Return on Investment: Accounting Earnings versus Cash Flows - Assignment Example

December 7, Question In order to estimate Return on Investment (ROI), there are three kinds of approaches mainly used by the analysts. These three approaches are set out in the form comparative differences with respect to each other. The following discussion entails the significance of all three approaches: A. ACCOUNTING EARNINGS VERSUS CASH FLOWS One of the most fundamental approaches in understanding and analyzing the return on investments is to see whether ROI should be analyzed based on accounting earnings or cash flows. Accounting earnings are obtained from the income statements prepared in accordance with the applicable accounting standards and frameworks, whereas cash flows are determined as the cash inflows and outflows generated from a certain project. There are some major factors, which constitute the differences between the accounting earnings and cash flows, such as: 1. Operating and Capital Expenditures Operating expenditures are considered as those expenses, which are directly linked with the revenues such as direct material, direct labor, overheads etc. Conversely, capital expenditures are those expenditures, which are incurred by the firm in order to develop the business infrastructure, e.g. purchasing a building, land, equipment etc. Under accounting earnings, operating expenditures are included in arriving at the final net income figure. However, capital expenditures are spread over the useful lives of those assets and then systematically depreciated. Under cash flow estimations, both operating and capital expenditures are included in order to analyze the overall viability of the project. In short, the mainstream difference between the accounting earnings and cash flows is the exclusion of capital expenditures from the accounting earnings but its inclusion in cash flows. 2. Non-cash Expenses Another major difference between the accounting earnings and cash flows is the inclusion of non-cash expenses in the accounting earnings, which are discarded in the cash flow approach. However, these non-cash expenses are not included in the cash flow approach but they provide benefit in the form of tax savings. Accounting earnings are quite worsened due to the inclusion of these non-cash expenses such as depreciation and amortization as the net income reduces substantially. However, due to low taxable income, the amount of tax is reduced substantially, which is in fact cash based expenditure. Under cash flow approach, depreciation, amortization and other non-cash expenses are not included, but the tax savings due to such non-cash expenses are included which lead to better cash flows. In short, non-cash expenses in deriving accounting earnings but they are excluded in cash flow approach. However, tax benefits are included as cash inflow in cash flow based approach. 3. Accrual versus Cash conventions Accounting earnings are purely established because of the relevant accounting standards and frameworks, such as GAAP and IFRS. These standards require the firms to draft their financial statements by utilizing accrual basis of accounting. Accrual basis of accounting states that, expenditure should be recognized in the financial statements in the period in which it is incurred, not in the period in which it is paid. Similarly, revenue is recognized in the financial statements in the period in which it is earned, not in the period in which it is received. On the other hand, cash flow approach works on the principle of cash inflows and outflows in the periods in which they are received and paid. Therefore, the major difference between accounting earnings and cash flows is the accrual versus cash based conventions, which lead to material differences between the amounts of returns obtained under both approaches. B. INCREMENTAL VERSUS TOTAL CASH FLOWS In order to analyze the return on investment, another important way to analyze is to look whether the whole firm is benefitted from that piece of investment or not. Obviously, a firm is benefitted from the cash flows provided by that project but it is important to check the magnitude of benefit exclusively provided by that project. Total and incremental cash flows can be differentiated with each other mainly on two bases. Firstly, there is a possibility that a firm might have incurred some expenditure irrespective of the fact whether the firm accepts or rejects that particular project. These costs are normally considered as sunk cost. Research and development cost is the example of sunk cost which cannot be recovered and considered whether a project is accepted or rejected. Secondly, there are some expenditures, which have incurred by the firm elsewhere but