A discussion on the crucial concepts of managerial finance
Managerial finance is often described as a hybrid approach that combines the concepts of managerial accounting with those adopted from corporate finance. Sound knowledge of financial management helps in the creation of organizational value while promoting agility by efficiently allocating scarce resources between the competing opportunities for business. Thus it is essential to understand its key concepts, some of which are discussed below.
Essential concepts discussed in the chapter
- Incremental cash flow
The term refers to the flow of cash in an organization as a result of undertaking a new project. It enables the organizational leaders to compare multiple opportunities and decide on the most fruitful investment option in hand.
- Financing cost: The cost of finances is described as the costs in addition to the interest and various other charges that are associated with lending money for building or purchasing assets.
- Sunk cost: It refers to the costs incurred by the entity which cannot be recovered any longer. These costs must be considered during the investment decision-making process.
- Incremental cost: It includes the additional costs related to the manufacture of an extra unit during production. The concept is beneficial for the formulation of the price to be charged from the customer for a single-time deal or for adding additional units in the production line (Austin & Bradbury, 1995).
- Externalities: The term refers to the benefit or cost obtained by a third party. The third-party cannot control the process through which the benefit or the cost was created.
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- Including inflation in cash flow estimation
Inflation is described as a quantitative measure for the rate of increase in the price level of goods or services over a specific period of time. The inclusion of inflation while estimating the cash flow enables the organization leaders to increase the quality of their decisions by helping them to increase the accuracy of their predictions.
- Profitability index
It is the ratio of the payoff expected from a specific project to the investment required for the same. One of the prime benefits of the profitability index is that it enables the organization to rank its projects sequentially, thus allowing the managers to quantify the value generated from each investment option (Gurau, 2012).
- Risks in capital budgeting
There are various risks that can impact the capital budgeting process in an organization. Some of the most common ones include failure of paying the cash flow as per the agreed time, the associated risk of collapse for the investee organization, and sinking of the funds by the management for a risky project (Froot & Stein, 1998). It is categorized as below:
- Standalone risk
- Corporate risk
- Market risk
- Risk analysis
Risk analysis enables the organization to understand the nature of the risks that should be expected and the scope of the unexpected risks that can hamper the organizational processes. Risk analysis in capital budgeting cuts down the risk of failed investment, i.e., failure of an investment to generate cash flow as expected. It is of three types, as mentioned below.
- Sensitivity analysis
- Scenario analysis
- Simulation analysis
These are some of the main concepts of managerial financing that find application in the business realm. Control over these concepts can provide the professionals with a significant boost to their daily roles.
Reference
Austin, L. M., & Bradbury, M. E. (1995). The accuracy of cash flow estimation procedures. Accounting & Finance, 35(1), 73-86.
Froot, K. A., & Stein, J. C. (1998). Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach. Journal of financial economics, 47(1), 55-82.
Gurau, M. A. (2012). The use of profitability index in economic evaluation of industrial investment projects. Proceedings in Manufacturing Systems, 7(1), 45-48.