Financial Environment Overview and Approaches

Financial Environment Overview

• The financial environment significantly impacts organizational operations through economic conditions and financial market behaviors.
• Key influences include the economic environment and the dynamics of financial markets.

Finance Approaches

• Intermediation: Involves financing arranged through financial institutions.
• Disintermediation: Companies engage directly with investors via money markets or stock exchanges for financing.

Economic Influences

• Inflation:
  • Occurs when demand surpasses supply, causing price increases.
  • Reduces the real value of money and leads to higher wage demands, influencing financial decisions.
• Interest Rate Changes:
  • Governments adjust interest rates to manage inflation.
  • Fluctuating rates affect the cost of corporate debt and equity, introducing financial risks.
• Foreign Exchange Rates:
  • Variability in exchange rates affects the costs of imports and exports.
  • Companies can manage these risks using derivatives such as swaps and options.

Financial Markets

• Capital Markets: Facilitate sourcing of long-term capital.
• Money Markets: Address short-term financing needs, typically under 13 months. Key instruments include:
  • Certificates of deposit
  • Commercial paper
  • Treasury bills
• Understanding market reactions to corporate policies, such as dividends and capital structure, is crucial for maintaining investor confidence.

Efficient Markets and Theories

• Efficient Market Hypothesis:
  • Asserts that share prices reflect all available information, providing an accurate valuation of companies.
  • Market participants effectively interpret information, leading to fair pricing.

Asset Mix

• Types of Assets:
  • Non-current Assets: Investments held long-term.
  • Current Assets: Short-term investments; some may be permanent.
• Optimal Asset Mix: A balance is sought between carrying costs (opportunity costs) and shortage costs.
  • Policies:
    • Neutral: Aims to minimize total holding costs.
    • Conservative: Maintains high levels of current assets to reduce shortage costs.
    • Aggressive: Reduces current asset holdings to enhance operational efficiency.

Finance Mix Choices

• Matching Approach: Aligns investment maturities with financing terms.
• Conservative Approach: Utilizes long-term finance for peak financial requirements.
• Aggressive Approach: Prioritizes short-term finance while minimizing long-term commitments.

Optimal Mix of Finance

• Considerations include the costs associated with short-, medium-, and long-term financing.
• The overall goal is to minimize costs while maximizing wealth for equity holders.

Influences on Finance Term Choice

• Important factors affecting finance choices include:
  • Set-up costs
  • Interest expenses
  • Type of financing
  • Company size
  • Available security
  • Gearing
  • Risk profile
  • Credit reputation

Summary of Key Points

• Understanding the interrelationship of the financial environment, economic variables, and financial markets is essential for business finance managers.
• Asset and finance mix strategies are influenced by industry standards, the nature of products, seasonal factors, economic conditions, and managerial perspectives.