My Sistah’s Closet
Running a small retail business is never easy. The competition can be intensive and, at times, cruel. At the same time, owning a retail business is a dream shared by thousands (Anonymous, 2007). What is needed is to thoroughly consider the existing market opportunities against the available and potentially available financial resources.
My Sistah’s Closet is a woman’s clothing store. It is a small business enterprise that sells the clothing items purchased in bulks from Macy’s Warehouses in different states. That the business is small does not mean it can do without professional finance. Actually, it is through wise and adequate financial management that My Sistah’s Closet can successfully operate in the competitive retail business environment. One of the biggest problems facing a small business owner is how to apply the concepts of NPV and the payback rule to make effective financial decisions.
At present, My Sistah’s Closet is looking for a new store location. Purchasing a new store is a serious long-term investment, and both NPV and the payback rule allow for the detailed analysis of the available investment options. The Payback method can be used to calculate the amount of time it will take the small business owner to “recoup” the investment. If it takes $150,000 to purchase a new store and the gained efficiencies are estimated at $12,500 annually (mainly as a result of rent savings and the capability to hire and locate additional sales staff), then the investment will start to work only by the end of the 12th year (150,000/12,500 = 12). However, the payback rule does not account for the changes in the value of money. 12 years for a payback period sound too long, but only the use of the NPV concept can guarantee that these conclusions are correct.
The NPV concept should be used to calculate the real value of the investment and the cash flow to pay it back; by using the two methods simultaneously, the owner of My Sistah’s Closet will have a more objective picture of the future investment and its potential returns. It is not uncommon for small retailers to apply to debt assets. However, debt financing has its advantages and drawbacks. According to Chandra (2011), debt interest is tax-deductible, which makes it a better alternative to equity and dividends. Debt assets do not dilute the voting structure of the small business because, unlike shareholders, debtors do not acquire any voting rights (Chandra, 2011).
Debt financing does not change the company’s structure, and its risks are lower than those of equity. Oftentimes, the terms of servicing the debt assets are nominal, thus securing the retail business owner from possible inflation risks (Chandra, 2011). Although debt may have a greater disciplining impact on the retail business, it is still risky, because the company may fail to meet its debt obligations for objective or subjective reasons (Chandra, 2011). Debt financing increases the cost of equity and limits the business’s oprational and financial capacities (Chandra, 2011). Therefore, a retail business as small as My Sistah’s Closet should think twice before applying to debt financing. Still, My Sistah’s Closet can leverage the needed financial resources by issuing either stocks or bonds.
The former option is better than the latter. In distinction from issuing bonds, which are also titled “debt finance”, issuing stocks is an example of equity financing (Mankiw, 2011). More often than not, large corporations and smaller businesses use a combination of debt and equity financing to leverage sufficient financial resources. This could also become an option for My Sistah’s Closet. However, the owner of the company’s bonds is its creditor, while the owner of its stock is also the company’s owner (Mankiw, 2011).
From the retail business’s perspective, stocks are preferable because they do not impose any additional obligations on the business owner. Stock owners simply get their share of profits, in case there are any. In difficult times, the company may not pay any dividends to its stock holders, while bonds require paying their owners, even when the company does not earn anything. To a large extent, stock ownership is associated with higher returns and higher risks, but it is the risk of the stock owner, not the company. With bonds, it is the company that assumes the entire responsibility for leveraging and paying back its debts.
It should be noted, that the relationship between financial risks and returns is positive and linear. Everything is simple: the higher the returns, the higher the risks are. Risk entails the possibility of unexpected events, such as market fluctuations or macroeconomic disturbances. The risk-return relationship is one of the most fundamental things My Sistah’s Closet needs to consider before it makes a serious investment decision. Bearing in mind individuals’ natural tendency for risk aversion, especially when the financial risks are high, the returns must also be adequate to compensate for possible losses. In the meantime, the company should regularly measure and monitor its debt ratios to be prepared for unexpected risks.
Debt to total assets and debt to total equity are the two ratios that can help My Sistah’s Closet estimate the amount of risk with regard to any particular debt investment idea. Whenever it comes to asset pricing, the concept of beta is one of its central elements. It is the concept, which measures the volatility of stock prices and its sensitivity to market changes (Antony & Jeevanand, 2007). Simply put, the concept of beta shows how the price of securities responds to various market forces. My Sistah’s Closet cannot measure and estimate its systematic risks without applying to beta (Antony & Jeevanand, 2007).
If the beta result of a stock is less than 1, it is not very sensitive to changes in the stock market; on the contrary, with a beta higher than 1, stocks will respond immediately and sensitively to any markeet fluctuations. My Sistah’s Closet may need to consider this measure, whenever an important investment decision is at stake. If the owner is looking for high returns, he(she) may choose the stocks with a beta more than 1. As a result, once the market goes up, the stocks will increase in value. If the owner is simply trying to minimize possible risks, it is better to choose the securities with a beta less than 1.
In case of a market decline, these investment targets will incur minimal losses. The small business cannot anticipate and prevent all risks, although the distinction between systematic and unsystematic risks needs to be considered. Systematic risks are those, which occur across more than one share and can be easily monitored (Smart & Megginson, 2008). Systematic risks may cover macroeconomic recessions and similar trends. By contrast, unsystematic risks are difficult to predict.
These risks impact a few stocks/ shares for a short period of time (Smart & Megginson, 2008). Unsystematic risks are sometimes called “idiosyncratic” or “firm-specific” (Smart & Megginson, 2008). For a firm that wants to avoid unsystematic risks, the only possible way to invest is through diversification. Investing $1 million is not a one-time effort. All risks and consequences of the investment decisions should be thoroughly reviewed. As mentioned previously, diversification is the only way to eliminate unsystematic risks; therefore, the systematic-unsystematic distinction is relevant here.
What should be considered is the beta value for each potential investment asset. The best decision will be to invest $1 million in the assets, whose beta is both above and below 1. Part of securities will have a higher beta level, thus presenting higher return opportunities but, at the same time, higher investment risks. Another share of securities will have a beta less than 1, thus providing better protection against market declines and losses. For instance, the firm may invest in electric utilities, whose beta is quite low, and financial services, whose beta is usually high. The exact nature of the investment plans will depend on the market conjuncture at the time the investment is made.
Conclusion The success of any small business heavily depends upon the quality of the financial decisions made by the owner. My Sistah’s Closet must be prepared to deal with tough market competition. Numerous factors need to be considered before an investment decision is made. Among others, the benefits and drawbacks of debt financing and the strengths and weaknesses of issuing stocks and bonds have to be taken into account. Diversification is the best way to reduce unsystematic risks, but even the best investment strategy cannot guarantee 100% success.
The nature of the final investment plan for My Sistah’s Closet should always depend on the market conjuncture at the time the investment is made.
