Understanding the Concepts Essay Example | Topics and Well Written Essays - 1000 words

Understanding the Concepts - Essay Example Concept of NPV/Payback Rule: The concept of NPV or Net Present Value of a particular investment represents the difference in its market value and its actual cost. The value of NPV is determined by estimating the present value of those cash flows that shall take place in the future. The cost is then deducted from the resultant to obtain the value of the NPV. According to the payback rule, a particular cutoff is selected and if the payback period is less than that cutoff, the project proves to be good to undertake. A payback period represents the time period when the cost of the project becomes equal to the total sum of the investments made on the project (Ross, Westerfield & Jordan, 2008, p.290). Thus, these two concepts can be utilized in the business in order to determine whether the investments made on the project and the costs being incurred are on a right track to provide the owner with sufficient returns. Advantages and Disadvantages of Debt Financing and Issue of Stocks over Bonds: The first advantage of debt financing is that a business only requires repayment of the borrowed amount but it is the owners who are accrued for any rise in the firm’s value. Secondly, debt is less costly in comparison to equity and carries lesser amounts of risk. Thirdly, the availability of debt financing is more frequent and easy than equity financing. The disadvantages of debt financing lie with the fact that debts have to be cleared even if the firm has undergone any losses in its finances. Secondly, in debt financing the assets of a firm are required to be used a guarantee that limits the further borrowing of the firm. Thirdly, several restrictions might be presented by the lenders in the process of debt financing. Lastly, personal guarantee might also be required in some cases (Seidman, 2005, pp.32-33). An organization would choose to issue stocks than bonds since firstly a stock represents the share of the owners of the firm, while a bond is a debt instrument. Secondly, a stock does not have a maturity period unlike bonds that have a fixed maturity period. Thirdly, dividends are gained over stocks while bonds borne fixed rates of interests (Brown, 2011). Risk-Returns Relationship: Financial risks are considered to be any such uncertainty that might affect the positive outcomes of a firm. Such risks might be associated with the market which is external to a firm. On the other hand, internal problems might also give rise to risks. The primary relationship between financial returns and risk arise based on the fact that investors always prefer higher returns and lesser risks. Thus it can be understood in this context that if financial risks are higher in case of an investment, the investor would have expectations for higher returns. This reflects on a trade-off that exists between the risks and the returns. Such a trade-off enables determination of the added amount of ret urn that an investor would receive if he considers a higher level of risk in his investment measure (Brigham & Houston, 2012, p.258). Thus depending on the level of risks that an investor can consider in his investment, the financial returns vary and this throws light on the relationship that exists between financial returns and risks. Beta and its Use: The concept of beta has been used for the measurement of systematic