Monday 26 September 2011
Tuesday 20 September 2011
Statistics - Permutation and Combinations
This article discuss the use of permutations and combinations in finding the possibilities of arranging or numbe of combinations by using the permutation and combination techniques, particualrly in calculating theoritical probabilities of given events.
ntroduction
In Mathematics problems in permutations and combinations are very tricky. This is because ther are many problems which cannot be categorized in to a particualr method to be applied. The problems have to be solved by using unique insights and intuition and my experimenting with many ways of approch by using a combination of methods. However, by asking some systematic questions many permutations and combination problems can be solved. In this article I will discuss these questions and the categorise some of these problems which can be asked in High scholl Mathematics. This will certainly help students and people who are interested in Mathematics to explore these problems with a systematic way to approach such problems and enable to develop techniques for more complex problems.
The permutations and combinations can be categorised in to two major categories. They are Permutations and combinations without restrictions and with restrictions. It can be Line or circle arrangement in permutation questions. In these cases all items are chosen or some items are chosen. The items can be unique or identical. Restrictions can be categorized in to restricted items and unrestricted items or one or more restrictions. All permutations formulas are for the without replacement or repetition. The categories under without restriction and without replacement can be summariazed as follows:
Permutations and combinations without replacement has two major categories. They are as follows:
1. Without restrictions
2. With restrictions.
Without restriction and with restrictions can have permutations and combinations problems depending on whether order of arrangement is important or not. The categories under without restrictions and with restrictions are as follows:
1. Without restriction
a) Permutation
b) combination
2. With Restriction
a) Permutation
b) combination
Without restrictions, permutations can be firther categorized in to line arrangement or circle arrangement. Like wise with restriction category. This categorization is as follows:
1. Permutation - without restrictions
a) Line arrangement.
b) circle arrangement
2. Permutation with restriction
a) Line arrangement
b) circle arrangement
Line arrangement under permutation without restruction can be further catagorised as all items or some items.
This is as follows:
Permutation without restriction - Line arrangement
1. All items
2. Some items
Permutation without restriction, line arrangement of all items can be further catagorized in to each item unique or some items identical. This is as follows:
Permutation -Without replacement- Line arrangement - All items
1. Each item unique
2. some item identical.
Solutions for permutation and combination, where there is no restrictions in arrangement or chosing
1. Permutation without replacement and without restrictions line arrangement all items are unque = n factorial. Where n factorial = n*(n-1)8(n-2)......................................................1.
2. Permutation without replacement and without restrictions- Line arrangement, some items used = n p r. Where n p r = n factorial/ r factorial * (n-r) factorial.
3. Permutation without replacement and without restrictions, line arrangement some r items are identical and all items are chosen = n factorial/ r factorial.
4. Permutation without replacement, with restriction -Circle arrangement all items used = (n-1) factorial.
Problems involving Permutations and combination without replacement and without restrictions
Question 1
How many ways 7 people be arranged in a line?
Answer 1
In this question it is an arrangement. There fore order important. That is it is a permutation problem involving all items without replacement and without restriction in a line arrangement. There fore the number of ways is equal to 7 factorial = 7*6*5*4*3*2*1= 5040.
Question 2
How many ways the letters of the word Wollongong be arranged?
Answer 2
This a line arrangement permutation where some items are identical. In this instant there are 10 letterers. where it has 3 letter o, 2 letters g and 2 letters l. Applying the formula for this category as per above solutions is as follows:
The ways of arrangement in line = 10 factorial/ 3 factorial*2factorial*2 factorial = 75600.
Question 3
How many different arrangement can be made using 3 letters from the word Monday?
Answer 3
This is a permutation question as it asks for order of arrangement. In this situation the letters are unique and without restrictions. As well, all letters are not arranges only some are arranged. There fore it is a permutation 3 letters out of 6 letters. That is 6 p 3 or 6*5*4 = 120.
Question 4
If people has to arranged ina round table how many different arrangements are there if there are 6 people?
Answer 4
This a circle arrnagement instead of line arrangement. There fore the the cicle permutation as per above solutions to the circle permutation without restrictions and without replacement have to be used. In this situation the number of arrangements are ( 6-1) factorial = 120.
Question 5
How many committees can be formed out of 8 people?
Answer
In this question the order is not important. There fore it is not a permutation problem. It is a combination problem without replacement and without restrictions. There fore applying the solutions formula as mentioned above is 8 c 4 = 8 factorial/ 4 factorial *( 8-4) factorial = 8*7*6*5/ 4*3*2*1 = 70
Solution Model for permutation and combination with restrictions
If the permutations and combinations have restrictions in the way the items have to placed or method of choosing then determine whether it is a line permutation or circle permutation or combination. After deciding from the problem the nature of the problem decide the patterns as per restrictions for a permutation problem of line arrangement and determine the number of arrangement of each restriction and then multiply it with the number of patterns. Say the number of patterns for a restricted permutation problem is (p) and the 1st restricted item of (u) is (u) factorial and the 2nd restriction is (r) items and there fore (r) factorial. Then the total number of restricted permutation = p*u factorial * r factorial.
If say the problem related to circle permutation, the leave one item out of the total number of items and use the line permutation with restrictions as discussed above. For example, say it has n items, ther fore one has to be taken away from the total items. That is (n-1) items are taken into consideration and then use the line arrangement model for the circle permutations.
If it is a combination problem, just like the permutation, the patterns or restrictions combinations have to calculated separately and then identify the different classes in accordance with the restriction or restriction rules. Then multiply the combinations together with that of the number of combination necessary in consonant with the restriction to solve the problem.
In complex situations one has to calculate differently the permutations for different components of the problem and then add all the components together to get the final solutions. As well, in some situations combinations and permutations have to to multiplied to get the accurate results. These are exceptions to the general methodology adopted normally as discussed in this article.
Question 1
How many ways 4 boys and 3 girls can be arranged with 4 boys togeter in a line?
Answer 1
Restricted items: 4 boys
non- restricted items 3 girls
The possible patterns with restrictions are as follows:
BBBBggg
gbbbbgg
ggbbbbg
gggbbbb
That is there are 4 patterns. If no replacement then 4 boys can be arranged in 4 factorial ways, 3 boys can be arranged 3 factorial ways. If there are 4 patterns, then ther are 4*4 factorial * 3 factorial = 576.
Question 2
If 4 males and 3 females are there and they have to be arranged alternatively, how many arrangements are there?
Restricted items: 4 males and 3 females.
Restriction: they must be arranged alternatively that is m f m f m or f m f m. That is only one pattern
4 males can be arranged in 4 factorial ways. 3 females can be arranged 3 factorial ways, only one pattern. There fore the number of total arrangement = 1*4 factorial * 3 factorial = 144.
Question 3
In how many ways 5 adults can be arranged in a circle table, if say Bred and Biggs are not to sit near to each other?
Answer 3
This is a circle arrangement. Fix a position for Bred. Then consider the 4 adults as Biggs will not be at each end.
The possible patterns are
A B A A or A A B A
Bigg can be arranged in 1 factorial ways. The other 3 adults can be arranged in 3 factorial ways. there are two patterns. There fore the total arrangements with bred and Biggs are not sitting together is = 2* 1 factorial * 3 factorial = 12
Question 4
How many committees can be arranged if 3 males and 5 females have to be chosen from 6 males and 10 females?
Answer 4
This do not require order , there fore it is a combination problem with restriction that 3 males have to chosen from 6 males and 5 females from 10 females.
The number of combination if 3 males are chosen from 6 males = 6 C 3 = 6 factorial/ 3 factorial* 3 factorial = 20
The number of combinations of chosing 5 females from 10 females = 10 c 5 = 10 factorial/ 5 factorial * 5 factorial = 252.
There fore, the number of committees are = 20*252 = 5040.
Question 5
In how many ways 5 adults can be arranged in a circle if Ben and Biggs must not sit near to each other?
Answer 5
This is a circle arrangement. Fix a position for Ben. The arrange the 4 adults in such a manner that Biggs do not sit at the end of a line arrangement. If this done, then there are two patterns. The are as follows:
A B A A
A A B A
Biggs can be arranged in 1 factorial way. Other 3 adults can be arranged in 3 factorial ways. There fore total arrangements in a circle with restriction = 2* 1 factorial * 3 factorial = 12.
Question 6
Calculate the probability if 4 males and 3 females are arranged in a line and they alternatively sit.
Answer 6
The number of arrangement possible if 4 males and 3 females are to be sitting alternatively = 1* 4 factorial * 3 factorial = 24 *6 =144
If no restrictions they can be arranged in 7 factorial ways = 7*6 * 5 * 4 *3 *2 *1 = 7*30* 24 = 240*24 = 5040
There fore the probability that the boys and girls alter nate arrangement = 144/ 5040 .
ntroduction
In Mathematics problems in permutations and combinations are very tricky. This is because ther are many problems which cannot be categorized in to a particualr method to be applied. The problems have to be solved by using unique insights and intuition and my experimenting with many ways of approch by using a combination of methods. However, by asking some systematic questions many permutations and combination problems can be solved. In this article I will discuss these questions and the categorise some of these problems which can be asked in High scholl Mathematics. This will certainly help students and people who are interested in Mathematics to explore these problems with a systematic way to approach such problems and enable to develop techniques for more complex problems.
The permutations and combinations can be categorised in to two major categories. They are Permutations and combinations without restrictions and with restrictions. It can be Line or circle arrangement in permutation questions. In these cases all items are chosen or some items are chosen. The items can be unique or identical. Restrictions can be categorized in to restricted items and unrestricted items or one or more restrictions. All permutations formulas are for the without replacement or repetition. The categories under without restriction and without replacement can be summariazed as follows:
Permutations and combinations without replacement has two major categories. They are as follows:
1. Without restrictions
2. With restrictions.
Without restriction and with restrictions can have permutations and combinations problems depending on whether order of arrangement is important or not. The categories under without restrictions and with restrictions are as follows:
1. Without restriction
a) Permutation
b) combination
2. With Restriction
a) Permutation
b) combination
Without restrictions, permutations can be firther categorized in to line arrangement or circle arrangement. Like wise with restriction category. This categorization is as follows:
1. Permutation - without restrictions
a) Line arrangement.
b) circle arrangement
2. Permutation with restriction
a) Line arrangement
b) circle arrangement
Line arrangement under permutation without restruction can be further catagorised as all items or some items.
This is as follows:
Permutation without restriction - Line arrangement
1. All items
2. Some items
Permutation without restriction, line arrangement of all items can be further catagorized in to each item unique or some items identical. This is as follows:
Permutation -Without replacement- Line arrangement - All items
1. Each item unique
2. some item identical.
Solutions for permutation and combination, where there is no restrictions in arrangement or chosing
1. Permutation without replacement and without restrictions line arrangement all items are unque = n factorial. Where n factorial = n*(n-1)8(n-2)......................................................1.
2. Permutation without replacement and without restrictions- Line arrangement, some items used = n p r. Where n p r = n factorial/ r factorial * (n-r) factorial.
3. Permutation without replacement and without restrictions, line arrangement some r items are identical and all items are chosen = n factorial/ r factorial.
4. Permutation without replacement, with restriction -Circle arrangement all items used = (n-1) factorial.
Problems involving Permutations and combination without replacement and without restrictions
Question 1
How many ways 7 people be arranged in a line?
Answer 1
In this question it is an arrangement. There fore order important. That is it is a permutation problem involving all items without replacement and without restriction in a line arrangement. There fore the number of ways is equal to 7 factorial = 7*6*5*4*3*2*1= 5040.
Question 2
How many ways the letters of the word Wollongong be arranged?
Answer 2
This a line arrangement permutation where some items are identical. In this instant there are 10 letterers. where it has 3 letter o, 2 letters g and 2 letters l. Applying the formula for this category as per above solutions is as follows:
The ways of arrangement in line = 10 factorial/ 3 factorial*2factorial*2 factorial = 75600.
Question 3
How many different arrangement can be made using 3 letters from the word Monday?
Answer 3
This is a permutation question as it asks for order of arrangement. In this situation the letters are unique and without restrictions. As well, all letters are not arranges only some are arranged. There fore it is a permutation 3 letters out of 6 letters. That is 6 p 3 or 6*5*4 = 120.
Question 4
If people has to arranged ina round table how many different arrangements are there if there are 6 people?
Answer 4
This a circle arrnagement instead of line arrangement. There fore the the cicle permutation as per above solutions to the circle permutation without restrictions and without replacement have to be used. In this situation the number of arrangements are ( 6-1) factorial = 120.
Question 5
How many committees can be formed out of 8 people?
Answer
In this question the order is not important. There fore it is not a permutation problem. It is a combination problem without replacement and without restrictions. There fore applying the solutions formula as mentioned above is 8 c 4 = 8 factorial/ 4 factorial *( 8-4) factorial = 8*7*6*5/ 4*3*2*1 = 70
Solution Model for permutation and combination with restrictions
If the permutations and combinations have restrictions in the way the items have to placed or method of choosing then determine whether it is a line permutation or circle permutation or combination. After deciding from the problem the nature of the problem decide the patterns as per restrictions for a permutation problem of line arrangement and determine the number of arrangement of each restriction and then multiply it with the number of patterns. Say the number of patterns for a restricted permutation problem is (p) and the 1st restricted item of (u) is (u) factorial and the 2nd restriction is (r) items and there fore (r) factorial. Then the total number of restricted permutation = p*u factorial * r factorial.
If say the problem related to circle permutation, the leave one item out of the total number of items and use the line permutation with restrictions as discussed above. For example, say it has n items, ther fore one has to be taken away from the total items. That is (n-1) items are taken into consideration and then use the line arrangement model for the circle permutations.
If it is a combination problem, just like the permutation, the patterns or restrictions combinations have to calculated separately and then identify the different classes in accordance with the restriction or restriction rules. Then multiply the combinations together with that of the number of combination necessary in consonant with the restriction to solve the problem.
In complex situations one has to calculate differently the permutations for different components of the problem and then add all the components together to get the final solutions. As well, in some situations combinations and permutations have to to multiplied to get the accurate results. These are exceptions to the general methodology adopted normally as discussed in this article.
Question 1
How many ways 4 boys and 3 girls can be arranged with 4 boys togeter in a line?
Answer 1
Restricted items: 4 boys
non- restricted items 3 girls
The possible patterns with restrictions are as follows:
BBBBggg
gbbbbgg
ggbbbbg
gggbbbb
That is there are 4 patterns. If no replacement then 4 boys can be arranged in 4 factorial ways, 3 boys can be arranged 3 factorial ways. If there are 4 patterns, then ther are 4*4 factorial * 3 factorial = 576.
