Why Caledonia Has to Adopt Free Cash Flows Approach and not Accounting Profit Approach - Math Problem Example

? Week 4 team paper Task Week 4 team paper Introduction Cash flows are the finances a corporation acquires from its daily sales and spends it in the operations of the business at that particular period. It is the liquidity position of the company and does not constitute for sales credit (Mulford & Comiskey, 2005). Moreover, it involves financial instruments such as inventory, which the corporation can easily convert into money. The cash flow statement can highlight the economic position of the firm and its solvency capacity within that financial period. Alternatively, the accounting profits refer to the gain or loss of the investment of the entrepreneur after the accumulative revenues are subtracted from the expenses (Profit ? = Revenues – Expenses). In addition, the net income is for the whole year (Wayman, 2010). For most corporations, revenues are realized when the money is earned but not received. This means some items can be sold on credit and recorded on the Income Statement as sales even if the money is not actually received. Why Caledonia has to adopt free Cash flows approach and not Accounting profit approach According to Mulford & Comiskey (2005), both the cash flow methods and accounting profits are methods that corporations use to assess their economic performance. However, the concepts of computing these two formulas are different and constitutes of different elements. Cash flows have several qualities that make it preferable than the accounting profits. First, cash flows consider the time value of transactions and money, which is important for the business. It considers the money value in a particular period has a different purchasing power than in a future period. Clearly, numerous economic conditions influence the fluctuation of prices and the accounting profits do not consider this. They assume the price remains constant for a particular economic period. For example, oil prices are affected by global factors such as depletion of oil wells, shortages or regulations, which cause the frequent alteration of the prices to meet the contemporary financial situations. In this instance, the cash flow approach will realize the inflows and expenditures of the new prices of the commodity according to the time of occurrence. Whereas the accounting profit model ignores this and uses the average price of the year in computing its revenues. Therefore, the corporation will be able to measure their liquidity situation more efficiently and thus this will help them in planning their operational functions better. Besides the cash flow model emphasizes real time payment unlike accounting profit is realized later ((Mulford & Comiskey, 2005)). If the corporation acquires finances directly after sales, they can use it when a great opportunity arises. They will not have to postpone their prospects since they have sold items on credit and do not have the actual money. Secondly, the accounting profit approach considers depreciation as an expense item and this is not an actual expense item (Mulford & Comiskey, 2005). Therefore, if the depreciation increases this will mean that the expenses will increase but this is not reflective of the true expense of the business. It is a non-cash amount that the corporation assumes it affects the profitability of the business. However, the cash flows ignore depreciation as cash expense since it does not have a monetary value. If Caledonia utilizes the cash flow approach, its profits will be higher and reflect the true cash position of the business, unlike a net profit figure which will be lower since it comprises of depreciation. Finally, the cash flow method is essential for capital budgeting which requires comparison of the benefits and costs (outflows) of the investment they are taking (Wayman, 2010). Since the cash flow method considers the cash values of the projects, it can be an appropriate basis to calculate the financial progress of the investment. Consequently, the accounting method disregards the cost at the time of initiation of the project. The accounting figures are not reflective of the real values of the actual profits at the time thus making the cash flow method the appropriate