1a. future cash flows due to the erosion

1a. The
timing and value of future cash flows from financial assets and corporate
investment projects can be impacted by a number of factors or risks. Name two,
discuss their impact, whether or not they can be mitigated and if so, how?

 

Two factors that can impact
the timing and future cash flows from financial assets and corporate investment
projects are future inflation and interest rates. The amount and timing of cash
flows from a corporate investment project determines it’s present value. The
value of cash in a given time (i.e., one-year) depends on how it’s invested and
the Net Present Value (NPV). Future Value (FV) will be greater than Present
Value (PV) in the right conditions.  Present
Valuation allows the company to compare future cash flows at different
timepoints to make informed decisions about the relative value of the company.
The equation for calculating value is PV
= FV/(1 + r)t. Where r
is the discount rate and t is the
time or number of years.

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Inflation, which is the
tendency of prices to rise over time, negatively impacts the timing and future
cash flows due to the erosion of the company’s purchasing power. With nominal
investments, the corporation has to take on the risk of inflation of the
potential purchasing power from their investments. One way to mitigate the risk
associated with inflation is through the purchase of Treasury Inflation-Protected
Securities (TIPS). TIPS are bonds that index the principal and income for
inflation. The principal of the bond is adjusted for inflation, the coupon rate
is a fixed rate that is based on real interest, and the coupons are adjusted
for changes in inflation and paid semiannuallyi.
Two other ways of accounting for inflation are the nominal method and real
method. With the nominal method, real cash flows are converted to nominal cash
flows and then discounted by using the nominal discount rate. The real method
involves estimating the real cash flows and discounting them using the real
discount rate. Both methods result in the same final net present value.

 

Interest rates can also
negatively impact the amount and timing of cash flow for a corporation. Lenders
may lose out on repayment of a loan’s principal as well as the interest
associated with it if the borrower defaults. Defaults can interrupt cash flows.
In risky cash flow situations, highly-leveraged corporations with discounted
cash flows require a discount rate that is higher that the Treasury rate. This
is due to the payment uncertainty or potential of default. Instead, the rates
that would be used would be from High Yield bond markets. The higher risk the
borrower the lender will require a greater return for taking on that riskii.

 

 

 

 

 

 

2. Leverage:
Discuss the advantages and disadvantages of using leverage on the B/S. Include
leverage metrics, cost and risk.

 

Leverage is defined as the
amount of debt a firm uses to purchase more assets. Corporations use leverage
so that they will not have to use equity to fund business operations. Leverage
can be both good and bad for a firm. Too much debt is a bad thing for a
corporation and investors but if the corporation can generate higher rates of
returns than the loan interest rates then the debt will help the corporation
grow in profitsiii.
On the other hand, corporations with high uncontrolled debt can get credit downgrades
or face bankruptcy. Likewise, firms that do not have enough debt can also be
viewed poorly. The corporation’s inability tor concern about borrowing can be
viewed as high risk due to small operating margins.

 

There are multiple leverage
metrics. These include: 1) operating income; 2) Earnings before interest and taxes
(EBIT); and 3) Earnings before interest depreciation and amortization (EBITDA).
EBITDA is the most commonly used leverage metric and looks at whether a corporation
is generating enough money to pay off debt. Another metric is Debt/Equity which
determines the amount of a firms assets are financed by debtiv.

 

Leverage adds risk. Leveraging
up during profitable periods will result in earnings appearing larger however the
same will be true for periods of the firm did not generate enough revenue. The
margin of error is really small. The company can start suffering losses on their
assets and it will impact their equity very quickly because when there are
losses or write downs the equity account directly absorbs the lossesv.
The firm would have essentially lost borrowed money.  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3.Why
does accrual accounting dominate cash accounting as the method of choice for
most enterprises when, as your instructor has declared, “Cash is King!”?  Briefly, discuss the pros and cons of each method
and which users of the financial statements might be most interested in cash
flows.

 

Cash -based accounting
involves subtracting cash received profits from the cost of supplies or
operations. This accounting method is rarely used because it does not always
provide the most accurate and complete picture of the firm’s financesvi.
For example, not all customers will pay cash the same day a service or product
is purchased. Some services will be invoiced and paid later which can be both
good and bad. It can be good because it provides flexibility to the customer that
may benefit the customer. Cash-based accounting does not count forthcoming
payments and as a result a company may appear as though it is running a deficit
when they are not. With cash-based accounting, revenues are noted when the company
is in receipt of the money and once paid expenses are recordedvii.

