Capital budgeting is an intricate process that a company follows to make the most out of it. The capital budgeting process needs enough decisions making which must be correct and closely followed. Capital budgeting has the power to either make a company hugely profitable or destroy the business entirely. That is why it is a very important process a business must master to obtain steady growth and profit from it.There are some fund-related and strategic issues in capital budgeting. Depending on the specific needs, the three levels of capital budgeting can be broadly classified into the following −Operating Capital BudgetingStrategic ... Read More

The pecking order theory is an explanation of a firm’s debt-to-equity financing portfolio. It helps investors to understand how a company sources its financing. In other words, the pecking order theory shows the optimal debt and equity structure of a firm’s financing model.Pecking order theory is essentially an idea that helps the managers of a company to decide how to finance the company.It is based on a hierarchy where the managers first use retained earnings (internal financing), then debt financing, and then equity financing.Internal FinancingUsually, the managers of a firm tend to use internal financing as the first choice because ... Read More

The FRICT approach is a very important way of measuring the results of the financial structure of a firm. It consists of the following factors −FlexibilityRiskIncomeControlTimingLet us now take a look at each of these factors in detail.FlexibilityThe capital structure of a company should be within its debt capacity and in no way should it exceed the maximum debt limit. The capacity usually originates from the company’s future cash flows.The company should have enough cash to meet the demands of the creditors and then should have extra cash to limit any future contingency.The capital structure should be able to adapt ... Read More

Also known as Fisher Hypothesis, the Fisher’s Effect was a theory proposed by economist Irving Fisher. The theory states that the real interest rate of an investment is not affected by other monetary measures, such as nominal interest rate and expected inflation. The theory describes the relationship between the inflation rate and both nominal and real interest rates.According to Fisher Hypothesis, the nominal interest rate is the difference between the real interest rate and the expected rate of inflation. It also states that an increase in real interest rate occurs with decreasing inflation rate and vice versa, unless the same ... Read More

Depending on the level of risk the investors want to take, they are divided into three categories. These three categories offer a view of risk attitudes the investors are willing to pursue. Although there is no straightforward method to describe a quantity to the investments in each category, these categories are broadly divided depending on the probability of risks they entail in the long run. Here are the three categories of investors depending on the risk attitudes.Risk-averse AttitudeRisk-averse attitude is shown by investors who want to avoid risk. They will go for fewer returns rather than going for high returns.As ... Read More

One of the most commonly used methods for the valuation of capital structure is the analysis of cash flows from the operations of the business. Cash flows are of the following three types −Operating Cash FlowsNon-operating Cash FlowsFinancial FlowsOperating Cash FlowsThese are related to the operations of a firm and can be obtained from the profit and loss statements of the firm. To calculate operating cash flows, net operating volume, sales, and the input/output prices over a given period are used.Non-operating Cash FlowsIt generally includes working capital changes and capital expenditure. For example, in times of recession, the firms may ... Read More

Operating risk is associated with a company’s cost structure. It is the risk a company faces due to the level of fixed costs in the company’s operations. As the name suggests, operating risks are associated with the operations of the business. This may include risks due to failure of fixed assets or unpredictable operational risks that cannot be foreseen.Business risks are of two types − Operating risk and Sales risk.Operating risk is related to the cost structure and fixed costs of a company.Sales risk is the risks associated with the loss of revenue due to fewer goods and services sold.Fixed ... Read More

Operating leverage is a tool that measures a company’s fixed costs as a percentage of its overall costs. It is often used to evaluate the breakeven point of a business and the profit from overall sales. When expressed as the degree of operating leverage (DOL), it represents a financial ratio that calculates the sensitivity of a company’s operating income to its sales. As such, the DOL is a financial metric that shows how a change in the company’s sales will affect the company’s operating income.High Operating LeverageIn the case of high operating leverage, a large portion of a company’s costs ... Read More

Free cash flow is the capital retained by a company after it has paid all its expenses, including building, rent, tax, payroll, inventory, etc. Companies may use the free cash flow for anything it sees fit.Free cash flow is a true measure of a company’s profitability.Businesses usually calculate free cash flow to take critical business decisions, such as whether to invest the money for expansion or to invest the money in ways to reduce the costs of operations.Investors use the free cash flow metric to check the frauds in accounting, as these measures are stringent and less manipulable than net ... Read More

Financial risk refers to a condition where a company with a certain amount of debt will fail to repay them in a given time period. In other words, financial risk means the risk of losing money by investing it in a lossmaking company.Investors usually remain averse to risky companies and hence calculating the financial risk is of paramount importance to them. In general, the more debt a company has, the more will be its financial risk.Types of Financial RisksFinancial risks can lead to loss of shareholders’ income, as the money is lost while carrying on with a loss-making company. However, ... Read More