Question 2
If 4 males and 3 females are there and they have to be arranged alternatively, how many arrangements are there?
Restricted items: 4 males and 3 females.
Restriction: they must be arranged alternatively that is m f m f m or f m f m. That is only one pattern
4 males can be arranged in 4 factorial ways. 3 females can be arranged 3 factorial ways, only one pattern. There fore the number of total arrangement = 1*4 factorial * 3 factorial = 144.
Question 3
In how many ways 5 adults can be arranged in a circle table, if say Bred and Biggs are not to sit near to each other?
Answer 3
This is a circle arrangement. Fix a position for Bred. Then consider the 4 adults as Biggs will not be at each end.
The possible patterns are
A B A A or A A B A
Bigg can be arranged in 1 factorial ways. The other 3 adults can be arranged in 3 factorial ways. there are two patterns. There fore the total arrangements with bred and Biggs are not sitting together is = 2* 1 factorial * 3 factorial = 12
Question 4
How many committees can be arranged if 3 males and 5 females have to be chosen from 6 males and 10 females?
Answer 4
This do not require order , there fore it is a combination problem with restriction that 3 males have to chosen from 6 males and 5 females from 10 females.
The number of combination if 3 males are chosen from 6 males = 6 C 3 = 6 factorial/ 3 factorial* 3 factorial = 20
The number of combinations of chosing 5 females from 10 females = 10 c 5 = 10 factorial/ 5 factorial * 5 factorial = 252.
There fore, the number of committees are = 20*252 = 5040.
Question 5
In how many ways 5 adults can be arranged in a circle if Ben and Biggs must not sit near to each other?
Answer 5
This is a circle arrangement. Fix a position for Ben. The arrange the 4 adults in such a manner that Biggs do not sit at the end of a line arrangement. If this done, then there are two patterns. The are as follows:
A B A A
A A B A
Biggs can be arranged in 1 factorial way. Other 3 adults can be arranged in 3 factorial ways. There fore total arrangements in a circle with restriction = 2* 1 factorial * 3 factorial = 12.
Question 6
Calculate the probability if 4 males and 3 females are arranged in a line and they alternatively sit.
Answer 6
The number of arrangement possible if 4 males and 3 females are to be sitting alternatively = 1* 4 factorial * 3 factorial = 24 *6 =144
If no restrictions they can be arranged in 7 factorial ways = 7*6 * 5 * 4 *3 *2 *1 = 7*30* 24 = 240*24 = 5040
There fore the probability that the boys and girls alter nate arrangement = 144/ 5040 .
Sunday 18 September 2011
Importance of Productivity for an Economy and Factors Contributing to Productivity and Its Impact on Sustainable Economic Growth
This article discuss the impotance of productivvity improvement for any economy to enjoy sustainable economic growth with low inflation.
mportance of productivity for an Economy and factors contributing to productivity and its impact on sustainable Economic Growth
The Definitions of Economic productivity
The economic productivity refers to the cost of factor input and the value of its output. For example if productivity is improved consistently the cost of production or unit cost comedown drastically and there fore it increases consumer welfare as prices comes down.
The measurement of productivity and the problems of measuring productivity
In theory as mentioned above the concept of productivity is straight forward. However, in practice to measure productivity is not easy. This is because, productivity can be increased by unemployed labor or increasing the work day or under severe adverse conditions and there fore productivity can be apparently increased. If this achieved by the above means the productivity is not improved but worsened. There fore the productivity must be approached by the appropriate means not achieved in adverse conditions. In addition, the productivity to measure services is not easy as services output cannot be easily measured accurately. This applicable to education, government services and other service industries.
The main factors affecting productivity in an economy
The productivity of an economy depends on many factors. However, all factors are do not contribute to productivity. However, there are common factors irrespective of the nature of economies boost productivity. The main factor increasing productivity is the availability and the quality of capital and labor resources particularly the skilled and semi-skilled workforce and the flexibility of the labor market. Another factor is the innovate capacity of private and public institutions and the incentives to innovate and consistent technological dynamic development. Another crucial factor contribute to productivity improvement is the level of research and development and the quality of education and training system. In addition, productivity also depends on the level of business taxation and regulatory regime. For example, if business is overly regulated it may have adverse effects on productivity as it may discourage business to invest in productivity enhancing activities because of cost of regulation and risk in investment. In some economies, the amount and quality of natural resources like water, soil quality and other mineral resource availability to greater extent if the majority of economic activity depends on such resources. However, in other economies also will be affected because of oil and other resources are important factor in its cost and quality which determines productivity. Another important factor for long-term productivity growth is the quality of social and physical and technological infra-structure.
If any economy do not concentrate on the major forces of productivity and not have economic policies to address any deficiency compared to other nations they may not be competitive in the global economy and may adversely affected in terms of sustainable economic growth potential and dynamic efficiency of the economy.
The relationship between productivity and economic growth
The main reason productivity has an impact on economic growth is due to the fact productivity improves the profitability of business enterprises and the dynamic efficiency of the private enterprises and there fore increase the level of investment in the economy and there fore increase the potential output of the economy as a whole in the long-term. That is it has the effect of moving the aggregate long tern supply curve to the right. As well, it will enable the economy to grow with less inflation and there fore increase the economic growth rate. As well, as it increases sustainably the real income of the workforce in general in the long-term it increases the consumption potential of consumers and there fore increase aggregate demand and through the multiplier effect produces consistent economic growth. In other words, government polices directed towards productivity improvement in most of the important sectors of the economy as well as the efficiency of the public sector enables the economy as whole to be more productive. This will also enable the economy to have sufficient resources and technology to tackle environmental issues effectively at a minimum cost. In addition productivity improvement also has the effect of attracting international capital to the economy and investment in the economy there by increasing the potential capacity to produce or lift the production possibility curve to the right.
Summary
As mentioned above, the concept of productivity is important for any economy. However the measurement of productivity is not easy. Any economy's productivity is dependent on some crrucial factors. If these factors are neglected over a period of time and if it lags behind some major competitors in a global economy it has severe negative consequences in terms of its economic performance. It is also important to note all economies have some unique factors depending on their economic structures. However, there are some common factors, which determine productivity improvement over a long-term. As discussed above, productivity affects the rate of economic growth and consumer welfare by increasing the level of investment, consumer spending, foreign investment, possibility to control inflation and non-inflationary economic growth and there for to ensure consistent and sustainable economic growth with less boom and bust cycles. It is important that government must play its appropriate role in engendering dynamic efficiency and allocation efficiency so that it can move the aggregate long term supply curve move consistently over a long period of time. In effect, productivity enhancing polices by private and government is a crucial economic welfare and standard of living as well as quality of living of an economy.
mportance of productivity for an Economy and factors contributing to productivity and its impact on sustainable Economic Growth
The Definitions of Economic productivity
The economic productivity refers to the cost of factor input and the value of its output. For example if productivity is improved consistently the cost of production or unit cost comedown drastically and there fore it increases consumer welfare as prices comes down.
The measurement of productivity and the problems of measuring productivity
In theory as mentioned above the concept of productivity is straight forward. However, in practice to measure productivity is not easy. This is because, productivity can be increased by unemployed labor or increasing the work day or under severe adverse conditions and there fore productivity can be apparently increased. If this achieved by the above means the productivity is not improved but worsened. There fore the productivity must be approached by the appropriate means not achieved in adverse conditions. In addition, the productivity to measure services is not easy as services output cannot be easily measured accurately. This applicable to education, government services and other service industries.
The main factors affecting productivity in an economy
The productivity of an economy depends on many factors. However, all factors are do not contribute to productivity. However, there are common factors irrespective of the nature of economies boost productivity. The main factor increasing productivity is the availability and the quality of capital and labor resources particularly the skilled and semi-skilled workforce and the flexibility of the labor market. Another factor is the innovate capacity of private and public institutions and the incentives to innovate and consistent technological dynamic development. Another crucial factor contribute to productivity improvement is the level of research and development and the quality of education and training system. In addition, productivity also depends on the level of business taxation and regulatory regime. For example, if business is overly regulated it may have adverse effects on productivity as it may discourage business to invest in productivity enhancing activities because of cost of regulation and risk in investment. In some economies, the amount and quality of natural resources like water, soil quality and other mineral resource availability to greater extent if the majority of economic activity depends on such resources. However, in other economies also will be affected because of oil and other resources are important factor in its cost and quality which determines productivity. Another important factor for long-term productivity growth is the quality of social and physical and technological infra-structure.
If any economy do not concentrate on the major forces of productivity and not have economic policies to address any deficiency compared to other nations they may not be competitive in the global economy and may adversely affected in terms of sustainable economic growth potential and dynamic efficiency of the economy.
The relationship between productivity and economic growth
The main reason productivity has an impact on economic growth is due to the fact productivity improves the profitability of business enterprises and the dynamic efficiency of the private enterprises and there fore increase the level of investment in the economy and there fore increase the potential output of the economy as a whole in the long-term. That is it has the effect of moving the aggregate long tern supply curve to the right. As well, it will enable the economy to grow with less inflation and there fore increase the economic growth rate. As well, as it increases sustainably the real income of the workforce in general in the long-term it increases the consumption potential of consumers and there fore increase aggregate demand and through the multiplier effect produces consistent economic growth. In other words, government polices directed towards productivity improvement in most of the important sectors of the economy as well as the efficiency of the public sector enables the economy as whole to be more productive. This will also enable the economy to have sufficient resources and technology to tackle environmental issues effectively at a minimum cost. In addition productivity improvement also has the effect of attracting international capital to the economy and investment in the economy there by increasing the potential capacity to produce or lift the production possibility curve to the right.
Summary
As mentioned above, the concept of productivity is important for any economy. However the measurement of productivity is not easy. Any economy's productivity is dependent on some crrucial factors. If these factors are neglected over a period of time and if it lags behind some major competitors in a global economy it has severe negative consequences in terms of its economic performance. It is also important to note all economies have some unique factors depending on their economic structures. However, there are some common factors, which determine productivity improvement over a long-term. As discussed above, productivity affects the rate of economic growth and consumer welfare by increasing the level of investment, consumer spending, foreign investment, possibility to control inflation and non-inflationary economic growth and there for to ensure consistent and sustainable economic growth with less boom and bust cycles. It is important that government must play its appropriate role in engendering dynamic efficiency and allocation efficiency so that it can move the aggregate long term supply curve move consistently over a long period of time. In effect, productivity enhancing polices by private and government is a crucial economic welfare and standard of living as well as quality of living of an economy.
Employee Motivational Theories and Their Applications in Modern Organizations
This guide discuss major employee motivational theories. In addition, it also highlights the limitations of earlier theories and the evolution of modern motivational theories. As well, this guide also discuss how a manager can use these theories to motivate staff.
Maslow's Hierarchy of Needs
Abraham Maslow is a humanistic psychologist developed a theory of personality, which is valuable in the field of employee motivation. Basically they believe humans strive for upper-level capabilities such as creativity and highest level of consciousness.
In his view, humans have five needs and if one need is satisfied they go to the next and motivated by unmet needs in stages. In an employee motivational perspective, applying this theory, managers must identify the unmet needs of employees to motivate them. The five needs are, physiological needs such as food, water shelter, clothing etc. They are the strongest needs because if a person is deprived of all needs the psychological ones comes first in search of satisfaction.
When psychological needs are satisfied for a person, the needs of safety become active. If the psychological needs are satisfied it no longer affects the thoughts and behaviour of humans. When the needs for safety and psychological needs are satisfied a person moves to the next need of love, affection and belongingness.
When the first three needs are satisfied, then they move to the next level of needs for self-esteem such as firmly based high-level self respect and respect from others. If these are satisfied, a person feels self-confident and valuable. When the previous four needs are satisfied the person moves to the highest need of self-actualization. That is the need, which is to do what ever the person is born to do.
In Summary, Maslow's Hierarchy of needs in the perspective of employee motivation is to identify the satisfied needs and provide opportunities to meet the unmet needs to motivate the employees. The major weaknesses of the need theory; is the non-recognition of individual differences and ignoring other factors. For example the work itself can motivate employees.
The Theory X assumes, humans are in average dislike work and avoid responsibility and must be controlled and threatened to work hard. As well, it assumes people that they don't like responsibility and desires security above all. They must be directed so that they work towards organizational goals.
These assumptions are at play behind most organization, which pursues tight control, and punishment or they prefer harmony at work and ignore more higher order needs as specified by Maslow's hierarchy of needs so that the employees behave as Theory X expected. Theory X must be used very carefully in modern organizational environment because it may be counterproductive and may reduce motivation of employees. Contrast to Theory X, Theory Y assumes people use mental and physical effort in work as natural as play.
As well, it assumes that people will direct themselves if they are committed to the goals of the organization. Under proper conditions, average person not only accepts responsibility, but also seeks responsibility. In addition, it assumes imagination, creativity; ingenuity can be used to solve work problems by a large number of employees.
Theory Y also assumes, that in modern industrial life intellectual potential of average man is partially utilized. In the context of employee motivation, if subordinates are not in agreement with the manager of the desired results then the only way for the manager is to use his authority to get the work done using the Theory X assumption. However, if the employees are emotionally mature, agrees with desired results, work is sufficiently responsible and flexible and the employee can see his position in the organizational hierarchy, then in these conditions participative approach to problem solving leads to much improved results applying the Theory Y.
As well, in situations, where the employees agree and commit to the objectives of the organization, then explaining the matter fully to the employees the purpose of action and allow them to self-direct them, they may use better methods and do a better work than simply carrying out an order from the manager. Theory Y is more appropriate in this situation.
As well, the reward satisfies an important need. Then the desire to satisfy the need is strong to make the effort maximize benefits and minimize pain. In this context, the managers must identify what an individual's value is, such as money, promotion, time-off, benefits or satisfaction rewards. They are called valence.
As well, employees have different expectations and confidence about what they are capable of doing. In this respect, managers must identify what resources, training, and supervision employee's need. They are called expectancy. In addition, employees may perceive as whether they will receive what they desire. In this regard management must ensure their promises of rewards are fulfilled and that employees are aware of these rewards. The employee perception of reward is called instrumentality. In this manner a manger can apply the expectancy theory to motivate employees.
Contingency theories of employee motivation recognize leadership and its relevance in different organizational situations and in the context of the profile of workers and type of jobs they do and match the leadership to situation or change situation to leadership style to manage workers and motivate them.
