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Management
4. Please explain the following equation for cash, and select and discuss three potential conflicts when a business attempts to increase cash (Hint: consider strategy and operations).
Cash = (Liabilities + Net Worth)-(Accounts Receivable + Inventory +Net Fixed Assets)
Conflicts
This equation summarizes the fact that the net or disposable cash of a company equals the total liabilities of the business minus the total assets of the company. The net worth of the company is essentially its capital, which outlines the investment of the shareholders. When trying to increase its cash holdings, a company may choose to increase its liabilities and its Net Worth, or reduce its Accounts Receivable, inventory or net fixed Assets. However, various conflicts may arise in this case.
An increase in the company’s Net Worth would entail borrowing from the shareholders. This could be done through selling bonds or increasing the company’s shares. However, the conflict entails the fact that the company would essentially be increasing its liabilities to the shareholders, which should lower its cash according to the equation.
Alternatively, the company could increase its cash holdings by lowering its net fixed assets. However, the Net Fixed Assets form a large part of the company’s net worth in which case a disposal of the net fixed assets would also mean a decrease in the company’s net worth. This, therefore, introduces a conflict since the action would have contra effect.
Moreover, the company may decide to increase its cash holdings by increasing its liabilities. These include the debts owed to creditors, accrued expenses among others. However, debts or liabilities would lower the company’s net worth, not to mention that they will still be paid using cash in which case the net effect would not be increasing cash but lowering it especially in the long term.
5. Pretend that you are the CFO and your boss, the CEO has told your company’s board of directors that because of recent unfortunate event that occurred with your main competitor, it will be possible to increase sales by 20%. You consulted the heads of the purchasing and collection departments and the treasurer. Based on their comments you have had to tell the CEO that she can’t keep her promise to the board. What did each of the managers tell you?
The ability of the company to increase its sales is dependent on its ability to purchase the necessary raw materials or stock, as well as the health of its finance department. These tasks are the prerogative of the purchasing department and the financing department handled by the treasurer. It is evident that the two departments expressed their inability to execute the functions.
In my opinion, the finance department manager or the treasurer has expressed the fact that the company does not have the money necessary or required to purchase the stock or raw materials needed for sale. In addition, the company may not have enough funds to employ extra individuals to execute the sales.
As for the purchasing department, there may not be sufficient stock in the market, not to mention sufficient money from the finance department to purchase the scarce raw materials or stock for sale. In addition, there may not be sufficient manpower to collect the materials or enough space for storing the same. This would limit the capacity of the company to meet its target of increasing the sales by 20 percent.
6. Select two of the following errors that can occur when estimating weighted average cost of capital and provide an example how the error can either overstate or understate the value of a project or investment
A company’s weighted average cost of capital (WACC) refers to the rate of return that is necessary or required by the providers of capital. This is weighted in line with the proportion of each element on the total capital. Inaccuracy or errors in measuring the various aspects of weighted average cost of capital has varied consequences.
If a company fails to use the market value of equity, it will be understating or overstating the value of equity. An understatement would mean that the projection of the company’s equity is lower than the actual amount. In this case, the company may end up underinvesting its capital thereby lowering the amount of returns that it provides its capital providers.
If a company does not use the current market cost of debt, it will either be overstating or understating the magnitude of investment that it can make. If it understates the cost of debt, it will overstate its returns or profits, which would then lead to overstating the weighted average cost of capital. In essence, the company may be forced to cut back its investments or projects so as to have sufficient funds to complete the projects that are crucial.
7. Select two of the following errors that can occur when projecting cash flow and provide an example how the error can either overstate or understate the value of a project or investment.
Errors in the projection of future cash flow may occur as either an understatement or an overstatement.
The inclusion of irrelevant costs would inflate the projected value of an investment or a project. Irrelevant costs refer to business costs that are considered to have immaterial impact on the overall costs of a project. These may include sunk costs, book values, non-monetary costs and overhead costs. It is worth noting that the impact is not the only factor that determines whether a cost is relevant or not. Either way, the inclusion of an irrelevant cost would essentially inflate the projected costs of the project and, therefore, inflate the value of the investment or the project.
The inclusion of a sunk cost would also inflate the cost or the value of a project or investment. Sunk costs refer to costs that have already been incurred in which case they may not be recovered. The difference between sunk costs and other projected costs of a business lies in the fact that, sunk costs have already happened or been incurred and are independent of other events that may take place in the future of the business. For example, if a business has an incomplete building that cost it 5 million dollars, the five million is considered a sunk cost. In essence, it must decide whether it should complete the building so as to regain its sunk cost or just leave it at that. Either way, the inclusion of the five million in the projected costs would inflate the costs of the investment since the money has already been spent.
8. Give an example of the risks associated with inaccurately measuring cost of capital or cash flows.
Inaccurate measurement of any cost in accounting has a bearing on the operations of the company. Capital determines the overall operations of a company, and the magnitude of operations that it has the capacity to undertake. The cost of capital may be defined as the amount of interests that a business pays as a result of borrowing from the shareholders. An inaccurate measurement of the cost of capital comes with varied risks depending on whether it has been understated or overstated. In the case of understating the cost of capital, the company would be likely to dedicate its capital on more projects than it can handle. However, this would force the company to suspend some of the projects in the cost of time so as to align its finances to the actual cost of capital. In essence, the company runs the risk of losing some money in the suspended projects.
