Total dollar amount of all permanent
ource of financing. Calculated a the total of all negotiated debt, preferred and common
tock, contributed urplu and retained earning of the company.
8/9/2019 Risks in Financial Decision Making Process
55/75
Capitalization method. A method of appraiing real etate. Calculated a net
operating income (NOI) divided by the property' current fair market value (FMV).
Cah flow. One meaure of a company' financial tatu. Cah flow can be
calculated directly or indirectly. One technique of recontructing a cah flow tatement
calculate cah flow a net income for a period plu any non-cah deduction, uch a
depreciation, amortization, depletion, deferred income taxe, and minority interet.
Depreciation. Depreciation i an accounting expene that allow for the
deduction of the initial cot of an aet over ubequent period. The amount by which
the value of improvement ha decreaed over time, becaue of wear and tear. The
periodic cot of owning depreciable aet (uch a building and equipment) that are
ubject to deterioration. No depreciation expene can be taken on land.
Dilution. The reduction of earning per common hare auming all convertible
ecuritie are converted to common hare.
Fair market value (FMV). The current market price at which an aet pae
from a willing eller to an intereted buyer.
Fixed aet. A balance heet item. Tangible, long-term aet that are held for ue
by the buine and ued to earn revenue. Example are real etate or equipment.
Effective annual interet rate (EAR). The interet rate a if it were compounded
only once per year. The periodic interet rate time the number of compound period in
the year equal the effective annual rate (EAR). The EAR i the actual interet rate
earned/paid after adjuting the nominal or tated interet rate for the frequency of
compounding employed.
8/9/2019 Risks in Financial Decision Making Process
56/75
Effective interet rate. The periodic interet rate conidering both the frequency
of compounding and the nominal rate of interet.
Equity or hareholder' Equity or tockholder Equity. The reidual
ownerhip interet of common and preferred hareholder. It i calculated uing total
aet minu total liabilitie of a company. Alo referred to a net worth.
Income method or invetment method. An appraial method typically ued for
valuing rental real etate. Thi valuation tool convert the net income tream produced by
the property into a market value by uing a capitalization rate.
Inflation riki the likelihood that the real return of the fixed-income invetment
will be le than the nominal (dollar) return. Inflation rik i referred to a the rik of
unanticipated increae in future inflation.
Intangible aet. An aet with no phyical form, e.g., goodwill.
Intrinic value. The real and true value of a ecurity. Thi value can be different
from the market price, and it can be different from the accounting book value.
Iteration. A mathematical proce in which a erie of operation i repeated until
an anwer i derived. It i a method of approximating and deriving an anwer by
repeatedly re-computing until a olution i arrived at.
Leverage. The ue of debt to finance the purchae and ownerhip of invetment.
The ue of debt magnifie the potential variation of yield on the equity portion of the
invetment.
Net operating income (NOI). Gro revenue minu vacancy allowance, bad debt
allowance, and total operating expene. NOI i calculated excluding income tax,
mortgage payment, and depreciation expene.
8/9/2019 Risks in Financial Decision Making Process
57/75
Opportunity cot. The earning potential of an invetment that i paed up in
favor of current conumption or by chooing an alternate invetment.
Phyical depreciation. The lo in value of a depreciable aet due to wear and
tear.
Preferred tock. The nonvoting cla of hare capital that i entitled to a dividend
payment before the company pay dividend to the common hareholder. Preferred tock
alo ha preference over the common hareholder with repect to claim on the
company' aet in the cae of liquidation.
traight-line depreciation method. One of the allowable method ued to
calculate depreciation expene for accounting purpoe. The annual depreciation expene
i calculated a purchae price minu expected alvage value divided by the economic
lifetime.
Real interet rate. The nominal rate of interet minu the inflation rate, where the
inflation rate i defined a t