In addition, contingency theories also recognizes the organizational structural issues, such as centralization opposed to decentralization, span of control, delegation, levels of management, decision -making process, which suits the external and internal environment and the static and dynamic nature of the internal and external environment.
As well, the contingency theory considers organizational culture, individual differences, conflict level and the recognition of these variables to motivate staff. That is, motivation of employees must differ from one organization to the next, depending on the nature of activities, profile of human potential, personality, skill, knowledge, experience, organizational culture, technology, nature of external and internal environment, planning horizons, individual differences, structure of organization, group behaviour and dynamics.
Maslow's Hierarchy of Needs
Abraham Maslow is a humanistic psychologist developed a theory of personality, which is valuable in the field of employee motivation. Basically they believe humans strive for upper-level capabilities such as creativity and highest level of consciousness.
In his view, humans have five needs and if one need is satisfied they go to the next and motivated by unmet needs in stages. In an employee motivational perspective, applying this theory, managers must identify the unmet needs of employees to motivate them. The five needs are, physiological needs such as food, water shelter, clothing etc. They are the strongest needs because if a person is deprived of all needs the psychological ones comes first in search of satisfaction.
When psychological needs are satisfied for a person, the needs of safety become active. If the psychological needs are satisfied it no longer affects the thoughts and behaviour of humans. When the needs for safety and psychological needs are satisfied a person moves to the next need of love, affection and belongingness.
When the first three needs are satisfied, then they move to the next level of needs for self-esteem such as firmly based high-level self respect and respect from others. If these are satisfied, a person feels self-confident and valuable. When the previous four needs are satisfied the person moves to the highest need of self-actualization. That is the need, which is to do what ever the person is born to do.
In Summary, Maslow's Hierarchy of needs in the perspective of employee motivation is to identify the satisfied needs and provide opportunities to meet the unmet needs to motivate the employees. The major weaknesses of the need theory; is the non-recognition of individual differences and ignoring other factors. For example the work itself can motivate employees.
Theory X and Theory Y
Theory X and Theory Y is about Human nature like the Maslow's hierarchy of needs.The Theory X assumes, humans are in average dislike work and avoid responsibility and must be controlled and threatened to work hard. As well, it assumes people that they don't like responsibility and desires security above all. They must be directed so that they work towards organizational goals.
These assumptions are at play behind most organization, which pursues tight control, and punishment or they prefer harmony at work and ignore more higher order needs as specified by Maslow's hierarchy of needs so that the employees behave as Theory X expected. Theory X must be used very carefully in modern organizational environment because it may be counterproductive and may reduce motivation of employees. Contrast to Theory X, Theory Y assumes people use mental and physical effort in work as natural as play.
As well, it assumes that people will direct themselves if they are committed to the goals of the organization. Under proper conditions, average person not only accepts responsibility, but also seeks responsibility. In addition, it assumes imagination, creativity; ingenuity can be used to solve work problems by a large number of employees.
Theory Y also assumes, that in modern industrial life intellectual potential of average man is partially utilized. In the context of employee motivation, if subordinates are not in agreement with the manager of the desired results then the only way for the manager is to use his authority to get the work done using the Theory X assumption. However, if the employees are emotionally mature, agrees with desired results, work is sufficiently responsible and flexible and the employee can see his position in the organizational hierarchy, then in these conditions participative approach to problem solving leads to much improved results applying the Theory Y.
As well, in situations, where the employees agree and commit to the objectives of the organization, then explaining the matter fully to the employees the purpose of action and allow them to self-direct them, they may use better methods and do a better work than simply carrying out an order from the manager. Theory Y is more appropriate in this situation.
Hertszberg's Motivation and Hygiene Theory
In this theory, there are two sets of needs. They are basic needs and motivational needs. The basic needs can be working conditions, supervision, company policy and administration, salary and interpersonal relationship. These needs if not met, then employees will be dissatisfied, but not motivate them. That is, if the manager wants to stop the employees doing something, then they must consider hygiene needs. However, if they want to get someone to do something, then they must consider motivational needs. In this theory, the motivational needs are achievement and recognition, work variety, responsibility and advancement.Expectancy and Contingency Theories
According to expectancy theory, people behaviour at work and their goals are not simple. The employee performance at work is based on individual factors such as personality, skill, knowledge, experience, and abilities. The theory suggests even if the individuals have different sets of goals, they can be motivated if they believe their effort leads to performance and performance results in desirable reward.As well, the reward satisfies an important need. Then the desire to satisfy the need is strong to make the effort maximize benefits and minimize pain. In this context, the managers must identify what an individual's value is, such as money, promotion, time-off, benefits or satisfaction rewards. They are called valence.
As well, employees have different expectations and confidence about what they are capable of doing. In this respect, managers must identify what resources, training, and supervision employee's need. They are called expectancy. In addition, employees may perceive as whether they will receive what they desire. In this regard management must ensure their promises of rewards are fulfilled and that employees are aware of these rewards. The employee perception of reward is called instrumentality. In this manner a manger can apply the expectancy theory to motivate employees.
Contingency theories of employee motivation recognize leadership and its relevance in different organizational situations and in the context of the profile of workers and type of jobs they do and match the leadership to situation or change situation to leadership style to manage workers and motivate them.
In addition, contingency theories also recognizes the organizational structural issues, such as centralization opposed to decentralization, span of control, delegation, levels of management, decision -making process, which suits the external and internal environment and the static and dynamic nature of the internal and external environment.
As well, the contingency theory considers organizational culture, individual differences, conflict level and the recognition of these variables to motivate staff. That is, motivation of employees must differ from one organization to the next, depending on the nature of activities, profile of human potential, personality, skill, knowledge, experience, organizational culture, technology, nature of external and internal environment, planning horizons, individual differences, structure of organization, group behaviour and dynamics.
Friday 16 September 2011
Biotechnology Issues
In this article, I will discuss origins of biotechnology, Biotechnological practice, cell biochemistry and fermentation procedures, cell chemistry, Recombinant DNA, Application and area of Research and biotechnology ethical issues.
What is Biotechnology ?
It is a method of using living organisms or parts of organisms to create new products and processes which are useful and enhance the productivity and other qualities and which are more beneficial to society. Due to genetics and the genome project now scientist can also alter living organisms by genetic engineering. Due to expansion of sophisticated biological research techniques, the outcome of this are applied to traditional sectors of the economy.
Role of biotechnology and biotechnology methods in key sectors
Biotechnology methods are applicable to a wide range of industries such as agriculture, mining, medicine, food processing, manufacturing and the environment. Due to advances made in biotechnology research, it is expected that biotechnology impacts and consequences may have far reaching outcomes to the economy as well as to the environment. It has the potential to improve productivity and also to create new beneficial products in the future if these techniques are applied carefully and ethically and regulated appropriately.
In Biotechnology DNA probe is a technique used in biotechnology. This technology is used to identify whether patients have inherited genetic diseases such as cystic fibrosis, thalassaemia, muscular dystrophy and Huntington's chorea. In addition the DNA fingerprints from blood or hair from an individual can easily identify crime identification of a criminal act. That is it is a useful technique in identifying tge puzzle of who committed the crime.
Genetic engineering is another technology, which can be used to transfer useful genes from plants and animals to bacteria to produce large quantities of biotechnology-based therapeutics for the treatment of animal and human diseases. For example insulin is produced in large quantities using this technique to cure diabetes.
Genetically modified bacteria also can produce enzymes which can be used food technology for appearance, flavour or aroma. In addition, these generically engineered bacteria also can be used in manufacturing process to control temperature and there fore reduce waste. As well, it is also a useful technique in mining industry to make the ore sulfides oxidized and extract minerals such as iron and gold. These techniques can be used to genetically modify bacteria and they can be used to treat contaminated soil or waste chemicals.
Genetic engineering techniques also can improve productivity in agriculture. For example genetically modified cotton produces a pesticide which can kill leaf eating insects by producing the pesticide in its leaves. As well, this technique also can be used for better wool production by producing transgenic sheep by genetically introducing new traits in to animals. That is genetic engineering can be used to increase productivity and there fore reduce environmental issues arising from using chemical pesticides and fertilizers.
The tissue culture, which is a biotechnology technique, can be sued to produce large quantities of the plants with the same genetic makeup. In addition, cell lines of micro-algae can be used to produce food ingredients like polysaccharides for use in food processing and other useful chemicals such as beta-carotene and docosahexanic acid.
Above all, biotechnology is a fundamental tool in medicine. For examples cultures of skin cells are used grow skin and used for grafting on to burns. Researchers are examine whether they can use borne marrow as a raw material to produce bones which can be used in accident victims to replace broken bones or bones which become brittle due to diseases. Complete sequencing of the human genome also is providing a powerful technique or tool for the diagnosis of diseases and the development of new drugs and treatment.
The major biotechnology techniques are as follows:
DNA Probe
Monoclonal Antibodies
Genetic Engineering/ Selection of normally occurring organisms
Tissue culture
What is Biotechnology ?
It is a method of using living organisms or parts of organisms to create new products and processes which are useful and enhance the productivity and other qualities and which are more beneficial to society. Due to genetics and the genome project now scientist can also alter living organisms by genetic engineering. Due to expansion of sophisticated biological research techniques, the outcome of this are applied to traditional sectors of the economy.
Role of biotechnology and biotechnology methods in key sectors
Biotechnology methods are applicable to a wide range of industries such as agriculture, mining, medicine, food processing, manufacturing and the environment. Due to advances made in biotechnology research, it is expected that biotechnology impacts and consequences may have far reaching outcomes to the economy as well as to the environment. It has the potential to improve productivity and also to create new beneficial products in the future if these techniques are applied carefully and ethically and regulated appropriately.
In Biotechnology DNA probe is a technique used in biotechnology. This technology is used to identify whether patients have inherited genetic diseases such as cystic fibrosis, thalassaemia, muscular dystrophy and Huntington's chorea. In addition the DNA fingerprints from blood or hair from an individual can easily identify crime identification of a criminal act. That is it is a useful technique in identifying tge puzzle of who committed the crime.
Genetic engineering is another technology, which can be used to transfer useful genes from plants and animals to bacteria to produce large quantities of biotechnology-based therapeutics for the treatment of animal and human diseases. For example insulin is produced in large quantities using this technique to cure diabetes.
Genetically modified bacteria also can produce enzymes which can be used food technology for appearance, flavour or aroma. In addition, these generically engineered bacteria also can be used in manufacturing process to control temperature and there fore reduce waste. As well, it is also a useful technique in mining industry to make the ore sulfides oxidized and extract minerals such as iron and gold. These techniques can be used to genetically modify bacteria and they can be used to treat contaminated soil or waste chemicals.
Genetic engineering techniques also can improve productivity in agriculture. For example genetically modified cotton produces a pesticide which can kill leaf eating insects by producing the pesticide in its leaves. As well, this technique also can be used for better wool production by producing transgenic sheep by genetically introducing new traits in to animals. That is genetic engineering can be used to increase productivity and there fore reduce environmental issues arising from using chemical pesticides and fertilizers.
The tissue culture, which is a biotechnology technique, can be sued to produce large quantities of the plants with the same genetic makeup. In addition, cell lines of micro-algae can be used to produce food ingredients like polysaccharides for use in food processing and other useful chemicals such as beta-carotene and docosahexanic acid.
Above all, biotechnology is a fundamental tool in medicine. For examples cultures of skin cells are used grow skin and used for grafting on to burns. Researchers are examine whether they can use borne marrow as a raw material to produce bones which can be used in accident victims to replace broken bones or bones which become brittle due to diseases. Complete sequencing of the human genome also is providing a powerful technique or tool for the diagnosis of diseases and the development of new drugs and treatment.
The major biotechnology techniques are as follows:
DNA Probe
Monoclonal Antibodies
Genetic Engineering/ Selection of normally occurring organisms
Tissue culture
Economic Policies to Reduce Unemployment
NTRO
BODY
ü Effectiveness:. these policies unlikely to reduce the structural unemployment rate, it instead increases inflationary pressure because high economic growth induced by technological change can result in high structure unemployment
ü Fiscal policy: one of the macroeconomic policies which can influence resources allocation, redistribution income and reduce the fluctuation of the business cycle, by varying the amount of government spending and revenue, the government can alter the economic activity, which will influence the economic growth, inflation, unemployment and the external indicators in the economy.
ü The aim of this policy is to sustainable economic growth and unemployment rate in Australia by reducing public sector dissaving and our reliance on overseas borrowing.
ü The budget has moved into fiscal surplus since 1997 by a sustained fiscal consolidation policy of reduction in government outlay, therefore provided a higher economic growth and lower unemployment rate.
ü In 2000 the unemployment rate rises to 7 % which is higher than 1900s however as the curs this rising trend the government undergoes expansionary fiscal policy consequently with no new major employment initiatives in 2003’s budget, it will be expected that no further reduction in unemployment until mid 2004.
ü Monetary Policy: Is macroeconomic policy which involves action by the RBA , on behalf the government, to influence the cost and availability of money and credit in the economy. It is used to smooth the effects of fluctuation in the business cycle and influence the level of economic activity, output, employment and price.
ü Used as a long term policy aimed to keeping inflation low, providing an environment which is attractive for investment and employment growth.
ü Once the RBA believe there is a stable low inflation, which will have a greater range for reducing the interest rate in hance to lower the unemployment rate. If the RBA feels that the level of unemployment is approaching the natural rate, they will tighten monetary policy to prevent excessive spending feeding into higher prices and wages.
ü Labour market programmes are aimed to increase the ability of the unemployed to complete effectively in the labour market. Training programmes are one of the significant programmes which allowed the unemployed to be re-employed again and let the labour market to function more effectively and promote a better synergy between supply and demand.
3. Microeconomic reform: is the government improving the resource allocation between firms and industries, in order to maximise output and seeking to improve the efficiency and productivity of producer. A wide rang of microeconomic reform have been introduced to improve the competitive economic environment in Australia and increase the potential for higher productivity, employment and economic growth. Recent solid productivity growth in Australia economy has led to a stronger economic growth and a lower unemployment rate. There are three major microeconomic policies to reduce the unemployment rate. (industry reform, reduction in real wage, and taxation reform)
ü Industry reform: based on encouraging research and development and encouraging innovation in specific industry, this can boost their productivity and growth in that particular industry. By increase more understanding and experience therefore can improve the efficiency growth and job creation in hence to lower the unemployment rate.