 

In contrast, accrual
accounting looks at revenue and expenses in the period which they are earned.
Accrual accounting uses the Generally Accepted Accounting Principle (GAAP) which
matches earnings during a time period with the operation costs. Accrual
accounting allows the firm to report profit before invoices are submitted. The
down side to accrual accounting is the firm does not have the cash flow to spend
or reinvest until the invoices are paid. This creates risk for the corporation
because if the customer does not pay their bill, the corporation will not have
enough cash flow and will eventually fail. Auditors are especially interested in
cash flows – especially accrual accounting since it uses the GAAP. Auditors
will make sure all financial statements are accurate, free from misstatements, and
are in compliance with GAAP guidelines.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4b. You succumb to bitcoin mania and
purchase 1 bitcoin with the dollars in your savings account. Are you making an
investment or buying a currency? What’s the difference and how do you know if
the price is fair? Using the language and concepts developed in Part 3 will
increase your score!

 

Bitcoin does not meet the
standard definition of a currency or investment. Currencies are, by definition,
a medium of exchange, a measure of value, and have a store of value even if it
is not invested in anything to earn interest. Bitcoins are not investments
because Bitcoins cannot be valued  – rather
only traded. Bitcoin has been described as a crypto, virtual, data, or digital
currency that resides in decentralized computer networks spread around the
worldviii.
Transactions are logged in an open-sourced register called the block-chain. The
block-chain is constantly updated and viewable to anyone who participates in
the Bitcoin network. There are a maximum number of Bitcoins in circulation (about
21 million) which is controlled by the block-chainix.
The creators of Bitcoin were hoping to avoid issues fiat currencies around the
world experienced with low interest rates and printing moneyx.

 

At this point in time,
Bitcoin may best be described as a limited currencyxi.
It is limited because there are not too many places that accept Bitcoins as a
medium of exchange, but they do exist. For example, more South Korean
businesses are adopting Bitcoin each day but Bitcoin is still limitedxii.
Citizen’s cannot pay their taxes or transact all business using Bitcoin.
Another feature of Bitcoin is the volatility. The price of Bitcoin is extremely
volatile and perhaps too volatile to be a store of value like cash or goldxiii.
For example, in January 2017, Bitcoin was priced at $1,000 per coin. Two weeks ago,
it was priced at $18,000 per coin but the price dropped by $3,000 the next day
which shows the potential for fluctuation. People who buy Bitcoins do not know
what the price will be tomorrow, next month, or years from now.

 

Currently, there is not a way
to value Bitcoin but it can be pricedxiv.
However, there is not a real way to know whether Bitcoin pricing is fair.
Bitcoin’s price is determined by bidding on super volatile exchanges and by the
demands of traders.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

5b. Explain
how to calculate the WACC for a firm and the role it plays in the
decision-making process for long-term capital projects. Is it always the best
possible hurdle rate for a new project? Provide an example to support your
view.

 

The most commonly used metric to measure the after-tax cost
of capital is called the weighted average cost of capital (WACC). The standard
equation is: D/(D+E)x(Cost of Debt) + E/(D+E)x(Cost of Equity) where D = the
amount of debt on the balance sheet and E = the amount of equity on the balance
sheet. In other words, WACC is the proportion of debt x by the cost of debt +
the proportion of equity x the cost of equityxv. A corporation’s
assets are funded either by debt or equity. WACC averages the costs of the
sources of funding and is weighted according to its use. The weighted average indicates
the amount of interest a firm has to pay for every dollar it finances. Both
lenders and equity holders have an expected return on the capital they have
provided.

 

WACC tells them the return they can expect. WACC is important
for long-term capital projects because it provides the opportunity cost of assuming
the risk of investing in the companyxvi. WACC
may not always be the most appropriate hurdle rate. The hurdle rate is an arbitrary
or negotiated number that is set by the firm. It is the firm’s minimum acceptable
return for a specific project or investmentxvii. WACC
describes the overall operating and financial risk to a corporation but the hurdle
rate may be higher than the WACCxviii. For
example, a corporation that has diverse internal projects can set the hurdle
rate at whatever they want irrespective of the WACC. Where they set the hurdle
rate can be project specific if they wish to take on higher risk projects. They
can also use a specific hurdle rate to encourage project development that
matches a different direction in which the company wishes to go.