Cash Flow and Profit Flow Statement - Coursework Example

Corporate Finance) (Name of the student) (Name of the professor) (Name of the institution) Table of Contents Table of Contents 2 Executive Summary 3 1.0 Cash flow and profit flow statement 3 2.0 Discuss what discount rate should Butterflies should use in assessing the project, taking into account the information provided to you 4 3.0 NPV, IRR and Payback 5 4.0 Sensitivity Analysis 6 5.0 Discussion of sensitivity analysis 7 6.0 Market structure theories 8 6.1 Irrelevancy theory of Modigliani &Miller 8 6.2 Trade off theory 9 6.3 Static trade off theory 9 7: Debt Capital 10 8.0 Conclusion 10 Reference 11 Executive Summary This paper discusses investment analysis of the case of cafeteria business. It highlighted the difference between cash flow statement and profit statement though in this case from year two it gives the same profit and cash flow figures which is not always the case. The paper further discussed the ideal discounting rate that can be used for the business which was found to be at 8%. NPB, IRR and payback period was calculated for the business and both proved that the project was viable to invest in giving IRR to be 32.8%. They were also used to carryout sensitivity analysis of the project. The paper discussed the various market structure theories and concludes that the business can be run without capital debt and its value will still be high in the market. Lastly, debt capital is useful for business operation but the cost should be factored in before its borrowing. 1.0 Cash flow and profit flow statement a. Prepare a cash flow forecast for the appropriate period showing the relevant investment and operating cash flows, showing the net flows in each year Cash flow as from beginning is (£103,000) followed by £ 44500 then from year 2 business received £ 56,350 annually. On profit flow, year one is a loss of £ 44500 while from year 2 business receives £ 56,350 annually c. Explain clearly any differences between the cash flow and profit forecast and why any numbers included in one forecast are not included in the other, and why you choose to include the numbers that you do A profit forecast is a process of a testing the assumptions that exists in the trading activities of a business whether they will be profitable and sustainable in the long term. It gives the owners of the business and other stakeholders to evaluate the business viability and to determine whether he or she should continue supporting it or not (Dittmar, 2004). From the excel, the profit for the first year is (£44,500) indicating a loss from the company while in proceeding years from year two to year six the profit flow is £ 56,350 annually. On the other hand, cash flow forecasts helps in identifying the timing of cash movements in and out of the business. This is important in identifying the funding that is required for enterprise to deliver the profit forecast. Cash flow forecast takes into account the initial starting capital and also identifies some of the future cash requirements to cope with shortfalls resulting from seasonal fluctuations (Atkeson, & Cole, 2005). From excel, the cash flow from the beginning to be (£103,000) while year one is (£44,500). From subsequent years the business received cash flow of£ 56,350 annually. Some of the factors or items that cause difference between cash flow forecast and profit forecast include: Timing differences between the two items are different, valuation of VAT and, capital expenditure treatment, how loans are accounted for, how investments are treated and how corporate tax are treated bring the difference in figures. In the above scenario, cost of disposing the business is added in year six in the cash flow forecast while was omitted in the profit flow forecast bring the difference in figures and also tax in the profit flow started in the second year and not first year since the timing of tax in cash flow differs from that of profit forecast. 2.0 Discuss what discount rate should Butterflies should use in assessing the project, taking into account the information provided to you Discounting cash flows to realize Net present value (NPV) is having some hurdles. However it has one merit that makes all the results directly comparable and transparent on the methodology used to get it. The problem with discount rate is when different tenders offer different discounting rate. As investment risks relates with time the discount rate choice is even more problematic is such cases as PFI projects carry with them a higher perceived risk during the construction phase than operating phase (Dittmar, 2004). The discounting rate used to evaluate a project should be in a position to reflect the following: The cost of the capital which is quite unique to the business concerned, most of businesses have an expectation that their investment will be greater in the future (Dittmar, 2004). The discounting rate should be also in a position to reflect the risk of the project to the business. Lastly, the opportunity cost of the capital that is the money received now can be put to work to earn a return so that in a year’s time it can accumulate in the value (Atkeson, & Cole, 2005). From