ü Reduction in real wage: by reducing the real wages there will be a higher employment rate but it can also increase a high unemployment rate in certain industries and a lower real wage will increase young unemployment.
ü Taxation reform: introduced in July 2000 which is aimed at improving the investment climate in Australia therefore and a higher potential for economic growth and lower the unemployment rate.
- Unemployment refer to a situation where the aggregate demand for the labour is less than the aggregate supply of labour, so that there is an increase in the proportion of the workforce actively seeking work but who are unable to find.
- Unemployment is major cost to an economy not only in terms of the opportunity cost if lost production, but also in term of major long term social cost including increased inequality, poverty, family problems, crime and social division.
- The Australian governments have struggles with the challenge of the achieving a sustain reduction in unemployment. A variety of strategies have been used over the last three decades.
BODY
- Reducing unemployment in one of the most difficult task for the economy management. Unemployment has remained stubbornly high. In Australia, despite a range of government policies designed to attack the unemployment problem. Even after a decade that experienced the longest and strongest growth period on record, the unemployment rate in 2003 had not fallen below its level at the end of the pervious business cycle in 1989.
- The policies a government uses to reduce unemployment will depend upon what it sees as the main causes of the unemployment problem. ????(for instance) the government will stimulate a rate of economic growth that is sufficient absorb that unemployment and the growth in the labour force, while at the same time holding down the rate of inflation.
- ??
- in 1994 the Keating Government introduces Australia’s first comprehensive set of unemployment policies in half of the century, known as Working Nation Labour Market Policy these polices consisted of labour market assistance, apprenticeships and education and training programs. It was aim to help the long-term unemployment to acquire new job skills and become employable again.
- Late 1990s, the Howard Government reduced the fund for labour market programs. (They think the policy was ineffective and expensive and that most people returned to the rank of the unemployed after their training program) the policies shifted to broader labour market reform. They claimed that these restrictions prevent employers and employees implementing flexible workplace arrangements that maximise productivity.
- There is a multi-pronged policy approach low unemployment rate at stimulating aggregate demand, improving productivity, and providing low inflation, competitive and dynamic economy containing all preconditions for high long-term economic growth.
ü Effectiveness:. these policies unlikely to reduce the structural unemployment rate, it instead increases inflationary pressure because high economic growth induced by technological change can result in high structure unemployment
ü Fiscal policy: one of the macroeconomic policies which can influence resources allocation, redistribution income and reduce the fluctuation of the business cycle, by varying the amount of government spending and revenue, the government can alter the economic activity, which will influence the economic growth, inflation, unemployment and the external indicators in the economy.
ü The aim of this policy is to sustainable economic growth and unemployment rate in Australia by reducing public sector dissaving and our reliance on overseas borrowing.
ü The budget has moved into fiscal surplus since 1997 by a sustained fiscal consolidation policy of reduction in government outlay, therefore provided a higher economic growth and lower unemployment rate.
ü In 2000 the unemployment rate rises to 7 % which is higher than 1900s however as the curs this rising trend the government undergoes expansionary fiscal policy consequently with no new major employment initiatives in 2003’s budget, it will be expected that no further reduction in unemployment until mid 2004.
ü Monetary Policy: Is macroeconomic policy which involves action by the RBA , on behalf the government, to influence the cost and availability of money and credit in the economy. It is used to smooth the effects of fluctuation in the business cycle and influence the level of economic activity, output, employment and price.
ü Used as a long term policy aimed to keeping inflation low, providing an environment which is attractive for investment and employment growth.
ü Once the RBA believe there is a stable low inflation, which will have a greater range for reducing the interest rate in hance to lower the unemployment rate. If the RBA feels that the level of unemployment is approaching the natural rate, they will tighten monetary policy to prevent excessive spending feeding into higher prices and wages.
- Labour market reform is by using labour market programmes to improve the flexibility of the labour market to reduce structural unemployment. It can increase the labour productivity, control cost increases and improve flexibility in the supply of the labour market.
ü Labour market programmes are aimed to increase the ability of the unemployed to complete effectively in the labour market. Training programmes are one of the significant programmes which allowed the unemployed to be re-employed again and let the labour market to function more effectively and promote a better synergy between supply and demand.
3. Microeconomic reform: is the government improving the resource allocation between firms and industries, in order to maximise output and seeking to improve the efficiency and productivity of producer. A wide rang of microeconomic reform have been introduced to improve the competitive economic environment in Australia and increase the potential for higher productivity, employment and economic growth. Recent solid productivity growth in Australia economy has led to a stronger economic growth and a lower unemployment rate. There are three major microeconomic policies to reduce the unemployment rate. (industry reform, reduction in real wage, and taxation reform)
ü Industry reform: based on encouraging research and development and encouraging innovation in specific industry, this can boost their productivity and growth in that particular industry. By increase more understanding and experience therefore can improve the efficiency growth and job creation in hence to lower the unemployment rate.
ü Reduction in real wage: by reducing the real wages there will be a higher employment rate but it can also increase a high unemployment rate in certain industries and a lower real wage will increase young unemployment.
ü Taxation reform: introduced in July 2000 which is aimed at improving the investment climate in Australia therefore and a higher potential for economic growth and lower the unemployment rate.
Basic Principles of Financial management
Financial Management
Good financial planning cannot be underestimated. Many surveys have identified that around 74% of business closures were attributable to poor financial management. A good business will have a business plan that incorporates financial budget for projected sales, expenses, net profits, staff needs and capital acquisition (purchase of assets)
- The level of profitability in a business will have an impact on the liquidity of the business, and this must be continuously monitored. The amount of cash in the business daily and the credit available from bankers must be sufficient to allow the businesses to trade. The measure of business’s efficiency is the manner, in which it maintains its records promptly, collects its overdue receivables and maintains an inventory that turns over quickly.
- The ultimate measure of business success is the return on shareholder’s funds, often expressed as net profit divided by shareholders funds.
- Actual results should be reported against budgets at least monthly. This enables management to correct adverse trends . Corrections may include improved staff training, better cost control, improved purchasing from suppliers, and better marketing through advertising, etc.
- The importance of cash in a business and the speed with which it flows through the business accounts can be the difference between survival and failure. Cash is needed to pay bills. A business id deemed to be insolvent when it is unable to pay its debts as and when they arise. Bank lines of credit are very important to any business.
- The financial controls needed in s successful business are intended to minimise risk. Expense control should be firm and production costs should avoid wastage without compromising quality. Minimising risk is supplemented by insurance for fire, burglary, theft and loss of profits, etc.
- Many people enter business with little basic knowledge. Financial planning is about gaining knowledge in preparation for a course of action for any enterprise. It is important to know about financial reports such as budgets, cash flow, profit and loss statements and balance sheets. Record systems are the means of being able to check progress against past results.
- The planning cycle begins with a business looking at its present financial position. Then the managers prepare a business plan with objectives and budgets. Next are the implementation and control phrases. Planning is strategic or operational.
- Major participants in the financial market are:
- Investment/merchant banks
- Commercial banks – provide customers with a range of products including deposit and cheque accounts, credit/debit cards, personal loans and mortgages
- Money market dealers – buy and sell government securities on the secondary market, and offer cash or deposit facilities to major organisations.
- Finance companies – major providers of business finance, factoring, leasing and property financing
- Insurance/superannuation funds – involved in domestic and commercial mortgages, property developments, bonds, shares and government securities.
- Building societies/credit unions- make advances to customers for housing and personal loans, similar to banks.
- The reserve bank of Australia acts as banker for the government; implements monetary policy independently but in conjunction with the government of the day; monitors commercial banks; monitors foreign exchange rates; manages coin and note issues; and monitors economic data.
- Merchant/investment banks are major players in the short-term money markets, dealing with all money market instruments or securities such as commercial bills. They act as primary advisors to corporations seeking to issue shares or debentures/bonds. They also underwrite new share/debenture issues, and tender and deal in government securities.
- The Australian Stock Exchange Limited (ASX) has many customers, but the principle ones are investors, listed companies and stockbrokers , who are intermediaries (links) between them and the capital markets.
- Domestic market influences on our capital markets include where we are on the economic cycle; economic management policies of the Federal Government ; interest rate changes by the Reserve Bank; level of unemployment ; industrial stability; consumer demand; the level of investment in the economy; the innovation rate; and the level of inflation.
- Overseas market influences are affected by the world economic position. These effects flow into our capital markets. Interest rates, unemployment, government management, consumer demand, industrial stability and regional conflicts all affect our markets.
- Like most countries, Australia can point to certain indicators of financial health eg. Changes in inflation rates; the consumer price index; the rate of unemployment; the level of new investment; the increase/decrease in our overseas debt; rate of imports; stock market index; value of currency etc. All these indicators combine to identify trends in our financial markets.
- Internal funds are generated from monies furnished by the owners of the business. If a business is successful financially, the owners may decide to leave some or all of the profits from operations inside the business. These are known as retained profits. A large, old and well-established business may have several hundred million dollars in retained profit. A new small business may have little or no retained profits.
- When business owners decide to borrow , they must obtain the funds from external sources. Short term funding refers to borrowing likely to be repaid within one year. Long term funding refers to borrowing that will be repaid over a term as long as 10-20 years. Mortgages (loans secured by real property or business assets) and debentures (loans from the general public) are commonly used to meet long term funding needs. It is important not to confuse sources of funds (eg banks) with types of finance (overdraft, mortgages).
- Factoring allows businesses to obtain external funds by selling their accounts receivable. Factoring occurs when businesses allow credit in payment for merchandise. The factoring company charges the business a small fee and the business has the advantage of receiving an immediate credit in its bank account. As factoring has become a more common business practice, businesses specialising in factoring have been established in Australia.
- Borrowers need to take care that they will be able to repay the borrowed funds during the life of the intended business expenditure. For example, short term borrowing via on overdraft to fund and expected 90-day cash shortage is considered acceptable business practice. However, taking a long-term mortgage to fund the same expected 90-day cash shortage is generally not considered sound management.
- Philosophies vary about the right combination of debt and equity finance. If the business is unable to repay the debt, including principle, interest and associated charges, creditors may take control of the business. Too much debt financing can mean that all stakeholders are at risk.
- Gearing refers to the percentage of funding that is borrowed against an asset or the total assets of a business. The greater percentage of funding that is borrowed, the higher the gearing ratio. In most cases, a business is unwise to owe more than it owns.
- Both balance sheets and revenue statements are normally prepared at the end of the financial year. They are designed to answer two questions:
- Is the business profitable (from the revenue statement)
- What is the business’s financial position (from the balance sheet)
- The accounting equation (A=L+OE) , from the balance sheet is also expressed as (A–L=OE). For example of the assets of a business are sold for $100 000 and the owners repay all liabilities of $60 000, the remaining $40 000 is what the owner gets to keep – that is, the owners equity
- Current ratios range from 0.6:1 to 3.0:1, depending on how easily inventories and accounts receivable can be converted to cash, and how quickly cash flows in from a sale.
- The higher the debt to equity ratio, the higher the risk for creditors and owners. Solvency (gearing) ratios, like liquidity ratios can vary widely, from debt free to over 300%. A gearing ratio below 100% is usually considered safe or conservative.
- Generally the higher a businesses gross profit ratio, net profit ratio and return on owner’s equity ratio , the better for the business. Profitability ratios are typically starting points for evaluating businesses.
- Efficient managers work to lower expense ratios by monitoring and cutting costs wherever possible. Conversely, they seek to raise accounts receivable turnover ratio by establishing realistic credit policies and monitoring credit collections.
- Ratios allow analysts to compare a business with other similar businesses. Through ratios analysts can also examine the operations of any business over time, or compare a business with a benchmark .
- Both financial reporting and ratio analysis, however useful, have limitations. One business may legally use a different accounting method of its competitors. Another business may value its goodwill differently. The true value of assets may be understated on balance sheets because of historical cost accounting . Analysts need to be wary.
- The term working capital refers to an actual dollar amount. Most businesses need more current assets than current liabilities at all times. A key management responsibility is to ensure the business always has enough working capital to pay for the continuing operating costs incurred by the business.
- The relationship between current assets and current liabilities is often expressed as a ratio.
- A business’s current mix of payables, short-term loans and overdrafts is also largely controllable. Businesses that do not control the mix of their current assets are likely to experience liquidity problems – that is, they will not be able to pay current operating expenses. This commonly occurs when managers allow accounts receivable to become overdue.
- A business’s current liability mix of payables, short-term loans and overdrafts is also largely controllable, and is another important responsibility for managers. Normally, businesses that allow their current liabilities to become greater than their current assets are asking for trouble because creditors, such as telephone companies and suppliers, are likely to stop extending credit when accounts are not paid on time.
- A common management trend is for businesses to manage or improve their dollar amounts and their ratios of working capital by lessening assets or by selling assets and then leasing them back. Factoring is the management strategy of selling accounts receivable, at a discount, to a third party in order to convert accounts receivable to cash. Effective ways to improve the quality of working capital are to improve the collection of receivables, install just-in-time inventory controls, have sales of excess stock and install cost control programs.
- Regrettably many businesses do not recognise the importance of checking cash resource daily . This is vital knowledge to enable creditors, wages, loans and other expenses to be paid. Cash will be tied up in receivables, inventories, or in other investments the business has made. The bank overdraft , usually secured, is intended to be a fluctuating account according to the needs of the business.
- Cash flow statements are presented to management monthly. They show the opening cash flow balance from last month, the total cash received from all sources, receivables , cash sales, proceeds for asset sales, loans received etc and the total payments made out, such as expenses , new inventory and loan repayments. The balance at the end of the month should be within capability of the business bank overdraft. A good cash flow statement should also show the value of receivables, inventory and ideally the sales last month to give a trend.
- Businesses may sell goods for cash or on credit . Management should have policies for checking customer creditworthiness and effective methods of collecting accounts. Customers who do not pay on time will tie up the cash in a business and can jeopardise the success of a business
- Suppliers who value large orders often may offer a discount for bulk purchase or for earlier payment. Discounts can be very effective in lowering the costs of a business, provided the business can manage its cash well. Management can also buy goods on extended terms whereby a supplier has agreed to allow the purchaser to pay over a set period by certain instalments at fixed times.
- Management should have other strategies to ensure the available cash in their business is effectively used. They may sell off idle assets, watch for wastage, and consider factoring and leasing.
- Large companies have found that special cost centres enable different managers to overview how costs are progressing against budget. Production, marketing, administration, research and development may be cost centres. A small business usually has one cost centre. All businesses need to minimise expenses and ensure a senior person is controlling expenses. Costs are made up of two types.