their some portion is allocated to that particular project. These expenditures are known as allocated costs, e.g. marketing and selling expenses, which the firm generally incurs on the overall firm level. In short, the incremental cash flows are those cash flows which arise because of accepting that particular project otherwise they can be avoided in case of non-acceptance of the project. Sunk costs and allocated cost should not be considered while computing the incremental cash flows. C. NOMINAL VERSUS TIME-WEIGHTED (DISCOUNTED) CASH FLOWS Another important method of analyzing the return on investment is to consider whether cash flows arising over a specific tenure of time should be considered on their nominal values arising in that time or those cash flows should be adjusted to reflect time considerations. There can be no doubt in the notion that there is no comparison between the nominal cash flows and time-weighted cash flows. Nominal cash flows should not be preferred in evaluating the return on investment because of the three main reasons, which are highlighted as under: a. Present consumption is preferred by the individuals over the future consumption. People require more return if they have to make consumption in future. b. Nominal cash flows carry the impact of inflation with them due to which they cannot be compared with current values of cash flows. c. Nominal cash flows include the element of uncertainty, which makes the present cash flows incomparable with the present cash flows. On the basis of above three main reasons, cash flows should be time-weighted and this can be done by discounting the future cash flows with the appropriate discount factor, which is generally the cost of capital of the firm. On a concluding note, the return on investments should be analyzed on the basis of 1) cash flow approach, 2) incremental cash flow basis and, 3) time-weighted cash flow basis. These three methods collaboratively can lead to towards the most accurate evaluation of the return on investment, which cannot be established in case of considering other methods of analysis such as accounting returns, or total cash flows, or nominal cash flows. Question 2 The financing decisions taken by the firms have the deeper effects on the cash flows such that different factors play different roles, which become a hard task for the financial managers to cope with. Some of the factors play the role of opponent such that if the effect of one factor is reduced, it increases the impact of other factors. In this way, it becomes a dilemma to establish a proper mix of those factors. Firms raise finance with the mix of debt and equity. However, the choice and appropriate mix of debt and equity require careful considerations of the financial managers. The following discussion highlights those factors, which play a key role in determining the appropriate mix of debt and equity. The discussion also entails the relative advantages and disadvantages of these five factors suggested by Higgins in their individual capacity as well as in collaboration with each other. 1. TAX BENEFIT When determining the appropriate debt and equity mix, there are potential advantages of factors that pull the choice relevant choice of source of finance. Tax benefit is the advantage or factor that mainly emphasizes upon the inclusion of debt as the major part of the capital structure of the firm. The major argument provided by the supporters of tax benefits in this regard holds the view that debt financing actually increases the interest cost of the company. Interest cost is actually the return demanded by the creditors of the firm, which are actually the finance suppliers just like the owners. However, because interest cost is tax deductable, therefore, it decreases the tax liability of the firm. Assume that the firm is wholly equity financed, in that case there would be no amount of interest cost as a result net income or return earned by the owners i.e. suppliers of finance would be wholly taxable. For that case, the tax liability of the company would have increased substantially and a major portion of the net income would have gone to the taxation authorities rather than would have been supplied to the financiers of the firm even though they are creditors. In short, tax benefit is that factor which increases the payments to suppliers of finance rather than increasing the tax payments of the firms. In this way, tax benefits act as a shield to cover the residual net income after interest payments. 