Question

Review the material in Chapter 2 on "Basic Ideas of Finance."

What are the purposes and uses of assets?

What is the main risk of buying or borrowing capital to invest in an asset?

What financial factors should you consider when deciding to borrow capital?

Answer 1

Asset is one of the most important resources for any company, It is controlled by the entity in expectation that it will generate future econimic benefit which can be increase in sales or decrease in cost or increase in efficency which utlimalety results into higher profits.

Borrowing which is also known as gearing will help organisation to earn higher profits when the ROI of the company is higher than the intrest rate however things changes quickly once the company get stuck in high tide, one of the best example would be covid period, during covid period the companies who was working with higher leverage has suffered the most for example Airline industry, as their ROI dropped below the intrest rate, things has become worst for them. The following are the main risk in borrowing capital for investment :  

• Higher losses — Investment value falls rapidly once the return worsens as you need to repay the loan and interest regardless of how your investment goes.
• Capital risk — The value of your investment can go down in order to service the loan If you have to sell the investment quickly it may not cover the loan balance.
• Interest rate risk — The interest rate and interest payments can increase in case of variable intrest rates.

The following financial factor you should consider before borrowing:

1. Servicability - Make sure that your business generate enough reveneus (after operation and adminstrative cost) that you would be able to service your loan without any default or adversely impacting you business.

2. Payment tranches - Make sure you are comparing the same repayment, loan term, and loan amount, rather than just comparing interest rates. As a general rule og Thumb, higher loan amount attracts higher interest due to higher risk for Lenders.

3. Understand the terms - Different types of lenders tend to use different fee structures, so it is critical that you understand exactly how much you need to repay and when. lenders might hit you with additional fees such as early exit fees or hefty fees on transferring loan to other lender or processing charges for changing interest rates (Obviosly lower), the message is that you should understand the full loan terms along with its conditions before signing on the dotted line.

4. Explore all the options - Make sure you explore all the options to get cheaper financing, such as rates comparison, loan on collaterel or using past relationship to get better interest rates