- Fixed costs – such as monthly rent, insurance and leasing charges that do not vary with volume or sales
- Variable costs – vary with the volume of business
- Revenues may be controlled by varying the sales mix and the target markets. As effective pricing policy meets or beats competition, seeks a greater market share and sells surplus stocks.
- Unconscionable conduct usually falls into two major categories; those practices that are illegal , either deliberately or through ignorance, and those practices that may be unethical , through the use of unacceptable actions, generally dictated by the society in which we live.
- Ethics is a set of principles by which our actions are judged by others. It is about how we make decisions to do the right thing and involves honesty, fairness, caring and courage to make the right decision. Businesses can sometimes have dilemmas in deciding between the interests of shareholders , staff, customers, the environment and the wider community.
- Public companies come under more scrutiny as they involve the investment of other people’s money. All public companies must have recognised accounting firm appointed as auditors, who must complete a full investigation of the accounting records each year. The audit report to shareholders is included in each annual report.
- All businesses must follow certain reporting conventions. The Australian accounting profession has laid down minimum standards that must be followed in reporting financial results. The audit report gives a true and fair view of the company’s financial position
- The corporations Law sets out the minimum criteria all companies must meet. Directors may be personally liable for breaches, and heavy penalties can be imposed. Proprietary/private companies must also meet these standards. Certain types of illegal conduct include, bribery, misuse of funds in the business, directors acting against the interest of the company, failure to declare conflicts of interest and continuing to trade while insolvent.
- The Australian Securities and Investment Commission is empowered to administer the Corporation Law and to ensure that all businesses meet their statutory obligations. Such statutory obligations include the duty to act with reasonable care and diligence, to ensure the correct payment of taxes, to act honestly in the exercise of their powers, and to report changes of address or company directors.
- Unethical behaviour is unacceptable conduct. Excuses are often used and rejected as reasons. Certain types of conduct such as asset stripping, giving gifts for favours, illegally obtaining information through others, disposing of waste in the wrong manner and taking advantage of staff, are all unethical and in certain circumstances may be illegal.
Good financial planning cannot be underestimated. Many surveys have identified that around 74% of business closures were attributable to poor financial management. A good business will have a business plan that incorporates financial budget for projected sales, expenses, net profits, staff needs and capital acquisition (purchase of assets)
- The level of profitability in a business will have an impact on the liquidity of the business, and this must be continuously monitored. The amount of cash in the business daily and the credit available from bankers must be sufficient to allow the businesses to trade. The measure of business’s efficiency is the manner, in which it maintains its records promptly, collects its overdue receivables and maintains an inventory that turns over quickly.
- The ultimate measure of business success is the return on shareholder’s funds, often expressed as net profit divided by shareholders funds.
- Actual results should be reported against budgets at least monthly. This enables management to correct adverse trends . Corrections may include improved staff training, better cost control, improved purchasing from suppliers, and better marketing through advertising, etc.
- The importance of cash in a business and the speed with which it flows through the business accounts can be the difference between survival and failure. Cash is needed to pay bills. A business id deemed to be insolvent when it is unable to pay its debts as and when they arise. Bank lines of credit are very important to any business.
- The financial controls needed in s successful business are intended to minimise risk. Expense control should be firm and production costs should avoid wastage without compromising quality. Minimising risk is supplemented by insurance for fire, burglary, theft and loss of profits, etc.
- Many people enter business with little basic knowledge. Financial planning is about gaining knowledge in preparation for a course of action for any enterprise. It is important to know about financial reports such as budgets, cash flow, profit and loss statements and balance sheets. Record systems are the means of being able to check progress against past results.
- The planning cycle begins with a business looking at its present financial position. Then the managers prepare a business plan with objectives and budgets. Next are the implementation and control phrases. Planning is strategic or operational.
- Major participants in the financial market are:
- Investment/merchant banks
- Commercial banks – provide customers with a range of products including deposit and cheque accounts, credit/debit cards, personal loans and mortgages
- Money market dealers – buy and sell government securities on the secondary market, and offer cash or deposit facilities to major organisations.
- Finance companies – major providers of business finance, factoring, leasing and property financing
- Insurance/superannuation funds – involved in domestic and commercial mortgages, property developments, bonds, shares and government securities.
- Building societies/credit unions- make advances to customers for housing and personal loans, similar to banks.
- The reserve bank of Australia acts as banker for the government; implements monetary policy independently but in conjunction with the government of the day; monitors commercial banks; monitors foreign exchange rates; manages coin and note issues; and monitors economic data.
- Merchant/investment banks are major players in the short-term money markets, dealing with all money market instruments or securities such as commercial bills. They act as primary advisors to corporations seeking to issue shares or debentures/bonds. They also underwrite new share/debenture issues, and tender and deal in government securities.
- The Australian Stock Exchange Limited (ASX) has many customers, but the principle ones are investors, listed companies and stockbrokers , who are intermediaries (links) between them and the capital markets.
- Domestic market influences on our capital markets include where we are on the economic cycle; economic management policies of the Federal Government ; interest rate changes by the Reserve Bank; level of unemployment ; industrial stability; consumer demand; the level of investment in the economy; the innovation rate; and the level of inflation.
- Overseas market influences are affected by the world economic position. These effects flow into our capital markets. Interest rates, unemployment, government management, consumer demand, industrial stability and regional conflicts all affect our markets.
- Like most countries, Australia can point to certain indicators of financial health eg. Changes in inflation rates; the consumer price index; the rate of unemployment; the level of new investment; the increase/decrease in our overseas debt; rate of imports; stock market index; value of currency etc. All these indicators combine to identify trends in our financial markets.
- Internal funds are generated from monies furnished by the owners of the business. If a business is successful financially, the owners may decide to leave some or all of the profits from operations inside the business. These are known as retained profits. A large, old and well-established business may have several hundred million dollars in retained profit. A new small business may have little or no retained profits.
- When business owners decide to borrow , they must obtain the funds from external sources. Short term funding refers to borrowing likely to be repaid within one year. Long term funding refers to borrowing that will be repaid over a term as long as 10-20 years. Mortgages (loans secured by real property or business assets) and debentures (loans from the general public) are commonly used to meet long term funding needs. It is important not to confuse sources of funds (eg banks) with types of finance (overdraft, mortgages).
- Factoring allows businesses to obtain external funds by selling their accounts receivable. Factoring occurs when businesses allow credit in payment for merchandise. The factoring company charges the business a small fee and the business has the advantage of receiving an immediate credit in its bank account. As factoring has become a more common business practice, businesses specialising in factoring have been established in Australia.
- Borrowers need to take care that they will be able to repay the borrowed funds during the life of the intended business expenditure. For example, short term borrowing via on overdraft to fund and expected 90-day cash shortage is considered acceptable business practice. However, taking a long-term mortgage to fund the same expected 90-day cash shortage is generally not considered sound management.
- Philosophies vary about the right combination of debt and equity finance. If the business is unable to repay the debt, including principle, interest and associated charges, creditors may take control of the business. Too much debt financing can mean that all stakeholders are at risk.
- Gearing refers to the percentage of funding that is borrowed against an asset or the total assets of a business. The greater percentage of funding that is borrowed, the higher the gearing ratio. In most cases, a business is unwise to owe more than it owns.
- Both balance sheets and revenue statements are normally prepared at the end of the financial year. They are designed to answer two questions:
- Is the business profitable (from the revenue statement)
- What is the business’s financial position (from the balance sheet)
- The accounting equation (A=L+OE) , from the balance sheet is also expressed as (A–L=OE). For example of the assets of a business are sold for $100 000 and the owners repay all liabilities of $60 000, the remaining $40 000 is what the owner gets to keep – that is, the owners equity
- Current ratios range from 0.6:1 to 3.0:1, depending on how easily inventories and accounts receivable can be converted to cash, and how quickly cash flows in from a sale.
- The higher the debt to equity ratio, the higher the risk for creditors and owners. Solvency (gearing) ratios, like liquidity ratios can vary widely, from debt free to over 300%. A gearing ratio below 100% is usually considered safe or conservative.
- Generally the higher a businesses gross profit ratio, net profit ratio and return on owner’s equity ratio , the better for the business. Profitability ratios are typically starting points for evaluating businesses.
- Efficient managers work to lower expense ratios by monitoring and cutting costs wherever possible. Conversely, they seek to raise accounts receivable turnover ratio by establishing realistic credit policies and monitoring credit collections.
- Ratios allow analysts to compare a business with other similar businesses. Through ratios analysts can also examine the operations of any business over time, or compare a business with a benchmark .
- Both financial reporting and ratio analysis, however useful, have limitations. One business may legally use a different accounting method of its competitors. Another business may value its goodwill differently. The true value of assets may be understated on balance sheets because of historical cost accounting . Analysts need to be wary.
- The term working capital refers to an actual dollar amount. Most businesses need more current assets than current liabilities at all times. A key management responsibility is to ensure the business always has enough working capital to pay for the continuing operating costs incurred by the business.
- The relationship between current assets and current liabilities is often expressed as a ratio.
- A business’s current mix of payables, short-term loans and overdrafts is also largely controllable. Businesses that do not control the mix of their current assets are likely to experience liquidity problems – that is, they will not be able to pay current operating expenses. This commonly occurs when managers allow accounts receivable to become overdue.
- A business’s current liability mix of payables, short-term loans and overdrafts is also largely controllable, and is another important responsibility for managers. Normally, businesses that allow their current liabilities to become greater than their current assets are asking for trouble because creditors, such as telephone companies and suppliers, are likely to stop extending credit when accounts are not paid on time.
- A common management trend is for businesses to manage or improve their dollar amounts and their ratios of working capital by lessening assets or by selling assets and then leasing them back. Factoring is the management strategy of selling accounts receivable, at a discount, to a third party in order to convert accounts receivable to cash. Effective ways to improve the quality of working capital are to improve the collection of receivables, install just-in-time inventory controls, have sales of excess stock and install cost control programs.
- Regrettably many businesses do not recognise the importance of checking cash resource daily . This is vital knowledge to enable creditors, wages, loans and other expenses to be paid. Cash will be tied up in receivables, inventories, or in other investments the business has made. The bank overdraft , usually secured, is intended to be a fluctuating account according to the needs of the business.
- Cash flow statements are presented to management monthly. They show the opening cash flow balance from last month, the total cash received from all sources, receivables , cash sales, proceeds for asset sales, loans received etc and the total payments made out, such as expenses , new inventory and loan repayments. The balance at the end of the month should be within capability of the business bank overdraft. A good cash flow statement should also show the value of receivables, inventory and ideally the sales last month to give a trend.
- Businesses may sell goods for cash or on credit . Management should have policies for checking customer creditworthiness and effective methods of collecting accounts. Customers who do not pay on time will tie up the cash in a business and can jeopardise the success of a business
- Suppliers who value large orders often may offer a discount for bulk purchase or for earlier payment. Discounts can be very effective in lowering the costs of a business, provided the business can manage its cash well. Management can also buy goods on extended terms whereby a supplier has agreed to allow the purchaser to pay over a set period by certain instalments at fixed times.
- Management should have other strategies to ensure the available cash in their business is effectively used. They may sell off idle assets, watch for wastage, and consider factoring and leasing.
- Large companies have found that special cost centres enable different managers to overview how costs are progressing against budget. Production, marketing, administration, research and development may be cost centres. A small business usually has one cost centre. All businesses need to minimise expenses and ensure a senior person is controlling expenses. Costs are made up of two types.
- Fixed costs – such as monthly rent, insurance and leasing charges that do not vary with volume or sales
- Variable costs – vary with the volume of business
- Revenues may be controlled by varying the sales mix and the target markets. As effective pricing policy meets or beats competition, seeks a greater market share and sells surplus stocks.
- Unconscionable conduct usually falls into two major categories; those practices that are illegal , either deliberately or through ignorance, and those practices that may be unethical , through the use of unacceptable actions, generally dictated by the society in which we live.
- Ethics is a set of principles by which our actions are judged by others. It is about how we make decisions to do the right thing and involves honesty, fairness, caring and courage to make the right decision. Businesses can sometimes have dilemmas in deciding between the interests of shareholders , staff, customers, the environment and the wider community.
- Public companies come under more scrutiny as they involve the investment of other people’s money. All public companies must have recognised accounting firm appointed as auditors, who must complete a full investigation of the accounting records each year. The audit report to shareholders is included in each annual report.
- All businesses must follow certain reporting conventions. The Australian accounting profession has laid down minimum standards that must be followed in reporting financial results. The audit report gives a true and fair view of the company’s financial position
- The corporations Law sets out the minimum criteria all companies must meet. Directors may be personally liable for breaches, and heavy penalties can be imposed. Proprietary/private companies must also meet these standards. Certain types of illegal conduct include, bribery, misuse of funds in the business, directors acting against the interest of the company, failure to declare conflicts of interest and continuing to trade while insolvent.
- The Australian Securities and Investment Commission is empowered to administer the Corporation Law and to ensure that all businesses meet their statutory obligations. Such statutory obligations include the duty to act with reasonable care and diligence, to ensure the correct payment of taxes, to act honestly in the exercise of their powers, and to report changes of address or company directors.
- Unethical behaviour is unacceptable conduct. Excuses are often used and rejected as reasons. Certain types of conduct such as asset stripping, giving gifts for favours, illegally obtaining information through others, disposing of waste in the wrong manner and taking advantage of staff, are all unethical and in certain circumstances may be illegal.