2. DISTRESS Distress is considered as the opposite view of tax benefits. The opponents of tax benefits mainly points out distress as the major factor due to which the firms should not go towards debt financing. Cost of distress actually increases as the level of debt financing increases and overweighs the tax benefits. There are mainly three types of cost distress, which are discussed as under: a. Cost of Bankruptcy The most obvious cost of distress is the cost of bankruptcy such that probability of going bankrupt increases as the level of debt financing increases. Due to increase in the level of debt financing, a firm finds it extremely hard to meet its financial obligations on time. With the continuous increase of debt in the capital structure, the firm itself closes down the its further financing sources as the equity investors are reluctant to provide finance to that firm which is already near to the risk of bankruptcy. Similarly, debt providers already have provided significant portion to the firm, therefore, they also do not wish to put their further money on stake. In this way, if the firm becomes unable to generate better cash flows from its operating activities, it becomes very difficult for it to make the time interest payments as well the repayment of the principal amount of loan. Even though bankruptcy is considered as the last breaths of the firms, however, at times it happens that the firms even after getting bankrupt bounced back and remained successful in avoiding the liquidation. In those cases, when the case of the bankruptcy is filed in courts, it takes too much time as well as cost of liquidation to make a complete wrap up of the firm. Except attorneys and judges, no other person has the idea as to when would this bankruptcy be completed. At times, it happens that the firm in the process of bankruptcy begins performing on good note and improves its operating performance. By considering this, the debt providers also reschedule the loans and in this way, the firm starts taking new lifeblood and thus avoiding liquidation. b. Indirect Costs Another strong argument presented by the opponents of debt financing is the increased level of indirect costs that arise due to increase cost of distress. As the firm keeps increasing its debt financing, the cost of distress also increases, due to which many other cost increases as a chain reaction. Chiefly, there are two types of indirect costs, which are internal and external costs. Internal cost associated with the cost of distress is the cutting of investments, reduction in research and development costs, decreased level of marketing and advertisement expenditures etc. With respect to the external costs associated with cost of distress are the lost sales because the customers feel the fear regarding the future aspects of the firm and raise their concerns on the quality of the products. Decreased level of external financing and credit facilities due to the decreased likelihood of paying the money back is also an external cost of distress. Reduced credit terms from the suppliers as suppliers become concerned regarding the long-terms commitments of the firm is another example of such indirect costs. In this way, the cost of distress is the serious factor when determining the optimal mix of capital structure of the firm. c. Conflict of Interest The major stakeholders of the firm i.e. owners, creditors and managers, all remain in a better and healthy position in the good times of the firm when they firm is on its way to prosper. However, in time of financial distress, all these stakeholders even refuse to recognize each other because all of them feel the fear of their interest leaving at stake. Owners have the concerns regarding their amount of money invested in the money of equity, which can be lost in case of liquidation of the company. Creditors have the danger of losing their money, which they have invested as debt financing. Managers become hopeless as their jobs can be evaporated if they did not protect the company from the probable liquidation. For that matter, all these stakeholders try not to compromise their stake and fight for their own rights. Because of this, the conflict of interest arises between these stakeholders which itself becomes a major cause of liquidation of a company. Generally, those firms, which remain successful in gelling their key stakeholders especially under such critical circumstances, also manage to win this battle against their survival foes. 3. FLEXIBILITY The above-discussed two factors i.e. tax benefits and cost of distress, are considered as the one –time long-term event of the company. However, in case if a company needs the financing today, what options does it have, this question is raised by flexibility factor. Flexibility is that factor which allows the firm to raise money from capital markets at any time whenever they need it. Mainly, it depends upon two factors which are 1) growth potential of the firm and, 2) its access