excel, discounting rate of 8% gives maximum outcome from the investment hence is the preferred discounting rate. The yield of the bond will be 9.2% at the maturity date. 3.0 NPV, IRR and Payback Calculate the NPV, IRR and payback periods for the proposed expansion at Oakley. How much value is created for Butterflies by opting to develop the new restaurant? Discuss what the 3 Investment Appraisal techniques tell you A net present value (NPV) of an income statement is the total sum of the individual present value of income stream. Each and every income stream is discounted, meaning that it is divided by the number of representing opportunity cost of holding capital at this moment. The word net in the present value shows that all the calculation includes the initial cost of the project and the subsequent profits that follows. If the cost of capital is 13.7% as per the market value, then the annual income of the new project would be $126,438 (Atkeson, & Cole, 2005). Internal rate of return shows the return of the original money that the business has invested in the project being undertaken. It also shows that cash flows occur in early years and cash inflow in latter years in the project life. For any standard project NPV>0 if and only if IRR> cost of capital IRR rule chose the project if and only if IRR> cost of capital. The pay back periods 32.8% > 13.5% shows the time frame under which a project will return its initial capital outlay. In this project, the payback period is 5 years and 0.62 months (Brennan, & Schwartz, 1984), 4.0 Sensitivity Analysis Mark is very concerned that the assumptions that Lisa has made might not be correct; in particular he notes that Lisa assumes that revenues will be “about £500,000”, and food costs will be “about 40%”. Carry out analysis to help them understand how sensitive the decision on whether to launch a new restaurant is to these assumptions The techniques used in carrying out the project feasibility includes Accounting rate of return, Profitability index, Net resent value, Internal rate of return and Pay back period. All these techniques have disadvantages and advantages. However, when all are combined, they give right direction concerning project feasibility. They are as follows NPV £ 85,171.36 PI 3.48% ARR 1.73 173% Payback period 3 years IRR 32.8% 5.0 Discussion of sensitivity analysis From the two assumption of constant profit of $500,000 annually is unrealistic since the business varies from year to year with the nature of the business that cannot be realistic. With cost of sales at only 40%, this shows that gross profit of the business is at 60%. From the net present value perspective, a net present value (NPV) of an income statement is the total sum of the individual present value of income stream. Each and every income stream is discounted, meaning that it is divided by the number of representing opportunity cost of holding capital at this moment. The word net in the present value shows that all the calculation includes the initial cost of the project and the subsequent profits that follows. If the cost of capital is 16% as per the market value, then the annual income of the new project would be $85,171. Since the NPV is greater than zero, the estimates are viable as it is for the NPV decision rule (Baker, & Wurgler, 2002). For Internal rate of Return, IRR shows the return of the original money that the business has invested in the project being undertaken. It also shows that cash flows occur in early years and cash inflow in latter years in the project life. In our case, the IRR is 32.7%; the cost of capital is 16%. Therefore, IRR>Cost of capital, the decision rule states that chose the project if and only if IRR> cost of capital 32.8% >13.7%. Hence the cost of sales and annual return is viable project return. Average accounting return also known as accounting rate of return is another accounting method used for the purpose of comparison with other capital budgeting calculation like NPV and IRR. It gives quick estimates of a project’s worth over its useful life period. From the analysis, the ARR is 173% indicating that the profits can double the initial capital 1.73 times. One of the problems with ARR is that it uses operating profit and not cash flows in which some project have high maintenance and up keep costs which tends to bring down profit level. However this is covered by NPV and IRR therefore this capital and budgeting appraisal techniques fully answered the question on the project feasibility fully. They cover both the time value of money and other economic factors in calculating the feasibility of the project (Baker, & Wurgler, 2002) 6.0 Market structure theories 6.1 Irrelevancy theory of Modigliani &Miller Modigliani &Miller way of analyzing capital theory which was proposed in the year 1950 advocates capital structure irrelevancy theory. The theories suggest that the valuation of a firm is quite irrelevant to the capital structure of a company. The theory believes that if a firm is highly leveraged or has lower debt component, it has no bearing on its market value. Nevertheless, the theory believes that the value of the firm depends on the operating profit of the company. Capital