Importance of Political Economy than NeoClassical Economics
Logical flaws in NeoClassical Economics
Issues of general equilibrium and disequilibrium
The neoclassical economics is basically based on methodological individualism. This school of thought of Economics has assumption that consumers are utility maximise under perfect information. In addition, they derive individual demand curves and add individual demand curves to get market demand curves. The same applies to the supply curves of firms in a competitive market. Then the demand and supply find prices and they allocate resources between different markets and arrive at equilibrium in goods, labor and money market simultaneously. In this school of economic thought, if markets to work without any hinderance they produce greatest efficiency and equity based on the assumptions of consumer behaviour and behaviour of firms at micro level achieves Pareto optimality in welfare and greatest efficiency at macro level.That is the marginalist and Neoclassical economics apparently give a coherent picture of the market economy which is the best of all worlds. However, they ignore many complex issues and aggregation issues at macro level to do get the outcome as explained above in theory. This neoclassical economics has many logical flaws and they ignore many factors which are important practical consideration in a real world economy which have diverse tastes, commodities, social interaction, conflict, institutional issues, gender issues as well class formatiion,
Classical Economics
Foundations of Economics or more appropriately the foundation of political economy were laid by "classical economists" in the wake of Industrial capitalism in Britain in the period of 17th and 18 century. Adam Smith's " Enquiry into Wealth of Nations" in 1776, si the first most comprehensive treatise on this subject. He considered that the key to wealth of nations is the broadening of market. He identified the basic force of the market economy is the self-interest of producers and consumers which also in the same time with the "invisible hand" increased public good. He also emphasized division of labour and specialization to increase the efficiency of the market system. He identified demand and supply as the basic market forces. He also developed to some extent the labor theory of value which is further developed by has successor Ricardo, in his book Principles of Political Economy and Taxation, 1817. Ricardo also formulated the law of comparative advantage and the market forces to international trade, which holds ground even today. He also formulated law of diminishing returns especially in relation to land. J.S. Mill formulated, who is the last among the last in classical economists, between production and distribution, where production must be guided by free market forces and distribution can have scope for intervention by non-market forces, in his " Principles of Political Economy, 1848".
As well, Thomas Malthus in his "Principles of Populations, 1798" identified the long-term race between agriculture and population growth. He observed, that the former grows by arithmetic proportion the latter grows by geometric proportions, which leads to an imbalance, which can only be resolved by pestilence, disease and famine. This theory is till relevent to some countries even today.
As well, they all believed that the economy will be always at equilibrium at very close to full-employment if government intervention is small but necessary for the efficient functioning of markets by laws and some essential services such as postal and security services and protection of basic freedoms. In addition, they developed the quantity theory of Money.They also identified classes and class formation.
However, Karl Marx in "Das Capital" was not confident of the free market system and he has predicted the collapse of the system. He identified, contradiction inherent to the free market system when it develops due to of exploitation and wages less than the value created by social labor and under consumption and the rate of profit falling down, creating crisis of the system . In his view, the labor theory of value is the regulator of the system and its dynamics and the demand and supply is the executor of the system.
Marginalism and Neo-Classical Economics
In 1870, and in later years the Neo-Classical economics emerged and neo-Classical economists developed precise economic laws of optimizing consumer at the margin given their preferences by maximizing the utility or calculating the cost and benefit of consumption at he margin of consuming goods and services spend by the last unit of money. In the same time, the firms produce, where small productivity is equal to wages, rate of interest is equal to the small efficiency of capital and rent is equal to small efficiency of land except for more productive land where there may super profit as identified by Ricardo. This law, optimizes the use of the factors of production. The level of production, is determined where marginal cost equals marginal revenue where profit is maximized. As well, demand and supply is always equal as there is tendency of equilibrium through the price mechanism. In addition, Pareto equilibrium states, that the free market produce best results. In effect, according to Neo-Classical economic point of view, competitive market equilibrium theory implies, that the role of government must be as small as possible. These laws, were further developed and refined by Alfred Marshall, of england, J.B. Say of France, Kunt Wicksell of Sweden, Irving Fisher and J.B Clark of USA.
As, well, in neoclassical economics, Mathematics is important to neo-classical Economists. For example, the economist William Stanley Jevons and Leon walrus used mathematical analysis as economics used quantitative measurements. In this way, Walrus pioneered " General Equilibrium Theory" using equations of all transactions in an economy. Mathematical approach to economics was given shape by P.A. Samuelson in his book of " Foundation of Economics, (1947). In addition, recently mathematic approach to economics in neo-Classical economics came into being by " Game Theory". It was first pioneered by John Van Newman, Oskar Margenstern and by John Nash in " The Theory of Games and economic behavior" in 1944. In 2005, it was further popularized, by a Nobel prize-winning economist Thomas Shelling. In the same time, technique of complex theory had an impact on economics using mathematical techniques.
However, one of the founder of Neo-Classical economics Alfred Marshall has been critical about mathematical techniques as a major way to ask the economic phenomenon. For example, he has observed in his principles, that 'Use of Mathematics as a short-term language and not an engine of inquiry". As well, John Maynard Keynes, trained as a Mathematician, has commented that purely mathematical approach to economic study is not right or not fruitful.
The flaws in the Foundation of Neo-Classical Economics
In Neo-Classical economics, is based on a concept called 'homo-economics'. That is, the person as an economic agent, whether the person is a consumer or a producer making choices is a faulty one. That is, people do not make choices independently their own choices, and their choices are influences by interpersonal relations, community values, media impacts as well by community and group values. In reality, people act in a social context, be seen in that way and not isolated people abstracted from the social world . Nobel prize economist Trygve Haavelelmo in his lecture " economics and Welfare 1989" has observed an individual embedded in a social world.
Another serious flaw in Neo-classical economics 'rational' choices made by a person in a self-interested way to maximize utility is extremely illogical. This is because, in reality people make spontaneous decisions, like impulse buying, thrill seeking, want to know the unknown, making decisions according to some religious or moral values especially in food consumptions and other consumptions, even though they need not be rational. In other words, in reality people make decisions, which are not motivated by self-interest alone and other influences which motivate them in consumption behaviour. They can also be motivated by ethical and moral values. In this sense, rational consumer behaviour as assumed by the Neo-Classical economics is extremely dubious and not based on empirical evidence or observation in day-to-day economic activity of any person.
In neo-classical economics, they base their ideal model to judge other market models. However, they rarely exist in any market economy. Most markets are far removed from the perfectly competitive markets. Some modern corporations are very huge and they exert power due to their money power as well their ability to manipulate consumers by the aid of advertisement, particularly in a reality where the information is asymmetrical and uncertainty is the norm and not exception. Corporations manipulate demand and not supply. A renowned economist J.K. Galbraith has observed this fact. In other words, even if consumers maximize utility, the utility is not controlled by the person but manipulated by the modern corporations in reality, perfect market conditions is a mere abstraction than concrete assumption based on empirical facts.
In marginalist economic analysis firms take decisions where marginal cost equals marginal revenue to optimize profit . However, in actual practice, the firms do not make decisions as marginalist suggest. They often make these decisions not based on marginalist economic analysis, but in response to technological breakthroughs as well as by compulsions of machinery. and capital equipment. As well, , there exist no constant coefficient of production and there is no perfect divisibility of goods or factors of production. If this is the case, even if markets are perfect, the economic efficiency and profit maximization is not the main goal of firms, or they cannot practice profit maximization based on marginalist analysis, they need not optimise the efficiency of the use of scarce resources.
In the text books, the market characterization is simple and they do not adequately cover brand and goodwill. They are important for any marketing people and marketing departments of any modern-day corporations. brands and goodwill are important considerations for modern business organizations than competitive markets alone as they do not compete with other firms solely o the basis of price alone. That is, some markets are not perfect markets and they are monopolistic markets and brand and goodwill are crucial factors competition than price.
In Neo-Classical general equilibrium model is static . They do not adequately consider uncertainty and dynamic processes in an economy. Input-output relationships is linear in their model. However, in reality they are normally non linear and they are chaotic . As well, they tend are a rule and not an exception.
In addition, the neo-Classical economic models overlook institutional set-up like legal system, educational set-up and cultural institutions, which are very difficult included due to the fact that these models are mathematically oriented and these are very difficult concepts to be incorporated.
In the neo-classical model, economic activity in non-market sectors like family, educational area, health area and government are heavily overlooked, even they are crucial in a given market economy or even any modern market economy. For example it has been estimated that the family economic activity accounts for at least 40% of GNP in Western economics.
Micro economics of the Neo-classical model to predict macro level economic forecasting is not impressive.
Conclusions
As discussed above, even neo-classical economics is the dominant school of thought in economics, by many economists for their narrow definition and there claim that their economics is scientific. it is obvious from the above discussion, it is clear it has many logical flaws as well it overlooks many issues of the real market system and how it works and its role in the issues of efficiency and fairness as well how it develops over time. If these issue are not addressed and broader definition of economics like political economy with other social sciences is not undertaken in future. Economics will be a dismal science and its usefulness to solve real world economic problems is questionable.
Thursday 15 September 2011
The Importance of Cost of Capital in Financial Management
The Importance of cost of capital in Financial Management
The concept of cost of capital is crucial in financial management. Like any other source of finance has a cost and cannot, therefore, be used in the most effective manner unless that cost can be accurately determined and taken into account.
There are many misconceptions about the cost of capital which must be carefully avoided. If, for example, a business has large amount of cash which it proposes to invest in a project, it might appear that the finance in this case is free of charge because no payment has to be made for its use to outside suppliers. It should be remembered, however, it does have an opportunity cost, ie the cost of foregoing which the cash might have earned in some other use even if this only be the placing of it on deposit at a bank.
Another cause of difficulty is the notion of the weighted average cost of capital. The fact that debenture is issued in order to raise the cash for a project does not mean that the cost of that debenture is the cost of capital for that project. Finance is not normally project-specific and must be regarded as being drawn from a common pool containing all sources in a desired mix. Many questions will require the calculation of weighted average cost of capital.
In this paper, I will try to illustrate the main variations on the theme of the cost of capital which are likely to be encountered and the main difficulties associated with these. They are:
The cost of individual components of capital, that is equity and debt.
The calculation of the weighted average cost of capital
The concept of marginal cost of capital
The implications of expected growth to the cost of equity.
It should be notices that other topics can creep unto question on the cost of capital. Examples are the calculation of the market prices of securities, ratios and investment appraisal.
Cost of individual components of cost of capital
To illustrate the implications of calculating individual components of cost of capital, I will use an example to explore the issues related to evaluate how debt affects the cost of capital and the concept of marginal cost of capital, to decide what form of finance best suite for a project.
Example:
Company X has the following balance sheet as follows:
000's
Share capital (1.00 per share) 5000
Reserves 2000
Trade creditors 3000
overdraft 1000
Total 11000
000's
Fixed assets 6000
Stock 3000
Debtors 2000
Total 11000
It intends to invest in a major project, which will increase earnings by 30%. The project will require the purchase of fixed assets totaling 2 million and stocks, debtors and creditors will increase by 25%.
At present the annual profits of the company are 2 million and dividends of 1.5 million are paid. Assume these figures are expected to to persist indefinitely ignoring the new project. The ordinary shares have a stock exchange value of 2.00 each.
The directors are considering alternative methods of raising the 2.5 million required for the project and have identified the following alternatives:
An issue of 2.5 million 15% debentures. This would have the effect of increasing to 25% the earnings yield required by the stock market on the ordinary shares of the company.
A rights issue on the basis of one new shares at par for each two shares already owned.
Say the directors want to calculate the cost of capital of the proposed debenture issue. As well, they want to calculate the value of the ordinary shares after making the proposed rights issue. Above all, they want to evaluate the relative merits of the proposed financing methods and any other alternatives to the proposed financing methods applicable for this project.
In order to address all issues relevant to this problem the directors must have a step by step method to address all the issues. My guide to this problem is as follows:
Step 1: calculate the marginal cost of capital in respect of the debenture issue.
In this example, this is complicated by the fact that the change in the capital structure has an effect on the cost of equity and that the calculation of the marginal cost of debenture issue must take into account.
Total cost of debenture issue:
Interest at 15% of 2.5 million 375000
Required increase in earnings
of equity 500000*
Total cost of Debenture issue 875000
*Current yield is earnings/ Value of equity = 2/10=20%
This has increased to 25%. That is it has to increase by 5% of 10 million. This is 500000.
There fore the actual marginal cost of debenture = 875000/2500000= 35%
Step 2: Calculate the probable value of the ordinary shares if the proposed rights issue is made.
In this instant, it can be presumed that the value or market value of the shares after rights issue is equal to the current market value of the existing shares plus the cash raised by the rights issue.
Value now is 5000000*2 10000000
Cash raised by rights issue 2500000
Value after rights issue 12500000
Number of shares after rights issue is 7500000
Value of each share = 12500000/7500000= 1.67
Step 3: Determine the rate of return offered by the major project under consideration.
Increase in earnings is 30% of 2 million. That is the expected earnings of the project is 600000.
Investment required
Fixed assets 2000000
stock 3000000
Debtors 2000000
Total 5000000
less creditors 3000000
Working capital 2000000
25% increase 500000
Total Investment 2500000
Yield = 600000/2500000=24% per year.
Step 4: Based on the above calculations, evaluate the merits of the proposed financing methods.
Step 1 shows that the marginal cost of debenture issue is 35% per year. If this form of finance is to be used the project is not worthwhile as it yields only 24%. This proposal therefore should be rejected.
The current cost of equity is 20%. It may be assumed that an increased yield is required only if gearing is introduced and that therefore the marginal cost of the rights issue is 20% per year. This same for the existing equity. This would make the proposal acceptable and this is the form of finance which should be used.
Step 5: Draw attention to alternative sources of finance.
The alternatives are:
Leasing of fixed assets. This is what is known as off balance sheet financing and means that the initial investment by the company is reduced to that required by the increase in working capital.
Consider Bank overdraft. The cash flow from the proposed project of 600000 would make it possible to pay back the initial investment of 2500000 in a little over four years. The bank may be willing to increase the overdraft facility for such a short time.
Retained profits. If dividends were curtailed and the project postponed for a period sufficient funds could be raised to finance the new project within a year or two.
The models used to calculate the expected return on equity and their advantages and disadvantages
The dividend growth model approach
The easiest way to estimate the expected cost of equity is to use the dividend growth model. Under this model it is assumed that the dividends will grow at a constant growth rate.
If the constant growth rate= g
The price per share = P0 then
P0 = D0* (1+g)/(Re -g) where D0 is the dividend paid now and Re is the rate of return on equity. That is Re = D1/P0 + g.
In this model to estimate Re one must know D0, P0 and g. For publicly traded shares D0 and P0 are readily observable. However g has to be estimated from past dividend data. The growth rate can be calculated on the basis of historical data or use the forecasts from different sources and average them because all the forecasts will vary considerably. It is obvious from this model that the accuracy of the Re depends on the accuracy of the dividend growth rate “g”. If the growth rate is not accurate then the expected return on equity also will be inaccurate more than the growth rate changes.
For example, suppose a company paid a dividend of 20 cents per share last year. The share is currently sell for 2.60. If one estimates dividend will grow steadily at 4 per cent per year into the indefinite period in the future. What is the expected return on equity?
In this example D0 = 0.2 there fore d1 = 0.20*(1+0.04) = 0.208
Using the dividend growth model Re = D1/P0 + g, Re = 0.206/2.60 + 0.04 = 0.12 or 12%.