to the capital markets. In an ideal situation, if a company has enough growth potential as well as having better access to capital markets, it can simply raise money by setting up new target capital structure. In case if debt level is on the lower side, it can compensate this by raising new debt financing. Conversely, if debt side is heavy, then there is a time for an equity issue. In either case, that firm does not face any difficulty in raising finance as it has the flexibility of both the options. However, for a firm which suffers in growth potential and has the limited access to the capital markets, then the options of debt and financing remains no longer flexible to it. 4. MARKET SIGNALING Another important factor that takes active part in deciding whether a firm should go for equity or debt is the consideration of the likely response to be reflected by the markets. Generally, when a firm intends to go for debt financing, the equity investors find themselves in a shaky position and the market value of equity starts declining as the investors start losing their confidence in the firm. Likewise, in case of further equity issues, markets also resist a bit in welcoming the further issuance of equity. Normally, it has been observed that the ex-right price of the shares decreases once the new issue comes in the equity markets. Overall, it can be concluded that whether it is an equity issue or debt issues, the markets feel hesitant to accept such new financing as the level of uncertainty increases with the upcoming opportunities in the minds of investors. In this way, they respond in such a passive manner which results in the declining share prices. 5. MANAGEMENT INCENTIVES Generally, in financing decisions, there is not too much say of the managers. However, under those cases where the managers are provided with some sort of autonomy and liberty, they start exploiting such opportunities in their favor by surpassing the organizational interest and preferring their personal interest. They want to keep the profits of the firm in the form of retained earnings rather than providing the benefits to the owners in the form of dividends. Conversely, in the time of financial distress when the firm exists solely on the support of creditors, these managers act as the servants of the creditors because the owners are deprived of their say. In case, if they do not fulfill the orders of the creditors, they will lose their jobs, or the firm will be liquidates which is also an end of the jobs of those managers. However, if they remain successful in taking out the firm from the financial distress, different fat bonuses wait for these managers. Question 3 Debt Preferred Stock Common Stock Market Value 1,500,000 250,000 1,250,000 Weight 50% 8% 42% Target Capital Structure 15% 10% 75% Rate of Return 8% 9% 10% Tax Rate 42%     After-tax Rd 4.64%           (15% x 4.64%) + (10% x 9%) + (75% x 10%)     WACC 9.10%           Years 0 1 2 3 4 Cash Flows (2,000,000) 400,000 600,000 700,000 900,000 Cumulative Cash Flows (2,000,000) (1,600,000) (1,000,000) (300,000) 600,000 WACC - Discount Factor (9.10%) 1.0000 0.9166 0.8401 0.7701 0.7058 Discounted CF (2,000,000) 366,636 504,083 539,043 635,248 Cumulative Discounted CF (2,000,000) (1,633,364) (1,129,281) (590,238) 45,011     NPV $45,011   IRR 10.00%   MIRR 9.71%   Profitability Index 1.02   Payback 3.33 years   Discounted Payback 3.93 years       h) The company should accept this project as NPV is positive and IRR is greater than the cost of capital. i) Equivalent cost method is the alternative method to compare projects of two different timeframes. This is not necessary to operate with the full physical life of the asset. In case if any other new asset is available which provides better cash flows, then old asset can be disposed off to invest in the new asset. Question 4 Source of Capital Cost % Range of New Financing a) Breaking Point Range of Total New Financing     Long-term debt 8% $0 - 300,000 $300,000 ? 0.25 = $1,200,000 $0 - $1,200,000   10% $300,001 and greater Greater than $1,200,000 Preferred Stock 14% $0 - 150,000 $150,000 ? 0.15 = $1,000,000 $0 - $1,000,000   16% $150,001 and greater Greater than $1,000,000 Common Stock 19% $0 - 225,000 $225,000 ? 0.60 = $375,000 $0 - $375,000   23% $225,001 and greater   Greater than $375,000     b) WACC will change at $375,000, $1,000,000, and $1,200,000.             