The Cash Flow Statement - Case Study Example

Butterflies Case Study Task Question 3 The cash flow and the profit ment The cash flow ment contains all the actual cash inflows and outflows during an operation, whereas, the profit statement contains cash inflows and outflows directly associated with the production and sales of goods and services in order to generate revenues. Therefore, some items might appear in one statement but not the other. To illustrate deeper, consider both the cash flow and the profit statement prepared for the Butterflies (excel file). First, the cash flow statement contains seven columns beginning from year zero (0) whereas, the profit statement has six (6) columns beginning in year one. In the cash flow statement, the year o contains cash outflows associated with the initial outlay (business start up) and the marketing research, which was conducted back in February (Nurnberg 1993). The initial outlay is £ 80,000 instead of £ 100,000 because, because £ 20,000 part of the £ 100,000 is the cost of kitchen equipment transferred out of the Child wall site. Therefore, there is no cash outflow associated with it being forming part of the capital. That is, it had already been bought and the outflow is part of the previous budget. Consequently, for the purpose of the business setup plan at Oakley, Mark and Lisa would need £ 80,000. In addition, £ 3000 for the market research is associated with the new project (to determine the suitability of the Butterflies restaurant at Oakley). Therefore, it is part of the initial outlay. On the other hand, the profit statement does not include either the cost of the startup or the cost of the market research. The reason is, the two cost items have no direct relationship with the production and selling of the foodstuffs in Butterflies restaurants (Nurnberg 1993). Second, the retirement bonus paid to Mr. Barnett is due at the end of one year. Therefore, the amount of £ 1,500 has been included in the cash flow to denote an outflow of cash. On the other hand, the retirement bonus is not included in the profit statement because it has no direct link to the revenue generation activities of the restaurant. Its omission increases the EBT to £ 32, 000 in the profit statement, compared to the net revenue of £ 30,500 in the cash flow statement. Third, payment of the tax expenses, as presented in the cash flow statement, is made in the succeeding financial period. For instance, year one income tax is paid in year two and so on (Nurnberg 1993). The arrangement is based on the guide “tax is paid in the year after the profit is made”. Therefore, since the actual cash outflow is to happen in the following year, the figures are matched to the period of occurrence. On the other hand, in the profit statement, the tax expenses are matched to the period of their accrual. That is, tax expense accrued in year one is recorded in that year, despite making the payment in the following year. Consequently, the tax records for year one and two in both the cash flow and the profit statement differ (Nurnberg 1993). Question 2 : Moth and Butterflies Moth is a similar restaurant to Butterflies. It has a beta of 1.15. The risk free rate is 6.2% and the return on the stock market is 13.7%. Using this set of information, it is possible to determine the required rate of return on Butterflies assuming it has the same beta as Moth. Given the three variables, that is, beta, risk free rate and return to the stock market, the capital asset pricing model is applicable. Note that the capital asset pricing model spells out the association between the risk and return on an investment. However, the following assumptions must be taken into account: first, Mark and Lisa towards are disinclined to risk. Second, Mark and Lisa are reasonable and base investment analysis of risk and return. Third, Mark and Lisa maximize the utility of end of period wealth. Fourth, Mark and Lisa among other investor have identical expectation regarding the return on investment. Fifth, there exists a risk free rate at which Mark and Lisa among other investors can borrow and lend. Sixth, the investment can easily be sold and can be owned in portions. Last, the capital market is ideal and well-organized (Treynor 1993). Considering the above assumptions, the following formula can be used to determine the required rate of return (the discount rate that butterflies should use to assess the viability of the project): Ri = RF + (RM - RF) ß where Ri is the required rate of return (discounting rate), Rf is the risk free rate, Rm is the expected return on the stock market and β is the beta. Therefore, substituting for the variables, Ri = 6.2 + (13.7 – 6.2) 1.15. Ri = 14.825 %. Consequently, Butterflies should use a discounting rate of 14.825 % (Treynor 1993). Question 3 : The NPV, IRR and Payback period analyses The calculations of the NPV, IRR and the payback period are in the excel file. Using the net cash flow as contained in the