Using the indirect method show the cash flows of the investment for the € 400,000 investment. Discuss your findings in about 250 words.
Cash flow from operating activities, assuming that it is a new business venture.
| Net investment | € 400,000 |
| Increase the accounts receivable | (120,000) |
| Less prepaid cost | 34,500 |
| Less account payable | (81, 500) |
| Net cash flow | € 233,500 |
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Net Cash Flow = 400,000 - 120,000 + 34,500 – 81,000
Net Cash Flow = € 233, 500
Under the indirect method, the operating cash flow is evaluated by first establishing the net income, then adding the non-cash expenses such as depletion, amortization, and depreciation. From the resulting figure, the changes in long-term assets, whether gains or loss are removed before adjusting the changes in current assets and liabilities to eliminate accruals from operating activities. The indirect method considers all the transactions as either revenue or expense (Bradbury, 2011). Expenses are recorded as cash payments whereas revenues are recorded as cash receipts that follow the accrual basis of accounting. The cash flow begins with the net investment, and adjustments are made to eliminate non-cash items since the expenses are deducted from during calculation of net income. Any increase in the accounts payable is added to the net income. Positive net cash flow indicates that the company has a safe cash flow margin, since the survival and continuity is guaranteed. The larger the magnitude of the cash flow margins the more financially comfortable the company. A Slim margin, on the other hand, means that the business is at risk, and therefore proper financial measures should be undertaken to avoid the blunder. Negative net cash flow indicates that the company is failing in terms of supporting its operations and is a sign of the risk of hitting a dead-end in the near future. For this case scenario, it can be concluded that with the net cash flow of € 233,500 the business is still up and running. The management, however, must be keen on implementing correction in key areas to increase cash output in the future hence increasing net cash flow.
Calculate the overall rate of return (WACC) for the € 400.000 investment based on your assumptions. How are you going to finance this investment? Discuss about the capital structure mix you have chosen and how this mix affects the WACC.
Weighted Average Cost of Capital = (cost of debt *(1-tax) * % debt) + (cost of equity * % equity)
Equity cost = 233, 500/400,000*10%= 0.058375
Debt cost = 120,000/400,000* 7%* (4%) = 0.00579
WACC= 0.058375+0.00579= 0.064165
WACC= 6.4 %
WACC is estimated to be the discount rate for evaluating the net present value of an investment. WACC computes the capital structure basing on the components of preferred stock, debt and equity. Equity cost is evaluated using the capital asset pricing model which involves equating the rate of return to volatility. In other words cost of equity is the opportunity cost of capital. Cost of debt is the yield to maturity on the company’s debt whereas preferred stock reflects the yield on the firm’s preferred stock. The cost of Weighted Average Cost of Capital is important to investors since it indicates whether a business is worth venturing (Frank & Shen, 2016). The company yield returns of 18% and its WACC is 6.4% implying that the rate of return is 11.6 %. Whenever the company returns are less than the Weighted Average Cost of Capital, the company’s value diminishes. The business can be financed through the pledging part of the company's future earnings. For instance, the company can commit to exchange 5 % of its future earnings for funding of, say, €250,000. The efficiency of such kinds of deals is however embodied in a personal investment contract in which the company and the investor must sign. Another way of obtaining funding for a company is through angel investors. These kinds of investors are normally super-rich individuals who providing funding for companies, especially during startups in exchange for partial ownership of the company. The main aim of the investment is to obtain an optimum mix of equity and debt. One way of optimizing the lowest cost of capital mix is by minimizing the Weighted Average Cost of Capital (WACC).
References
Bradbury, M. (2011). Direct or indirect cash flow statements? Australian Accounting Review , 21 (2), 124-130.
Frank, M. Z., & Shen, T. (2016). Investment and the weighted average cost of capital. Journal of Financial Economics , 119 (2), 300-315.