c) Range of Total New Financing Source of Capital Target Proportion Cost % Weighted Cost $0 - $375,000 Debt 25% 8% 2.00%   Preferred 15% 14% 2.10%   Common 60% 19% 11.40%     WACC = 15.50%       $375,000 - $1,000,000 Debt 25% 8% 2.00%   Preferred 15% 14% 2.10%   Common 60% 23% 13.80%     WACC = 17.90%       $1,000,000 - $1,200,000 Debt 25% 8% 2.00%   Preferred 15% 16% 2.40%   Common 60% 23% 13.80%           WACC = 18.20% Greater than $1,200,000 Debt 25% 10% 2.50%   Preferred 15% 16% 2.40%   Common 60% 23% 13.80%     WACC = 18.70%           d) Investment Opportunity IRR % Initial Investment Cumulative Investment E 27 $300,000 $300,000 F 24 $125,000 $425,000 K 23 $275,000 $700,000 G 21 $100,000 $800,000 C 19 $250,000 $1,050,000 H 19 $75,000 $1,125,000 D 18 $275,000 $1,400,000 J 17 $25,000 $1,425,000 I 16 $125,000 $1,550,000 B 14 $125,000 $1,675,000 A 12 $25,000 $1,700,000 e) The firm should accept investment opportunities E, F, K, G, C, and H as their IRR is greater than WMCC in all these cases. Question 5 a) Initial Investment     Installed Cost of New Asset   Cost of new asset 125,000   Add: Installation costs 6,000   Total cost of new asset 131,000 Less: After-tax proceeds from sale of old asset   Proceeds from sale of old asset (78,000)   Add: Tax on sale of old asset 23,712   Total proceeds from sale of old asset (54,288) Add: Change in working capital 19,000 Initial investment 95,712       Book value of old asset   [1 - (0.22+0.35+0.17) x 72000 18,720 Gain on sale of asset   78000-18720 59,280 Capital Gain Tax   59280 x 40% 23,712 According to Higgins, it is necessary to include inflation in estimating cash flows in order to make the cash flows comparable over the life of project or assets. In case, if no inflation is incorporated, the cash flows will no longer remain comparable and will provide the cash flows in real terms. b) New Sprockinator Years Profit before Depreciation and Taxes Depreciation Net Profit before Taxes Taxes Net Profits after Taxes Operating Cash Inflows 1 44,000 28,820 15,180 6,072 9,108 37,928 2 44,000 45,850 (1,850) (740) (1,110) 44,740 3 44,000 22,270 21,730 8,692 13,038 35,308 4 44,000 19,650 24,350 9,740 14,610 34,260 5 44,000 7,860 36,140 14,456 21,684 29,544 6 44,000 3,930 40,070 16,028 24,042 27,972 7 - 2,620 (2,620) (1,048) (1,572) 1,048 Existing Sprockinator 1 32,000 10,800 21,200 8,480 12,720 23,520 2 30,000 4,320 25,680 10,272 15,408 19,728 3 28,000 2,160 25,840 10,336 15,504 17,664 4 26,000 1,440 24,560 9,824 14,736 16,176 5 24,000 - 24,000 9,600 14,400 14,400 6 22,000 - 22,000 8,800 13,200 13,200 7 - - - - - - Calculation of Incremental Cash Flows Year New Existing Incremental Operating Cash Flows 1 37,928 23,520 14,408 2 44,740 19,728 25,012 3 35,308 17,664 17,644 4 34,260 16,176 18,084 5 29,544 14,400 15,144 6 27,972 13,200 14,772 7 1,048 - 1,048 In determining cash flows, engineering study should be conducted because the engineers who have the technical knowhow of that asset or project can better identify the estimated cash flows that can arise from that project or asset. c) Terminal cash flow     After-tax proceeds from sale of new asset   Proceeds from sale of new asset 34,000   Less: Tax on sale of new asset (12,552)   Total proceeds from sale of new asset 21,448 Less: After-tax proceeds from sale of old asset   Proceeds from sale of old asset -   Tax on sale of old asset -   Total proceeds from sale of old asset - Add: Change in net working capital 19,000 Terminal cash flow 40,448       Book value of asset at the end of year 6 2,620 34000 - 2620 recaptured depreciation 31,380 31380 x 40% 12,552 According to Higgins, terminal value is computed in order to consider the impact of last year on the overall cash flows. In determining the relevant cash flows of for the final year of the project, the expected remaining benefits pertaining to a particular project in the form of terminal can be identified as estimated. d) Year 6 relevant cash flow:   Operating cash flow 14,772 Terminal Cash flow 40,448 Total inflow 55,220     Question 6 A. CASH FLOW VALUATION APPROACHES There are different kinds of cash flow valuation approaches used by the analysts as per their needs. However, following three approaches are vastly used in order to determine the cash flows of a firm. These are highlighted as under: 1. Discounted Cash Flow Valuation Discounted cash flow approach is that cash flow technique under which all the existing and upcoming cash flows associated with the firm are estimated over the indefinite life of the firm. Then those cash flows are discounted with the appropriate discount factor in order to estimate the present value of all cash flows, which is considered as the value of the firm. The cash flow valuation approach is not that simple and requires careful estimations of the projected cash flows as well as technical cash flows. There are two major concepts, which in combination provide the present value of all future cash flows, i.e. free cash flows and terminal values. The following discussion highlights both these concepts in more detail. a. Free Cash Flows Free cash flows are mainly