cash flow statement (excel file), the present values of the net cash flows from year one to six using a discounting rate of 14.83% are £ 26,562.45, £ 74,209.44, £ 49,463.96, £ 43,074.99, £ 37,517.41, and £ 32,671.38 respectively. Considering the time value of money, the net present value of the intended project is £ 180,499.6. Therefore, the value created for Butterflies by the project is £ 180,499.6. The analysis of the project using the net present value method concludes that the project has a positive NPV. Projects whose NPVs are positive are deemed viable, thus, should be pursued. The argument is based on the NPV rule of thumb regarding project selection, which states that any project whose net present value is positive should be pursued since it demonstrates the wealth and value creation potential. Second, the internal rate of return analysis of the project indicates a rate of 73.56% (DiGabriele 2006). The decision rule using the IRR states that a project whose IRR is greater or equal to the required rate of return should be accepted. Considering the project under consideration, the required rate of return as determined by the capital asset pricing model is 14.83% whereas, the projects IRR is 73.56. Therefore, IRR > RRR. Last, the projects payback period is approximately 1 year and 9 months, which is short enough to encourage the undertaking of a venture. Therefore, based on the three valuation methods, Mark and Lisa should set up another Butterflies restaurant at Oakley (Borissiouk & Peli 2001). Question 4: Sensitivity analysis The revenue streams of the project are based on the assumptions made by Lisa. Lisa has assumed the revenue of £ 500,000 and the cost of food to be 40% of the sales. In case the actual revenue falls lower that the expected figure, say, £ 430,000 and the costs of food 50%, the following will be the effect of the change on the cash flow and the profit statement (calculations in excel), assuming other variables are constant: first, in the cash flow analysis, the cash flows after tax have decreased leading to the reduction of the present values for the whole six years. In addition, the net present value of the project has been heavily affected. The figure has reduced from £ 180,499.6 to £ 1,270.33. Second, the profit statement has also been negatively affected. The revenue level has been reduced and the costs of sales increased, leading to a decrease in the earnings after tax. Therefore, the project’s revenue has shown a strong sensitivity to variation in the assumptions made by Lisa. Consequently, the project is risky (Jain, Grabner & Onukwugha 2011). Question 5: Critics of the valuation methods First, the net present value method is preferable because of the following: first, it takes into account the time value of money. Second, it conforms to the shareholders’ wealth maximization objective because a positive NPV has the effect of increasing the net worth of owners of equity. Last, it considers the entire cash inflows thus, provides a realistic valuation of a venture. However, the method is not without limitations. The following are the drawbacks of the method: first, the cost of finance is composed of both the implicit and the explicit. The net present value method ignores the implicit cost of finance (considers only the explicit costs). Second, the method is preferred under certain circumstances. That is, it disregards risk, thus is not appropriate under risky situations (Walter 1995). Second, the payback period is a project valuation method that involves the determination of the length of time taken to recover the capital invested in a project. Every investor has a preferred payback period. This method is appropriate for analyzing projects under high risks. In risky situation, a project with a shorter payback period is preferred. Considering the project being analyzed, the payback period has been determined to be 1 year and 9 months, which is fairly short. However, the drawbacks of the method are as follows: it does not take into account the concept of time value of money (Halicioglu & Karatas 2011). In addition, the method does not indicate the impact of a project on the shareholders’ value creation objective. Third, the internal rate of return is the rate of return at which the net present value of a project is zero. This method is suitable because it measures the potential of a project to create wealth for the shareholders. In addition, it considers the time value of money (Halicioglu & Karatas 2011). Other factors such as the book value of the restaurant should be considered. Book value is another method used to assess the value of an investment. This method involves the use of the par value of capital as indicated on the balance sheet. The value of a company, using this method, equals the value of assets as indicated on the balance sheet. The financial statements of a similar restaurant could be used to obtain the value of total assets (Walter 1995). Question 6: Theories