Critically Evalutate The Main Discount Cash Flow

Published Date: 02 Nov 2017

According to Michailetz, Artemenkov, & Artemenkov, (2007) There are three types of investment appraisals, Average rate of return (ARR), Net present value (NPV) and Payback period. Investment appraisals help the investors in an effective decision making process, because the investment decisions can impact the future welfare and success of the investor. Investment appraisals also determine the worth of the proposal, as if the appraisal is increasing the current wealth possibly it will increase the future wealth. If Investment appraisals determine the positive increment in the wealth of the investors and business, then the investors accept the proposal. Because the objective of the investment is to increase the wealth of the shareholders and add value to business in the future. Investment appraisals contain risk, and risk is the possibility of loss occurs. For example, An investor receives a proposal for purchasing a machine which will make its current factory production more efficient and effective. If the investment appraisals show positivity than the investor will purchase the machine as it will cut its cost. Efficient allocation of resources is the most important thing in running a business. Investments are important for any business to increase its wealth in the future, as if invested today will give returns in future. The profits of the organizations are derived from the utilization of resources and resources needs to be purchased by investing in them.

According to Brealey, Myers, & Allen, (2006) These investments remain invested for long durations till the organization can make better use of it. Investments not only add value to business, also adds safety. The basic thing which organization measure in the investment appraisals is the requirement of the finance and Payback period. The organization might not have sufficient cash or do not wish to invest equity in new projects, in this scenario, an organization needs to generate finance through debt financing on which it has to pay a certain amount as an interest or profit. The appraisal should be covering all types of cost and profit margin than the company will invest in the appraisal. Investment appraisal assesses the financial feasibility of the project which mainly use discounted cash flow (DCF). Investment techniques focus on cost and benefits in different time frames and by calculating net present value (NPV), the firm determines the additional value in the business entity. All investment appraisals are generally calculated by using discounted cash flows because the business will set up in the near future but the assessment is being done today, so the cash flow needs to be discounted to get the present value of all future cash flows. It is based on the opportunity cost of capital and the level of risk in the business.

The different approaches of DCF are mentioned below;

Cost of equity

According to Brealey, Myers, & Allen, (2006) The cost of equity derived from the capital asset pricing model (CAPM). It is the expected return which an investor wants on the amount of risk taken by following the concept of higher risk will lead to higher profits. The CAPM contains risk free risk which is determined by T-bills and Beta is the risk involve in the company.

The formula of CAPM is

CAPM = rf+ B (rm-rf) where rm is the market return.

Cost of debt

According to Brealey, Myers, & Allen, (2006) Cost of debt is the interest charge on the amount borrowed from banks or financial institutions. The interest rate depends on the credit ratings of the company, as if a company (e.g.: S&P AAA) can take loan on lower interest rates. Interest rates are tax deductible which somehow benefits the company.

Weighted average cost of capital approach (WACC):

According to Michailetz, Artemenkov, & Artemenkov, (2007) The most important thing is discounted cash flow is to determine the discount rate. The company needs a detailed analysis of financing structure and market condition to determine the discount rate. Weighted average cost of capital (WACC) is the rate which helps the firm to discount its future cash flows. WACC is calculated by weighting the firm sources of financing and multiplying them with their costs.

Q.2  DISCUSS THE RELATIVE IMPORTANCE OF PROFITABILITY AND LIQUIDITY FOR THE SURVIVAL OF A BUSINESS AND EXPLAIN HOW WORKING CAPITAL CAN BE MANAGED TO MINIMISE THE RISK OF LIQUIDITY PROBLEMS

According to Lazaridis & Tryfonidis, (2006) Business is an exchange process of commodities with an objective of profit. The profits of the company are in the shape of cash flows and it measures the success of the company. The firms profit depends on the number of units sold and the margin between the cost and selling price. Customers are the base and soul of any business, because they the objective of the firm is served through them. Customers want a high quality product on low price, for this company has to take steps towards high technology and produce in economies of scale to cut the cost and offer the product at a lower price to customers. It helps the company to get an advantage over competitors and capture more market share which leads to higher sales and returns. Profits are the main source of cash which a firm retains. If the profits of the firm are constantly going down, it means the wealth of the shareholder and the company is falling, and the risk involve in the company is getting high. The profits of the firms help the company to improve its liquidity and make its financial condition strong. Liquidity management is receiving serious attention from every single firm around the globe and the basic reason is inflation and critical condition of the world`s economy.