estimated by the firm in order to determine the residual amount of cash left over for the providers of finance to the firm. There are two kinds of free cash flows, i.e. 1) free cash flow to the firm, and 2) free cash flow to equity. Free cash flow to the firm is estimated after incorporating all the necessary expenditures including working capital requirements and projected capital expenditures etc. Whatever the residual cash flow is available, it is for the owners and debt providers. Conversely, free cash flow to equity is estimated after taking into consideration all those effects, which are incorporated in determining free cash flows to firm. However, for valuing free cash flow to equity, there are two other effects are also taken into consideration, which are repayment of debt and interest payments for the projected life. After incorporating all those effects, the residual cash flow becomes available for the equity holders in the form of free cash flow to equity. b. Terminal Values Terminal values are used in determining those cash flows the projection of which is no longer possible for the firm to make after specific period. Firms can forecast their cash flow estimations for a limited period; however, the firm cannot estimate all the future cash flows individually for an indefinite life. For that reason, the concept of terminal value is advised by the analysts according to which the cash flows estimated in the last year of projection are compounded to the indefinite life. The compounding rate is determined as weighted average cost of capital minus the growth rate of the firm. In the end present value of all cash flows arising from the normal estimations as well as from the terminal values are computed in order to determine the free cash flows to firm and/or equity. 2. Comparison based Cash Flow Valuation Another important approach to value the firm is the comparison based approach such that different financial parameters of the firm. Those financial parameters of the firm are mainly in the form of comparable figures and ratios. Those ratios and figures can be compared with the overall industry figures as well as the competitors and own past performance of the firm. The more generally used ratios in this regard price/earnings multiple, debt to equity ratios, market value and book value based ratios etc. The firm can compare its performance and make the valuations such as market value of the firm, market value of equity, book value of firm, book value of equity etc. 3. Premium Control Valuation Premium control valuation is rarely used by the firms such that this kind of valuation is made for those companies, which are highly geared or indebted. The value of equity hardly represents more or less 10% of the overall firm value. In such case, the overall value of the firm is assessed through different techniques such as free cash flow to firm etc, and then market value of the debt is subtracted from the total market value of the firm in order to obtain the figure representing market value of equity. Since that market value of equity is very nominal as compared to market value of firm, therefore the market value of equity is considered as the premium for taking control of the firm. That premium can be sold to the acquirer of the business by the existing shareholders. B. BEST WAY OF VALUATION FOR ACQUISITION PURPOSE In case when a firm intends to acquire another firm, there are three main kinds of valuation models for such acquisition, which are discussed above. However, the best way to value a target firm is to identify and estimate the present value of all cash flows associated with that target firm. Mainly, there are three kinds of benefits available in acquiring a company such as tax shield, incentive effects, and control on free cash flows of that firm. a. Tax shield Tax shield is that benefit which arises because of having debt financing in the capital structure of the firm. Debt financing leads to increased level of interest payments, which are tax deductible. Therefore, the firm can substantially reduce its tax liability and make payments to suppliers of finance. In short, in case of a target company having appropriate level of debt financing can provide the tax saving advantage to the acquirer firm. b. Incentive effects Incentive effects are those effects, which a target firm brings other than tax benefits, which are mainly considered as a number game. c. Controlling free cash flows In the event of acquisition, the target firm brings some free cash flows, which also becomes the part of the acquirer firm thus increasing the value of the acquirer firm. References Higgins, Robert. Analysis for Financial Management. 6th ed. Virginia: University of Virginia, 2001. Print. Read More