of capital structure Mark and Lisa are conservatives, that is, there is no element of debt in the capital structure of the company. In order to assess the impact of the capital structure on the company’s value, references have been made to various theories of capital structures like the net income approach, Miller and Modigliani hypotheses and the traditional approach (Brendea 2011). First, the net income approach states that the value of a firm can be increased or the total cost of capital can be reduced when the proportion of debt in the capital structure is increased. The approach is based on two assumptions. First, the element of debt does not interfere with the investors’ sensitivity to risk. Second, the capitalization rate of debt is less than that of equity (Fosberg 2010). Therefore, when the cost of debt and equity are constant, an increase in the use of debt magnifies the earnings to shareholders thus increases the value of the firm (Fosberg 2010). Second, the traditional approach to capital structure assumes that there exists an optimal capital structure. The approach also holds that the company’s value can be increased through the use of debt. The approach states that the total cost of capital is bound to reduce with an increase in debt. Third, the net operating income approach states that the value of a company is dependent on the business risk, but is independent of the changes in the capital structure (Maßbaum & Sureth 2009). As has been witnessed, Mark and Lisa are conservatives. Therefore, the Butterflies Company has no element of debt in the capital structure. Based on the three theories of capital structures discussed above, the use of debt increases the value of a firm. Therefore, it can be concluded that the value of Butterflies business has been negatively affected due to the absence of debt in the capital structure. Based on the theories of capital structures, a third party can increase the company’s value by introducing debt in the capital structure (Brendea 2011). Question 7: Moth’s case Moth is partly funded by debt and has managed to grow faster than Butterflies. The use of debt, as discussed above, has both created more value and reduced the total cost of capital. First, the project valuation method such as the net present value discounts the future cash flows of a project. Cost of capital is used as a discounting factor. A higher cost of capital reduces the present value of the future cash flows, thus lowers the wealth creating capacity of an investment. A Similar argument applies to a company whose cost of capital is low (Omran & Pointon 2009). Second, a lower cost of capital creates more room to seek for more sources of funds. Third, a company whose value is high attracts more investors, thus increases the value of shares due to an increased demand for the shares. This increases the market value of the firm and the value of the shareholders’ equity. Therefore, Moth has been able to grow faster than Butterflies due to the mentioned advantages of increasing the value of the company (Groth & Anderson 1997). List of References Borissiouk, O. & Peli, J. 2001, "Real option approach to R&D project valuation: Case study at Serono International S.A", Financier, vol. 8, no. 1-4, pp. 7-71. Brendea, G. 2011, "CAPITAL STRUCTURE THEORIES: A CRITICAL APPROACH", Studia Universitatis Babes-Bolyai, vol. 56, no. 2, pp. 29-39. DiGabriele, J.A. 2006, "An Empirical Walk Down Valuation Way: Are the Valuation Methods of Closely Held Companies Chosen by the Courts a Function of the Type of Case and Level of Court?", Journal of Legal Economics, vol. 13, no. 3, pp. 39-64. Fosberg, R.H. 2010, "A Test Of The M&M Capital Structure Theories", Journal of Business & Economics Research, vol. 8, no. 4, pp. 23-28. Groth, J.C. & Anderson, R.C. 1997, "Capital structure: perspectives for managers", Management Decision, vol. 35, no. 7, pp. 552-561. Halicioglu, F. & Karatas, C. 2011, "ESTIMATION OF ECONOMIC DISCOUNTING RATE FOR PRACTICAL PROJECT APPRAISAL: THE CASE OF TURKEY", The Journal of Developing Areas, vol. 45, no. 1, pp. 155-166. Jain, R., Grabner, M. & Onukwugha, E. 2011, "Sensitivity Analysis in Cost-Effectiveness Studies", PharmacoEconomics, vol. 29, no. 4, pp. 297-314. Maßbaum, A. & Sureth, C. 2009, "Thin Capitalization Rules and Entrepreneurial Capital Structure Decisions", Business Research, vol. 2, no. 2, pp. 147-169. Nurnberg, H. 1993, "Inconsistencies and ambiguities in cash flow statements under FASB Statement No. 95", Accounting Horizons, vol. 7, no. 2, pp. 60. Omran, M.M. & Pointon, J. 2009, "Capital structure and firm characteristics: an empirical analysis from Egypt", Review of Accounting & Finance, vol. 8, no. 4, pp. 454-474. Treynor, J.L. 1993, "In defense of the CAPM", Financial Analysts Journal, vol. 49, no. 3, pp. 11. Walter, W.S. 1995, "Appraisal methods and regulatory takings: New directions for appraisers, judges, and economists", The Appraisal Journal, vol. 63, no. 3, pp. 331. Read More