That is, the expected return on equity or cost of equity is 12%.
In the above example, if say the growth rate is 2% instead of 4% what will be the effect on the expected rate of return? Applying the the model using 2% as growth rate the expected rate of return on equity is 0.0985 or 9.85%. That is the expected rate of return has changed by 2.15% if the the growth rate has changed by 2%. That is the expected rate of return on equity in the dividend growth model is very sensitive to the changes in the growth rate other things are being equal.
Advantages and disadvantages of the dividend growth model
The main advantage is the simplicity of the model. That is, it is easy to understand and easy to use. However, it has a number of practical problems in application and disadvantages.
First if companies do not pay dividends then the model is not applicable. Even they pay dividends this model assumes the dividends will grow at a constant rate. This is not the case for most of the companies. There fore, it is only applicable to companies where there is reasonable grounds to assume the dividends will grow steadily.
Secondly as demonstrated above the model is sensitive to changes to the growth in dividends. That is, if there is an error in the estimate of dividend growth rate the the expected return on equity will change more than the error in the estimate of dividend growth rate. As well, the dividends are estimated from past dividend records. The future dividends may considerably change because of future conditions may be quite different to the past.
Finally, the dividend growth model does not take in to account explicitly the riskiness of the investment like the Security Market Line approach. That is it does not take in to account the certainty or uncertainty of dividend growth rate. As a result, it is difficult to say the return on equity is commensurate with the level of risk. However, there is an implicit adjustment for risk using the current market price of shares. All other things being equal, the higher the risk lower the share price. Further, lower the risk higher the share price. However it has to assume all the other information is the same. This is not the case in reality.
The Security Market Line approach
According to Security Market approach expected return on a risky asset such as equity depends on three things. They are as follows:
Implementing the SML approach
To use one must estimate Rf the risk-free rate, market risk premium (Rm -Rf) and the beta co-efficient.
In a study it has been found the behavior of returns for shares and government bonds from 1882 to 1989 the risk premium over the period was 7.94%. Over the same period the risk free rate was found to be 5.21%. Studies in US, UK and Canada revealed the long-term premium to be around 7%. For large company shares from 1923 to 2003 it has been found that the risk premium in USA to be 8.6%, while for the 1901 to 2006 in Australia the risk premium was 7.6%. That is one can use 8% as risk premium and 5% as risk free rate in the SML model as an estimate. However, one must beware the SML model uses future reurns not past returns. The past returns can be used as future return assuming the economic conditions are not very different. If say for a company the beta of the shares is 0.875 then applying the risk-free rate of return and market premium rate the return on equity can be cal calculated as below:
Re = Rf + b*(Rm – Rf)
Re = 5% + 0.675*8% = 12%.
Advantages and disadvantages of SML approach in estimating the return on equity
The SML approach has two primary advantages. First, it explicitly adjust for risk. Second, it is applicable to companies other than with steady dividend growth. Thus it may be useful in a wide variety of circumstances.
There are disadvantages in SML approach. This approach is based on estimating the risk-free rate and the market risk premium and beta co-efficient. To the extent the estimates are poor, the resulting cost of equity will be inaccurate. For example using different time periods may estimate quite different risk premium and risk free rate. Finally, like the dividend growth model SML approach also uses historical data to estimate the inputs of the model even though the figures are for the future. That is the future is estimated on the past.
The future mat be quite different to the past and the estimation based on the past may not be relevant and it may be quite inaccurate. However, in a perfect world, the dividend and SML approach are both applicable and both result in similar answers. If this happens, one can have confidence in the estimation of the inputs in to these models. It advisable to compare the results of the calculation with other similar companies as a reality check.
The expected return on debt and preference shares
The expected return on debt
The cost of debt can be calculated using the coupon rate of say a debenture and using an approximate equation as follows:
Say the Interest = I, par value of debenture = PV, Net proceeds of issue = market price -cost = NP, number of years to maturity = n then expected return on debt “Rd' can be approximately expressed in the variables as mentioned above. The equation for the Rd is as follows:
Rd = [I + (PV – NP)/n] / (PV + NP)/2
If the rate of corporate tax is say = t%
Then the after tax expected return or the cost of debt = Rd* (1-t)
Say a company issued an eight year debenture at 7% interest on par vale of 100. Say it has been issued 2years ago.. The debenture is currently selling at 95.38. The expected after tax return calculation is as follows:
Rd = [7 + (100 – 95.38)/6] / (100 + 95.38)/2 = 7.95%
This rate of return for debentures is before tax. As tax is deductible for a company the interest cost the after tax return on debentures must be less by the tax percentage.
There fore, the Rd after tax = 7.95%* (1-0.30) = 5.565% approximately.
Expected return on preference shares
As preference shares have a fixed dividend rate, the value of preference shares is the perpetuity of the dividend amount discounted by the rate of dividend. That is, if the preference shares market price is “ P0” and the dividend amount is “D” then the the expected rate of return on preference shares “R p” can be expressed as follows:
R p = D/P0.
Say a company is trading preference shares in the stock exchange. Its current price is 2.11 and the par value of preference shares is 2. Its expected rate is 0.14/2.11. That is, the expected rate of return on preference shares is 6.64%.
The weighted average cost of capital(WACC)
Say the market value of debt = D
Market value of stock or shares = E
Then the total value V = D + E. therre fore the weights of equity is E/V and the weight of debt is D/V.
There fore like the portfolio average return, the weighted average cost of capital is as follows:
WACC(unadjusted) = E/V* Re + D/V*Rd.
If taxes are incorporated then the WACC equation will be as follows:
WACC = E/V*Re + D/V* Rd* (1- t), where t is the rate corporate tax.
Approximate and explicit after-tax expected return on debt
The equation above for the expected return on debt is an approximate equation, for the after tax expected return. The other concept is the approximate after-tax cost of debt and actual or explicit after-tax cost of debt or expected after-tax return on debt. In approximate after tax cost of debt one calculates the yield and then adjust for the tax on interest. However, in the explicit cost of debt calculation the tax is discounted and included in the original equation in one step.
If the current yield = Rd
Debt nominal interest rate = C
Par value = F
period to maturity = t
Current market price = P then
P = C* [1- 1/(1+ Rd)t ] /Rd + F/(1+Rd)t
Approximate after-tax cost of debt = Rd* ( 1- T) where T = corporate tax rate
If one wants to calculate the explicit cost of debt incorporating the tax effect in one step then the equation for explicit cost of debt is as follows:
Say the explicit after-tax cost of debt = R d(t)
Then market value P = C*(1-T)* [1 – 1/(1+R d(t))t ]/ R d(t) + F/(1+R d(t))t
say P = 94.75, C = 5, t= 3, F =100, T = 30%, then applying the approximate equation Rd or yield is as follows:
If one calculates the explicit cost incorporating the corporate tax in one step, then Explicit after-tax cost of debt for the above inputs is as follows:
Example - Calculation of WACC
Company A has 1.4 million shares outstanding. The share price of the company is currently is 20.00. The publicly quoted price of debt currently is 93 cents of par value. It has total book value of 5 million. The current yield is 11%. The risk-free rate is *5, and the market risk premium is 7%. The beta estimated for company A is 0.74. The corporate tax is 30%. Calculate the WACC of company A?
Solution
From using the SML model approach, cost of equity = 8% + 0.74* 7% = 13.18%. Total value of equity is equal to 1.4 million* 20 = 28 million. The pre- tax cost of debt is 11% as given. The market value of debt = 0.93* 5 million = 4.65 million. The total value = 2* + 4.65 = 32.65. The percentage of equity to total value = 28/32.65.= 0.8576. There fore debt to total value = 1-0.8576 = 0.142. There fore, the WACC for company A is as follows:
WACC = 0.8576* 13.18% + 0.1424*11% 8 (1-0.30) = 12.4%.
Divisional and project cost of capital
In a company the overall company risk may vary from that of divisional risks depending on the different risk profile of project they undertake compared to the overall risks of the company as whole. If projects are evaluated on the basis of the cost of capital compared with rate of return of individual projects of divisional performances, then based on the SML Line analysis, company may accept high risk projects, which tends to have higher returns as opposed to lower risk projects. This may lead to inaccurate project evaluation process and may cost the company and may loose shareholders wealth by investing in high risk projects.
That is, if projects are perceived to have high risk profile compared to ovral company activities then they must calculate divisional cost of capital compared with similar companies rather than using cost of capital for a company to evaluate the projects or divisional performances. In effect they must adjust the companies weighted average cost of capital so that it reflects the risk profile of those projects. In addition, if there exists financing cost to issue additional capital for a specific project, then this fact must be taken in to account in the weighted avarage cost of capital when evaluating competing projects before accepting or rejecting such projects.
Conclusion
As mentioned above the concept of cost of capital is an important concept in financial management as this can be used as a tool to compare different projects and to enable to use appropriate long -term finances and investing in projects which earns more than the risks involved in those projects. That is cost of capital acts as a bench mark if it is estimated properly and used wisely as discussed above. It is also essential to know the limitations of the models to estimate equity rate of return in particular and use appropriate models depending on the nature of their dividends, whether they are private or public companies and whether their operations differ substantially between different divisions. In addition, the cost of capital also is an important concept to be used in the proper capital structure of a company, particularly in real world cost of capital vary with different gearing ratios because of tax, cost of finances, risk of insolvency using debt and cost of bankruptcy.
The concept of cost of capital is crucial in financial management. Like any other source of finance has a cost and cannot, therefore, be used in the most effective manner unless that cost can be accurately determined and taken into account.
There are many misconceptions about the cost of capital which must be carefully avoided. If, for example, a business has large amount of cash which it proposes to invest in a project, it might appear that the finance in this case is free of charge because no payment has to be made for its use to outside suppliers. It should be remembered, however, it does have an opportunity cost, ie the cost of foregoing which the cash might have earned in some other use even if this only be the placing of it on deposit at a bank.
Another cause of difficulty is the notion of the weighted average cost of capital. The fact that debenture is issued in order to raise the cash for a project does not mean that the cost of that debenture is the cost of capital for that project. Finance is not normally project-specific and must be regarded as being drawn from a common pool containing all sources in a desired mix. Many questions will require the calculation of weighted average cost of capital.
In this paper, I will try to illustrate the main variations on the theme of the cost of capital which are likely to be encountered and the main difficulties associated with these. They are:
The cost of individual components of capital, that is equity and debt.
The calculation of the weighted average cost of capital
The concept of marginal cost of capital
The implications of expected growth to the cost of equity.
It should be notices that other topics can creep unto question on the cost of capital. Examples are the calculation of the market prices of securities, ratios and investment appraisal.
Cost of individual components of cost of capital
To illustrate the implications of calculating individual components of cost of capital, I will use an example to explore the issues related to evaluate how debt affects the cost of capital and the concept of marginal cost of capital, to decide what form of finance best suite for a project.
Example:
Company X has the following balance sheet as follows:
000's
Share capital (1.00 per share) 5000
Reserves 2000
Trade creditors 3000
overdraft 1000
Total 11000
000's
Fixed assets 6000
Stock 3000
Debtors 2000
Total 11000
It intends to invest in a major project, which will increase earnings by 30%. The project will require the purchase of fixed assets totaling 2 million and stocks, debtors and creditors will increase by 25%.
At present the annual profits of the company are 2 million and dividends of 1.5 million are paid. Assume these figures are expected to to persist indefinitely ignoring the new project. The ordinary shares have a stock exchange value of 2.00 each.
The directors are considering alternative methods of raising the 2.5 million required for the project and have identified the following alternatives:
An issue of 2.5 million 15% debentures. This would have the effect of increasing to 25% the earnings yield required by the stock market on the ordinary shares of the company.
A rights issue on the basis of one new shares at par for each two shares already owned.
Say the directors want to calculate the cost of capital of the proposed debenture issue. As well, they want to calculate the value of the ordinary shares after making the proposed rights issue. Above all, they want to evaluate the relative merits of the proposed financing methods and any other alternatives to the proposed financing methods applicable for this project.
In order to address all issues relevant to this problem the directors must have a step by step method to address all the issues. My guide to this problem is as follows:
Step 1: calculate the marginal cost of capital in respect of the debenture issue.
In this example, this is complicated by the fact that the change in the capital structure has an effect on the cost of equity and that the calculation of the marginal cost of debenture issue must take into account.
Total cost of debenture issue:
Interest at 15% of 2.5 million 375000
Required increase in earnings
of equity 500000*
Total cost of Debenture issue 875000
*Current yield is earnings/ Value of equity = 2/10=20%
This has increased to 25%. That is it has to increase by 5% of 10 million. This is 500000.
There fore the actual marginal cost of debenture = 875000/2500000= 35%
Step 2: Calculate the probable value of the ordinary shares if the proposed rights issue is made.
In this instant, it can be presumed that the value or market value of the shares after rights issue is equal to the current market value of the existing shares plus the cash raised by the rights issue.
Value now is 5000000*2 10000000
Cash raised by rights issue 2500000
Value after rights issue 12500000
Number of shares after rights issue is 7500000
Value of each share = 12500000/7500000= 1.67
Step 3: Determine the rate of return offered by the major project under consideration.
Increase in earnings is 30% of 2 million. That is the expected earnings of the project is 600000.
Investment required
Fixed assets 2000000
stock 3000000
Debtors 2000000
Total 5000000
less creditors 3000000
Working capital 2000000
25% increase 500000
Total Investment 2500000
Yield = 600000/2500000=24% per year.
Step 4: Based on the above calculations, evaluate the merits of the proposed financing methods.
Step 1 shows that the marginal cost of debenture issue is 35% per year. If this form of finance is to be used the project is not worthwhile as it yields only 24%. This proposal therefore should be rejected.
The current cost of equity is 20%. It may be assumed that an increased yield is required only if gearing is introduced and that therefore the marginal cost of the rights issue is 20% per year. This same for the existing equity. This would make the proposal acceptable and this is the form of finance which should be used.
Step 5: Draw attention to alternative sources of finance.
The alternatives are:
Leasing of fixed assets. This is what is known as off balance sheet financing and means that the initial investment by the company is reduced to that required by the increase in working capital.
Consider Bank overdraft. The cash flow from the proposed project of 600000 would make it possible to pay back the initial investment of 2500000 in a little over four years. The bank may be willing to increase the overdraft facility for such a short time.
Retained profits. If dividends were curtailed and the project postponed for a period sufficient funds could be raised to finance the new project within a year or two.
