Important: Corporation Finance course work. Three reasons for differences in net income and CFO

Corporation Finance Short Questions
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Corporation Finance Short Questions
1. Solution
Three reasons for differences in net income and CFO (Cash Flows from Operations) are mentioned below.
1) Net income is basically a profit earned by organization and CFO is described as the cash flows from the operating activities (Shapiro, 2014). Cash inflows and cash outflows include the receipts from products sales, payments to suppliers and employees during a period, rental and income tax payments.
2) Organization net income is determined by deducting the cost of sales and other expenses related to operations, depreciation, interest, amortization and taxes from the total revenues. Net cash flows from operations is determined by using the net income and then adjusting it for non-cash expenses and working capital changes (Call, 2008).
3) Changes in net income directly create an impact on the cash flows generated from the operational activities. Increase or decrease in expenses result into changes in net income, and thus further contributing towards creating a positive or negative impact on CFO.
2. Solution
(i) Free Cash Flow
Free cash flow can be described as the cash available to the company after cash is taken out for supporting the operational activities and maintaining the capital assets, and it is different from CFO, which is simply the cash inflows from operational activities. Free cash flow is an indicator of company profitability including the investment on tangible assets and working capital, and excluding non-cash expenses of income statement (Vanasco, 2014).
(ii) Cash Flow (balance sheet to balance sheet)
Changes in the balance sheet accounts are considered as the basis for preparing the statement of cash flows. The different kinds of changes in assets, liabilities and company equities are reported in the statement of cash flows or it is easy to establish that changes in balance sheet items are used for determining the cash flow amounts (Shapiro, 2014). Hence, balance sheets comparison year-to-year is important for developing cash flow statements.
(iii) CFO
CFO (cash flow from operating activities) show the amount of cash generated by the company by conducting regular activities including development and selling of products and services. It is important to understand that CFO does not include capital and investment expenditures.
3. Solution
(i) FCFF. Free cash flow to the firm (FCFF) can be explained as the amount of cash left to the company after paying for the costs of doing business, investments in long term and short term assets. The cash left can be used by company for paying to both investors, shareholders and debtholders (Mielcarz & Mlinaric, 2014).
(ii) Accrual. It is referred to different kinds of adjustments that are necessary to be made before issuing the financial statements of the company. Accruals include expenses and liabilities that incurred but not recorded in accounts and, revenues and assets that are earned but not recorded in accounts.
(iii) Impairment. It is explained as the permanent decrease in value of asset and it is tested by comparing the profits, cash flows and other benefits generated by asset with its book value.
(iv) IPO. The initial public offering involves a company offer of first price for selling its stock during the process of moving from private ownership to public. Companies use the option of IPO for generating new financial resources for different organizational activities (Dalziel, White & Arthurs, 2011).
(v) PMI. Private mortgage insurance is a policy that is basically bought by the mortgage holder on behalf of the lender. Policy is very effective for protecting the lender in situation of mortgage default.
(vi) Annuity Due. It is explained as a repeating payment that is paid at the beginning of every period and it contains the characteristics, such as; all payments are in the same amount and made at similar intervals of time (Motley, 2019). One of the most important examples of annuity due is rental payment.
(vii) LIFO Reserve. It is an account used for linking gap between FIFO (first in, first out) and LIFO (last in, first out) costs during the scene when the firm is using FIFO for recording inventories but uses LIFO technique for preparing the financial statements (Singh, 2019).
4. Solution
Underinvestment occurs in a situation where management decides to not make low-risk investments for providing benefits to the bondholders and the reason is that company makes this kind of decision for pleasing its shareholders, who are expecting a higher rate of returns on investments made (Farooq, Ahmed & Saleem, 2014). Underinvestment situation can contribute towards encouraging the bondholders in selling their bonds. Overinvestment occurs in the situation where the management decides to invest in large numbers of projects that generate less rate of returns for the shareholders or in different projects that are generating negative NPVs. Managers usually do overinvestment for getting personal benefits and they do not perform investment activities for the purpose of protecting interest of shareholders (Franzoni, 2007). Overinvestment situation can discourage shareholders from investing more in company because the required rate of return is not achieved.
5. Solution
Differences

Dividend discount model

The free cash flow model

Residual income model

Model values the company based on the dividends paid to the shareholders.

In this model, the intrinsic value of a firm is equal to PV of its free cash flow, net cash flow available for shareholders and debtholders in every period.

Model is based on the concept that company stock value is equal to PV of future residual incomes discounted at cost of equity. This model is more suitable for mature companies that follow irregular pattern of dividends (Alberro, 2015).

