Mini Case
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When we make financial decisions we should always look at the marginal or the incremental cash flow. The incremental cash flow to the company as a whole is the difference between the cash flows the company will produce both with and without the investment its thinking about making. The most fundamental principle of finance is that money has a “time” value, when simple translates to a dollar received today is more valuable than a dollar received one year from now. Because we can invest the dollar we have today to earn interest so that at the end of one year we will have more than one dollar. In every common decision any person makes we always anticipate an outcome. Every investor knows there are an unlimited number of investment alternatives to consider. But without exception, investors will not invest if they do not expect to receive a return on their investment. Most investors will look for a return that satisfies two requirements: [1] A return for delaying consumption, which is them simply looking for extra money to be paid to them in addition to their first investment, and [2] An additional return for taking on risk, which means that investors really dont like risk, therefore they want something in return for taking on such a risk. Thus, making risky investments less attractive– unless they offer the “prospect of higher returns”. Before investors make their investments they will browse various markets. To understand how the markets value or price their bonds and stocks they have to understand the concepts of an efficient market. Thus, an efficient market meaning “one where the prices of the assets traded in that market fully reflect all available information at any instant in time, in other words it is a market which the prices of securities, bonds and stocks, at any instant in time fully reflect all publicly available information about the securities and their actual public values. Many things we may run into throughout the investment world are conflicts of interest. Conflicts of interest will lead to what are referred by economists as an agency cost or “agency problem”. The agency problem results from the separation of management and the ownership of the firm. Thus, the principles of finance is cash flow to include a goal, a foundation and an outcome to it all. To interpret this evaluation we can look through this example:
Its been 2 months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at judging you understanding of the capital-budgeting process. THe memorandum you received outlining your assignment follows:
To: The Assistant Financial Analyst
From: Mr. V. Morrison, CEO, Caledonia Products
Re: Cash Flow Analysis and Capital Rationing
We are considering the introduction of a new product. Currently we are in the 34% marginal tax bracket with a 15% required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the new project: (See attached Excel Document.) Id.
Should Caledonia focus on cash flows or accounting profits in making its capital-budgeting decision? Should the company be interested in incremental cash flows, incremental profits, total cash free flows, or total profits?
The company should look solely into using the Cash Flows method over the accounting profits in marking its capital budgeting decision because we can analyze the timing of all the products and costs. This is more beneficial on an after tax base because that sort of cash flow is available to a shareholder. The type of cash flow that would be most beneficial to this company is incremental because they benefit from point of view of a company and it increases the value of the results in accepting projects. The incremental cash flow means the additional operating cash flow that an organization receives from taking on a new project (Wayman, 2010). A positive incremental cash flow means that the company flow will increase with the acceptance of the project (Wayman, 2010).
How does depreciation affect free cash flows?
Depreciation is considered an expense, so with a larger expense equals higher depreciation. It is understood that depreciation is not considered a cash flow because it affects the differential cash flows over a projects life only because it has an affect on taxes. For investment companies their stocks and bonds are their assets, therefore with depreciable assets, the original costs of an asset is allocated in the income statement over the assets