Page 483 - Introduction to Business

CHAPTER 13 Financial Management of the Firm and Investment Management 457

the local community who will purchase equity in the small business in exchange for
not only voting power but direct control of its day-to-day operations. Normally, the
original owner can buy out the venture capitalists within the next five years or so
and regain control of the firm. Venture capitalists many times were successful small
business people and offer expertise that is valuable in getting the new product off
the ground and making it a profitable capital budgeting project. Local banks and
organizations are good places to get references to local venture capitalists, other-
wise known as angels.

Financing Mix. Which forms of finance should a firm use to pay for acceptable
investment projects? Most experts would agree that there is a “pecking order” in
terms of the financing used.
• First, and most important, is retained earnings. Most new projects to purchase
assets are financed from the profits on previous projects. In effect, shareholders
are reinvesting their earnings in the firm in the hopes that new projects will
increase the price of common stock. If the price of the common stock rises,
shareholders can earn a capital gain as the market price of stock exceeds the
initial purchase price.

• Second, debt is used to finance assets. Due to interest tax deductions, it is
cheaper than issuing new equity. Also, the many forms of debt finance enable
firms to acquire large amounts of funds to meet their needs in paying for capi-
tal budgeting projects.
• Third, and last, common stock is used by firms. Because of its higher cost and
voting implications, shareholders prefer to use retained earnings, rather than
new stock issues, to provide equity financing. However, if the firm has many
acceptable investment projects, it may be necessary to issue common stock to
raise additional funds.
Firms generally seek some optimal mix of retained earnings, debt, and common
stock. The optimal financing mix is where total financing costs are at a minimum.
By lowering total financing costs, the firm can increase its profitability and, there-
fore, the value of its common stock.

Managing Cash Within the Firm

Another important function of financial managers is cash management. Cash
management encompasses not only the cash held by the firm but also the assets
that are readily convertible to cash or require cash payment in the near future.
Total cash receipts minus total cash payments at any point in time is net cash flow. net cash flow Total cash receipts minus
Corporate treasurers seek to maintain sufficient net cash flow to pay for unex- total cash payments at any point in time
pected bills. Excessive cash flow over this amount is wasteful because the extra
funds could be invested in productive assets. Thus, there is an opportunity cost of
excess or idle cash.
Net working capital is equal to total current assets minus total current liabili- net working capital Total current assets
ties. These accounts represent short-term uses and sources of cash. Current assets minus total current liabilities
include cash, short-term securities, inventory, and accounts receivables, that is,
products and services sold previously under trade credit terms that allow customers
to pay within 30 to 90 days. Like cash, managers do not want to have excessive lev-
els of inventory and accounts receivables. However, some amount of these current
assets is needed to fill customer orders and attract new orders for products and
services. Short-term securities can be readily converted into cash and are a good

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