According to James, & Van, (2002) Liquidity help the organizations to pay off its current debt when its due. And the only way to make better financial conditions is to increase profits. If the company is not able to pay its debt on time, the debtor can take legal actions against the firm which is not good for the positive image of the organization. The borrower lends the money on collateral, if the firm does not pay its liability to the borrower can sell the collateral to adjust the loan amount. Liquidity management can be managed effectively and efficiently from working capital management because most of the components of working capital are used to analyze the liquidity of the company. Liquidity determines the cash in the hands of the company, which can be used for any critical situation arise to the firm. The liquidity management and its effect on the business profitability and risk are very important. The liquidity position of the company helps the investors to decide either to invest in the company or not. Strong liquidity position of the company also impacts on the cost of debt of the firm, as the short term borrowing has higher interest rate which lower the profits of the firm. For example, when the investor analyzes the firm, the first thing they look into the finances of the company is the liquidity position as the company can pay its debt when it's due or not.

According to Michailetz, Artemenkov, & Artemenkov, (2007) The best way to maintain the liquidity position of the company is through working capital management, which helps the company to perform its day to day operation by providing sufficient capital. If the liquidity position of the company is strong, it gives the investors confidence to invest in the company as the risk is lower when the has sufficient cash. For example, if the firm liquidity position is not strong, investors will not prefer to buy the company share, because of two reasons, one is company cannot pay its own debts, second the cost of debt must be high which will impact the profits negatively. Liquidity and cash management depend on the credit policy of the company, which includes the buying and selling of material. The firm should maintain a level in the collection days of credit sales and accounts payable days. The firm should reinvest the excess cash to generate more profits and give more benefits to its investors. Efficient and effective capital management help the firm to decrease the risk, as the firm cash inflow and outflow is maintained properly, according to the requirement of the company.

Q.3 DISCUSS THE VIEW THAT IT IS IMPOSSIBLE TO SATISFY THE NEEDS OF DIFFERENT USERS WITH A SINGLE SET OF PUBLISHED ACCOUNT.

According to Lazaridis & Tryfonidis, (2006) Accounting is the backbone of any organization and by financial statements it gives a picture of the financial position of the firm. There are standards and procedures set by the international accounting standards which every firm has to follow when they publish their accounts or financial statements. According to Michailetz, Artemenkov, & Artemenkov, (2007) Financial statements include profit and loss accounts, balance sheet and cash flow statement. Profit and loss account give the detailed analysis and transactions of the company`s sales and cost. It also determines the profit margin of the company and calculate net income which company receive by performing an economic activity. Profit and loss account gives the complete picture of the firms' cost.

According to James, & Van, (2002) Balance sheet defines the company`s financial position. Balance sheet contains three divisions which are assets, liabilities and owner`s equity. The balance sheet is the main division of the accounting, as it shows the assets, current liability and current assets through which investors can easily analyze the financial position of the company. The balance sheet also explains the actual worth of the company and shows the financial risk of the company. Cash flow statement shows all flow of cash inflow and outflow. It shows every transaction which company made during the cash cycle. The positive cash flow shows the ability to survive in the company and attracts the investors to invest in the company. Cash flow notes the fluctuation of money in the organization.

According to Bodie, Kane, & Marcus, (2008) There are two types of financial statement users, internal and external. Internal users are management which uses the information to make decisions and strategy. External users are the people who have a financial interest in the company. External users are further divided into different subcategories, direct and indirect users. Direct users are the investors, owners, and the borrower and lender. Indirect users are government organizations like tax department, customers and employees.

According to Lazaridis & Tryfonidis, (2006) The direct users of the financial statement are the investors and owners of the firm, as their decision making and analysis of the company can be done through it. Financial statements also explain the profitability and long term success of the company, which helps the owners to continue the business or wind up. The basic and most important user of the financial is the management, all decision makings and strategies design by the management is on the basis of financial statement. Management is responsible for the company`s day to day operations and it defines the effectiveness of the management. Lenders of the firm also check the ability of the company through accounting, as it can pay its debt when it gets mature.

According to Bodie, Kane, & Marcus, (2008) The suppliers of the material also analyze the position of the company by its liquidity position. For example, The suppliers sell their material on credit to the company, and the company pays them when it completes its cash cycle, if the financial position of the company is not stronger than it can stop its operations any time and gets defaulter. It will incur a loss to the supplier, so they need to assess the financial position of the company. Employees of the firms are interested in the profitability and stability of the firm. Their concern from the company finances is to check it can pay their salary and bonuses or not. Employees also wants the growth of the company and more business expansions which creates more opportunities for them. Government bodies like tax authorities also check the financial statements of the company for taxation and legal purposes. The government bodies interest to check the net income of the taxpayer, to calculate tax. The income statement shows the tax calculations from net income. General public can also use the finances of the company, like students for assignments, researches and other various reasons.