structure can be defined as the method through which a firm uses to finance its assets. Most firms can either decide to finance its assets either through debt or equity or the combination of these two sources. The proposer of the theory argues that the firm capital structure can have majority of debt component or majority of equity or the mix of the two (Atkeson, & Cole, 2005). Capital structure irrelevancy theory advocated by Modigliani and Miller suggest that the valuation of a firm is quite irrelevant to the capital structure which the company takes, whether the firm is highly leveraged or has lower debt component in the financing mix, it does not count towards its market value and it is irrelevant (Alti, 2003). Therefore, using this theory, the capital structure which Mark and Lisa have chosen is inconsequential towards valuation of the market of their business (Atkeson, & Cole, 2005). 6.2 Trade off theory Many authors have used trade of theory to discuss several theories concerning capital structure. Among all these theories, a decision maker running a company evaluates the various costs and benefits of getting alternative leverage plans. In most cases, this theory assumes internal solution for the problem so that marginal cost and marginal benefits are balanced off. This theory originates from the Modigliani and Miller theorem of irrelevancy. In this theory, when the income corporate tax was added to the original irrelevance, this developed a benefit for the debt in that it served to shield earnings fro taxes (Akerlof, 1970). Due to the fact that the company objective is linear, and there is no offsetting cost of debt, it simply implies 100% financing. The theory though indicates several cost that are contained with debt borrowing, it concluded that debt financing improves the firm’s market value (Atkeson, & Cole, 2005). 6.3 Static trade off theory The theory affirms that companies have optimal capital structure which they can easily determine through trading off the costs against the benefits of the use of debt and equity (Atkeson, & Cole, 2005). One of the quoted benefits of the use of the debt is the tax shield, while the demerits of debt financing the cost the debt is coming with and the aftermath effect, more so when the firm relies too much on debt. Incorporating agency costs into the static trade off theory means that a firm determines its capital structure by trading of the tax merit against the agency cost of equity. Other theories supporting static trade off include dynamic trade off theory among other theories (Akerlof, 1970). Therefore the choice of capital structure depends on the individual firm managers and does not to a large extend determines a firms market value. 7: Debt Capital In order for a company to operate more efficiently, it needs financial capital. The amount of the equity and debt capital that sums up as company capital has several risks. This makes it prudent for the company management to properly decide and determine the firm’s capital structure. Financial leverages have value due to the interest tax shield that is afforded to it more so by the U.K corporate income tax law. This in itself can enable the company to grow faster as a result of the interest tax shield given to it (Fama, & French, 2002). The use of company financial leverage has value when the assets that are purchased with the debt capital earn more than the cost of the debt that it was acquired for to finance. In both circumstances, the use of financial leverage increases the company profits hence the growth justifying the arguments of the growth of Moths Company. In circumstances when the company does not have sufficient taxable income to shield, or their operating profits are under critical value, financial leverage will reduce the equity value hence reducing the companies’ value (Fama, & French, 2002). 8.0 Conclusion Since the company leverages varies with the industry, in the food industry, the leverage is high hence the need for shield. The debt capital also gives the company additional advantage of resources that were not initially in the business resulting to additional of more resources that may boost the operating capital resulting into increase or mass production (Alti, 2003). However, many companies have closed down as a result of excessive leverage or they have applied for bankruptcy (Fama, & French, 2002). Reference Akerlof, G. (1970), “The market for ‘emons’: Quality uncertainty and the market mechanism,” Quarterly Journal of Economics, 84(3), pp. 488-500. Alti, A, (2003), “How persistent is the impact of market timing on capital structure?” working Paper. Atkeson, A., & Cole H, (2005), “A dynamic theory of optimal capital structure and executive Compensation”, work paper, NBER 11083. Baker, M., & Wurgler J, (2002), “Market timing and capital structure”, Journal of Finance 57. Brennan, .J. & Schwartz, E (2005), “Optimal financial policy and firm valuation”, Journal of Finance 39. Dittmer, A., (2004), “Capital structure in corporate spinoffs”, Journal of Business 77. Fama, E., and French, K (2002), “Testing trade-off and pecking order predictions about Dividends and debt”, Review of Financial Studies 15, 1-33. Read More