The models used to calculate the expected return on equity and their advantages and disadvantages
The dividend growth model approach
The easiest way to estimate the expected cost of equity is to use the dividend growth model. Under this model it is assumed that the dividends will grow at a constant growth rate.
If the constant growth rate= g
The price per share = P0 then
P0 = D0* (1+g)/(Re -g) where D0 is the dividend paid now and Re is the rate of return on equity. That is Re = D1/P0 + g.
In this model to estimate Re one must know D0, P0 and g. For publicly traded shares D0 and P0 are readily observable. However g has to be estimated from past dividend data. The growth rate can be calculated on the basis of historical data or use the forecasts from different sources and average them because all the forecasts will vary considerably. It is obvious from this model that the accuracy of the Re depends on the accuracy of the dividend growth rate “g”. If the growth rate is not accurate then the expected return on equity also will be inaccurate more than the growth rate changes.
For example, suppose a company paid a dividend of 20 cents per share last year. The share is currently sell for 2.60. If one estimates dividend will grow steadily at 4 per cent per year into the indefinite period in the future. What is the expected return on equity?
In this example D0 = 0.2 there fore d1 = 0.20*(1+0.04) = 0.208
Using the dividend growth model Re = D1/P0 + g, Re = 0.206/2.60 + 0.04 = 0.12 or 12%.
That is, the expected return on equity or cost of equity is 12%.
In the above example, if say the growth rate is 2% instead of 4% what will be the effect on the expected rate of return? Applying the the model using 2% as growth rate the expected rate of return on equity is 0.0985 or 9.85%. That is the expected rate of return has changed by 2.15% if the the growth rate has changed by 2%. That is the expected rate of return on equity in the dividend growth model is very sensitive to the changes in the growth rate other things are being equal.
Advantages and disadvantages of the dividend growth model
The main advantage is the simplicity of the model. That is, it is easy to understand and easy to use. However, it has a number of practical problems in application and disadvantages.
First if companies do not pay dividends then the model is not applicable. Even they pay dividends this model assumes the dividends will grow at a constant rate. This is not the case for most of the companies. There fore, it is only applicable to companies where there is reasonable grounds to assume the dividends will grow steadily.
Secondly as demonstrated above the model is sensitive to changes to the growth in dividends. That is, if there is an error in the estimate of dividend growth rate the the expected return on equity will change more than the error in the estimate of dividend growth rate. As well, the dividends are estimated from past dividend records. The future dividends may considerably change because of future conditions may be quite different to the past.
Finally, the dividend growth model does not take in to account explicitly the riskiness of the investment like the Security Market Line approach. That is it does not take in to account the certainty or uncertainty of dividend growth rate. As a result, it is difficult to say the return on equity is commensurate with the level of risk. However, there is an implicit adjustment for risk using the current market price of shares. All other things being equal, the higher the risk lower the share price. Further, lower the risk higher the share price. However it has to assume all the other information is the same. This is not the case in reality.
The Security Market Line approach
According to Security Market approach expected return on a risky asset such as equity depends on three things. They are as follows:
- The risk free rate “ r f “
- The market risk premium, “E(rm)- r f”.
- The systematic risk of the asset relative to average, which is the beta co-efficient, “b”.
Implementing the SML approach
To use one must estimate Rf the risk-free rate, market risk premium (Rm -Rf) and the beta co-efficient.
In a study it has been found the behavior of returns for shares and government bonds from 1882 to 1989 the risk premium over the period was 7.94%. Over the same period the risk free rate was found to be 5.21%. Studies in US, UK and Canada revealed the long-term premium to be around 7%. For large company shares from 1923 to 2003 it has been found that the risk premium in USA to be 8.6%, while for the 1901 to 2006 in Australia the risk premium was 7.6%. That is one can use 8% as risk premium and 5% as risk free rate in the SML model as an estimate. However, one must beware the SML model uses future reurns not past returns. The past returns can be used as future return assuming the economic conditions are not very different. If say for a company the beta of the shares is 0.875 then applying the risk-free rate of return and market premium rate the return on equity can be cal calculated as below:
Re = Rf + b*(Rm – Rf)
Re = 5% + 0.675*8% = 12%.
Advantages and disadvantages of SML approach in estimating the return on equity
The SML approach has two primary advantages. First, it explicitly adjust for risk. Second, it is applicable to companies other than with steady dividend growth. Thus it may be useful in a wide variety of circumstances.
There are disadvantages in SML approach. This approach is based on estimating the risk-free rate and the market risk premium and beta co-efficient. To the extent the estimates are poor, the resulting cost of equity will be inaccurate. For example using different time periods may estimate quite different risk premium and risk free rate. Finally, like the dividend growth model SML approach also uses historical data to estimate the inputs of the model even though the figures are for the future. That is the future is estimated on the past.
The future mat be quite different to the past and the estimation based on the past may not be relevant and it may be quite inaccurate. However, in a perfect world, the dividend and SML approach are both applicable and both result in similar answers. If this happens, one can have confidence in the estimation of the inputs in to these models. It advisable to compare the results of the calculation with other similar companies as a reality check.
The expected return on debt and preference shares
The expected return on debt
The cost of debt can be calculated using the coupon rate of say a debenture and using an approximate equation as follows:
Say the Interest = I, par value of debenture = PV, Net proceeds of issue = market price -cost = NP, number of years to maturity = n then expected return on debt “Rd' can be approximately expressed in the variables as mentioned above. The equation for the Rd is as follows:
Rd = [I + (PV – NP)/n] / (PV + NP)/2
If the rate of corporate tax is say = t%
Then the after tax expected return or the cost of debt = Rd* (1-t)
Say a company issued an eight year debenture at 7% interest on par vale of 100. Say it has been issued 2years ago.. The debenture is currently selling at 95.38. The expected after tax return calculation is as follows:
Rd = [7 + (100 – 95.38)/6] / (100 + 95.38)/2 = 7.95%
This rate of return for debentures is before tax. As tax is deductible for a company the interest cost the after tax return on debentures must be less by the tax percentage.
There fore, the Rd after tax = 7.95%* (1-0.30) = 5.565% approximately.
Expected return on preference shares
As preference shares have a fixed dividend rate, the value of preference shares is the perpetuity of the dividend amount discounted by the rate of dividend. That is, if the preference shares market price is “ P0” and the dividend amount is “D” then the the expected rate of return on preference shares “R p” can be expressed as follows:
R p = D/P0.
Say a company is trading preference shares in the stock exchange. Its current price is 2.11 and the par value of preference shares is 2. Its expected rate is 0.14/2.11. That is, the expected rate of return on preference shares is 6.64%.
The weighted average cost of capital(WACC)
Say the market value of debt = D
Market value of stock or shares = E
Then the total value V = D + E. therre fore the weights of equity is E/V and the weight of debt is D/V.
There fore like the portfolio average return, the weighted average cost of capital is as follows:
WACC(unadjusted) = E/V* Re + D/V*Rd.
If taxes are incorporated then the WACC equation will be as follows:
WACC = E/V*Re + D/V* Rd* (1- t), where t is the rate corporate tax.
Approximate and explicit after-tax expected return on debt
The equation above for the expected return on debt is an approximate equation, for the after tax expected return. The other concept is the approximate after-tax cost of debt and actual or explicit after-tax cost of debt or expected after-tax return on debt. In approximate after tax cost of debt one calculates the yield and then adjust for the tax on interest. However, in the explicit cost of debt calculation the tax is discounted and included in the original equation in one step.
If the current yield = Rd
Debt nominal interest rate = C
Par value = F
period to maturity = t
Current market price = P then
P = C* [1- 1/(1+ Rd)t ] /Rd + F/(1+Rd)t
Approximate after-tax cost of debt = Rd* ( 1- T) where T = corporate tax rate
If one wants to calculate the explicit cost of debt incorporating the tax effect in one step then the equation for explicit cost of debt is as follows:
Say the explicit after-tax cost of debt = R d(t)
Then market value P = C*(1-T)* [1 – 1/(1+R d(t))t ]/ R d(t) + F/(1+R d(t))t
say P = 94.75, C = 5, t= 3, F =100, T = 30%, then applying the approximate equation Rd or yield is as follows:
-
- = 5*[ 1- 1(1+ Rd)3] /Rd + 100/ (1+Rd)3
- = 5*[ 1- 1(1+ Rd)3] /Rd + 100/ (1+Rd)3
If one calculates the explicit cost incorporating the corporate tax in one step, then Explicit after-tax cost of debt for the above inputs is as follows:
-
- = 5*(1-0.30)*[1 -1/ (1+ R d(t)3] / R d(t) + 100/ (1+ R d(t) )3
- = 5*(1-0.30)*[1 -1/ (1+ R d(t)3] / R d(t) + 100/ (1+ R d(t) )3
Example - Calculation of WACC
Company A has 1.4 million shares outstanding. The share price of the company is currently is 20.00. The publicly quoted price of debt currently is 93 cents of par value. It has total book value of 5 million. The current yield is 11%. The risk-free rate is *5, and the market risk premium is 7%. The beta estimated for company A is 0.74. The corporate tax is 30%. Calculate the WACC of company A?
Solution
From using the SML model approach, cost of equity = 8% + 0.74* 7% = 13.18%. Total value of equity is equal to 1.4 million* 20 = 28 million. The pre- tax cost of debt is 11% as given. The market value of debt = 0.93* 5 million = 4.65 million. The total value = 2* + 4.65 = 32.65. The percentage of equity to total value = 28/32.65.= 0.8576. There fore debt to total value = 1-0.8576 = 0.142. There fore, the WACC for company A is as follows:
WACC = 0.8576* 13.18% + 0.1424*11% 8 (1-0.30) = 12.4%.
Divisional and project cost of capital
In a company the overall company risk may vary from that of divisional risks depending on the different risk profile of project they undertake compared to the overall risks of the company as whole. If projects are evaluated on the basis of the cost of capital compared with rate of return of individual projects of divisional performances, then based on the SML Line analysis, company may accept high risk projects, which tends to have higher returns as opposed to lower risk projects. This may lead to inaccurate project evaluation process and may cost the company and may loose shareholders wealth by investing in high risk projects.
That is, if projects are perceived to have high risk profile compared to ovral company activities then they must calculate divisional cost of capital compared with similar companies rather than using cost of capital for a company to evaluate the projects or divisional performances. In effect they must adjust the companies weighted average cost of capital so that it reflects the risk profile of those projects. In addition, if there exists financing cost to issue additional capital for a specific project, then this fact must be taken in to account in the weighted avarage cost of capital when evaluating competing projects before accepting or rejecting such projects.
Conclusion
As mentioned above the concept of cost of capital is an important concept in financial management as this can be used as a tool to compare different projects and to enable to use appropriate long -term finances and investing in projects which earns more than the risks involved in those projects. That is cost of capital acts as a bench mark if it is estimated properly and used wisely as discussed above. It is also essential to know the limitations of the models to estimate equity rate of return in particular and use appropriate models depending on the nature of their dividends, whether they are private or public companies and whether their operations differ substantially between different divisions. In addition, the cost of capital also is an important concept to be used in the proper capital structure of a company, particularly in real world cost of capital vary with different gearing ratios because of tax, cost of finances, risk of insolvency using debt and cost of bankruptcy.
Strategies of survival for an individual and small business in a recession
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Survival methods for an individual and small business organization
Jobs and investment opportunities
In a recession, other people lose their jobs than you. However, in a depression, you and others lose jobs. if a recession is anticipated, average consumer worries about how it negatively affect them and how they can cope with these negative effects. The following are some of the effects of recession and how to cope with them.Negative impact of recession on borrowing and credit availability and how to cope with it.
In a recession banks will be less reluctant to grant loans to people and businesses. This is now a problem due to the credit crisis as it affects availability of loans itself. To manage debts in these circumstances, one must not borrow excessively and must combine their existing debts in to lower interest rate bearing accounts.
Recession and its impact on interest rate and reduced mortgage repayments
In recession, the interest rate is most likely lower. This enables people and businesses to save on mortgage repayments. This gives some savings in a crucial time to cope against job losses, if that occurs.
Recession and its impact on unemployment and how to cope with unemployment
Recession is an economic condition, where the rate of unemployment increases to a high level compared to the level of unemployment at normal economic activity for a country. As the output is decreased, the demand for labor is also reduced and this created unemployment is some sectors worse than others. In other words, the impact of recession on employment is not the same for all sectors of an economy and unemployment is concentrated in some sectors. For example, the recession may affect finance and housing market than agriculture or manufacturing sector.
To cope with possible unemployment if you work in a sector where it affects your possibility of losing your job, think of alternatives, such as online work or online business opportunities. As well, if you think you may lose your job plan to take unemployment insurance, if you don't have it at the present moment in time. The future unemployment may occur or not occur, so don't worry too much about it. The best possible solution is, to look for other work opportunities and learn new skills, where there is a high demand for labor. For example, you may learn information technology skills or electronics where there is high demand for this type of labor in most industries.
Recession and its impact on falling profitability of business and how a small business can cope with it
If one is operating a small business recession may affect your business adversely because of falling rate of profit. It may also affect the survival of business if it is operating in a sector which is severely affected by it. To cope with such a situation, a small business can look for cutting costs which do not compromising the business. There is always waste in any business and this gives an opportunity to cut cost and improve efficiency. Some economists think that recession are good as it gives a business to increase the efficiency of business and benefits the economy as well as it can improve productivity of the economy. The small business also can consider whether it has possibilities to diversify if recession is affecting its rate of profit. For example, it can add some new lines of business which attracts frugal customers as recession affects consumers buying behaviour. In addition, the fall in profit is cyclical. As this is the case, plan to borrow at lower cost for the difficult years.
Recession and its impact on Stock Market and how to secure profitable investment in a recession
In a recession, normally there is a chance the stock market may cut in value due to falling profits and low dividends. If this is the case, look for diversifying the portfolio or invest in commodities like gold or other commodities which may do well even in a recession. In recession, the stock market reduces in value. It anticipates a recession and it may not fall in value during recession.
Recession and its impact on consumer confidence and how to cope with it
The worst impact of recession is its negative impact on consumer confidence as consumers become more uncertain about the future. However, do not depend on media to judge consumer confidence as they mostly exaggerate the situation by sensational news. To cope with this situation, be calm about it and make the best out of the situation. If you panic, you may end up worse than keeping a calm mind about consumer confidence.
Conclusion
As discussed above, if a person or small business can adopt these strategies they can cope with the negative consequences of recession and take advantage of the positive consequences of recession and can survive and cope well in recession as well they may become more competitive and can grow after the recession is over.
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