MOdern finance theory & small business financial management

Part A

The modern business environment is characterized by a high level of competitiveness and as a result business organizations have to constantly reengineer their internal operations in to build and maintain a competitive edge . In to implement these initiatives for performance improvements , business organizations implement a variety of strategies for arranging financing . One of these strategies is the selling of securities in the capital markets . The capital market model is build upon a number of assumptions the most important of which has to do with the relationship between risk and

return . Investors expect greater return from securities that exhibit greater volatility in the market . In other words , if the market assessment of a particular security is that of high risk , then the organization offering the security to the market has to set a greater return in for it to be attractive to the potential investor . In this respect , the investor looks at two categories of risk : systematic risk and non-systematic risk (cited in Brigham Ehrhardt , 2007 . The investor is able to eliminate non-systematic risk by means of investing in a wide range of securities However the systematic part of the risk remains regardless of the nature of the security portfolio

There are two sources of financing : debt and equity . When a particular business organization is investing in the capital market , it is making use of equity as the source of financing . This form of financing results in loss of decision-making authority to some extent as the number of shareholders increases . However equity financing reduces the level of risk as the business owners are not obligated to make periodic interest payments in settling debt . However debt financing has its own advantages in the form of limiting decentralization of the decision making authority . Therefore the management in a business organization makes use of a combination of debt financing and equity financing in creating the financial structure of the company . In to get the best return on assets , this combination is recommended . However maximizing the return on assets requires managers to follow some assumptions in building their investment models . One of these assumptions as mentioned before is that risk and return are considered to be directly proportional . Therefore when the management of a business organization is seeking to invest in the capital market by releasing securities , it has to make a careful assessment of the level of risk inherent in the securities and conduct the valuation process accordingly . If the value of the security is too high , then the company will lose profits in the long run by having to maintain high price-to-earnings ratios and high dividend yields . The high rates in both respects will cut into the profitability of the company in the long run

In the perfect capital market , the level of information available to all parties concerned is considered to be equal (cited in Aaker , 2004 . As a result , no one single party is in a unique position to profit more than others . As a...