Dividends are the actual cash flows forwarded to shareholders, therefore valuing the PV (Present Value) of these cash flows give investors an idea about the real worth of shares (Lazzati & Menichini, 2013).

Total firm value is determined by discounting FCFF at WACC (weighted cost of capital). Secondly, discounting the FCFF at cost of equity can give the shareholders equity value.

Residual income can be calculated by first determining the equity charge and it is calculated by multiplying total equity capital with the required rate of return of equity. This rate can be calculated by using the CAPM (capital asset pricing model). The formula can be, residual income = (net income * equity charge)

6. Solution
CFO is considered as a better indicator for company financial health as compared to the net income. A high CFO clearly reflect that the company has more cash inflows as compared to the cash outflows. The CFO show strong business operations from non-accounting perspective. Strong cash inflows help the companies in meeting short term obligations, utilizing the growth opportunities for generating high rate of return and also contribute towards issuing dividends to shareholders. Positive cash flows provide support in achieving stable net income, although company can experience low-income periods in the situation when the non-cash expenses are recorded. Net income is a less credible indicator because it can decrease drastically in the situation when the company records a high interest or depreciation expense, although the company may be performing financially more efficiently.
7. Solution
Economic profit is described as the difference between the monetary revenue and total costs, and the costs include explicit and implicit costs. The economic profit is lower than the accounting profit because it includes the opportunity costs related to production. Analysts use the economic profit for determining whether or not a company should enter the market. On the other side, accounting profit is described as the variance between monetary revenues and total monetary costs, and it is figured out by using GAAP (Generally Accepted Accounting Principles) (Akkapeddi, Srivastava & Tomar, 2017). In simple words, accounting profit can be the net income during a period and economic profit is a surplus generated after deducting total costs from total revenues. Another difference is that accounting profits reflects company profitability and economic profit is an indicator for highlighting efficiency of company in allocating resources.
8. Solution
Data validation

The data validation helps in validating the users' input to worksheet. Validation rule provides support to the user in controlling the data type that can be entered into a specific cell. Excel data validation helps the users in permitting only numbers with particular range allow numeric or text values in cell and also provide support in identifying incorrect values in validated cells. Data validation help the users in getting protected from entering wrong data in model. During financial modelling a drop-down list can be created in cell with options of Yes and No, and with this, user cannot enter anything else (Fairhurst, 2019).

Absolute cell referencing

It is a kind of cell referencing in a spreadsheet that cannot be changed or remain constant even in the situation where spreadsheet size and shape changes. It is used in formulas, charts and functions during financial modelling. The absolute cell remains the same, whether it is copied or the spreadsheet changes in another way (Techopedia, 2019). In excel, a cell can be absolutely referenced by pressing the key F4.

Custom formatting

Number formats help in controlling how the numbers are displayed in excel during financial modelling. Custom formatting benefit is that; it changes looks of numbers without changing data. Custom formatting provides support in making the worksheets look more consistent and professional. Customer number formats provide support to financial analysts in displaying he numbers, percentages, times and other values (Exceljet, 2019). In excel, custom formatting can be used for formatting large numbers in millions or thousands.

Naming a range

Naming a range is one of the most useful tools for making formulas easier to understand. It further contributes to simplifying the complex spreadsheets (Foeller, 2019). User can assign a name to single cell or range of cells, and then the name can be used in different formulas for explaining the source of graphs. Naming a range can be explained with an example, such as; in financial model, user can insert the name like tax rate in place of cell reference, and it helps in understanding the spreadsheet easier for auditing purposes.

9. Solution
1) Ginny’s restaurant is a very important case scenario of course because it helped in understanding different concepts related to capital investment valuation. Calculating and determining the most suitable investment option helped in improving the concepts related to decision making and further contributed towards understanding different factors involved in the valuation process. Companies usually have a lot of investment opportunities available and managements can use the valuation methods for determining how much should be invested in specific option and how much capital can be allocated on risk-free investments for earning high returns. The other concept understood from case is related to source of finance for financially supporting the projects. Ginny’s restaurant case analysis developed a detailed understanding of the debt and equity financing options, and how both can be used for selecting the most suitable investment option.
2) (a) Taxes. Adjusting the taxes in NPV (Net Present Value) calculations can create an impact on the investment decision-making process. Currently, Virginia has no debt and introduction of taxes factor can encourage to change the lending decisions. Virginia investment of $4 million into restaurant can also be changed due to high taxes and Virginia may plan to invest ...