method for evaluating capital budgeting. Total revenues and Costs of year 1-5 Sales = Selling price * Units sold TVC = Variable Cost * Units sold Year 1 (300 * 70,000) = 21,000,000 (180 * 70,000) = 12,600,000 Year 2 (300 * 120,000) =36,000,000 (180 * 120,000) = 21,600,000 Year 3 (300 * 140,000) = 42,000,000 (180 * 140,000) = 25,200,000 Year 4 (300 * 80,000) = 24,000,000 (180 * 80,000) = 14,400,000 Year 5 (260 * 60,000) = 15,600,000 (180 * 60,000) = 10,800, 000 Depreciation for 5 years Cost of new plant and equipment: $ 7,900,000 Depreciation for each year = $ 7,900,000 = 1,580,000 5 yrs Calculation of Incremental Cash flows Year 1 2 3 4 5 $ ‘000’ $ ‘000’ $ ‘000’ $ ‘000’ $ ‘000’ Incremental revenues 0 15,000 6,000 (18,000) (8,400) Less: Incremental costs 0 (9,000) (3,600) +10,800 +3600 Less: Incremental Depreciation 0 (1,580) (1,580) (1,580) (1,580) Incremental EBIT 0 4420 820 (8780) (6380) Less: Tax (34%) 0 1502.8 278.8 2985.2 2169.2 Incremental EBIT after tax 0 2917.2 541.2 (5794.8) (4210.8) Add back Incremental Depreciation 0 1,580 1,580 1,580 1,580 Incremental Cash flows after Tax 0 4497.2 2121.2 (4214.8) (2630.8) Initial Outlay Initial outlay = {Cost of new plant and equipment +Shipping +installation costs} = $ (7,900,000 +100,000) =$ 8,000,000 Calculation of Cash flows Year 0 1 2 3 4 5 $ ‘000’ $ ‘000’ $ ‘000’ $ ‘000’ $ ‘000’ Sales revenue 21,000 36,000 42,000 24,000 15,600 Less: Variable Costs (12,600) (21,600) (25,200) (14,400) (10,800) Less: Fixed Costs (200) (200) (200) (200) (200) EBDIT 8,200 14,200 16,600 9,400 4,600 Less: Depreciation (1,580) (1,580) (1,580) (1,580) (1,580) EBIT 6,620 12,620 15,020 7,820 3,020 Operating Cash flow EBIT 6,620 12,620 15,020 7,820 3,020 Less: Tax (34%) (2250.8) (4290.8) (5106.8) (2658.8) (1026.8) Add Depreciation (1,580) (1,580) (1,580) (1,580) (1,580) Cash from Operating Cash flow 2,789.2 6,750 5,933.2 8,318.2 10,013.2 Net Cash flow Initial Working Capital 100 Net Working Capital Needs (10% of Sales) 2,100 3,600 4,200 2,400 1,560 Less: Liquidation of Working Capital 1,560 Change In Working Capital 100 2,000 1,500 600 (1800) (2,400) Calculation of Free Cash flow Operating Cash flow 33,803.8 2,789.2 6,750 5,933.2 8,318.2 10,013.2 Less: Change in Working Capital 100 2,000 1,500 600 (1800) (840) Less: Change in Capital spending 0 Free Cash flows 27063.8 789.2 5,250 5,333.2 6518.2 9173.2 Less: Initial Outlay (8000) NPV 19063.8 IRR = 36.57% Decision: The NPV of the project is upbeat therefore, Caledonia should accept it. Moreover the IRR is more than the cost of capital 15%, which means returns are more hence profitable. Internal Rate of Return The discount rate = 15% Year 1 2 3 4 5 Free cash flow 789.2 5,250 5,333.2 6518.2 9173.2 PVIF 0.8696 0.7561 0.6575 0.5718 0.4972 Present Values 16177.43 686.29 3969.53 3506.58 3727.11 4560.92 Less: Initial Outlay (8000) NPV 1 8177.43 Try discount rate of 25% Year 1 2 3 4 5 Free cash flow 789.2 5,250 5,333.2 6518.2 9173.2 PVIF 0.8000 0.6400 0.5120 0.4096 0.3277 Present Values 12386.07 631.6 3360 2730.6 2699.85 2994.26 Less: Initial Outlay (8000) NPV 2 4386.07 IRR (%) = Low rate + {NPV (low rate) –0__________ (high rate-low rate) NPV(low rate) –NPV (high rate) = 15% + + {_8177.43–0_____}_ (25% - 15%) {8177.43 –4386.07} IRR = 36.57% Factors to consider if Caledonia wants to Lease versus Buying The period of leasing is essential in establishing whether to undertake leasing or purchase of an asset (Mulford & Comiskey, 2005). In addition, the cost will also be vital in determining which option to undertake for Caledonia. Furthermore, the nature of the business venture can be crucial in establishing which model to undertake between leasing and buying. Caledonia should consider the useful life of the asset since this will give insight as to the benefit if that equipment to the business. If the equipment has a leasing value, which is substantial and near the purchase value of the asset, the firm should buy it (Mulford & Comiskey, 2005). If the duration of the project is similar to the assets’ useful life Caledonia should consider purchasing it or alternatively get a financial or operating lease. References Mulford, C. W., & Comiskey, E. E. (2005). Creative cash flow reporting: Uncovering sustainable financial performance. Hoboken, N.J: J. Wiley. Read More