Cash Flows

Forum 1

We focus on cash flows rather than accounting profits is because cash can spent or reinvested. Whereas, accounting profits do not represent cash flows at all which makes it a less fundamental importance for investment analysis. Capital budgeting decisions should only include those of what will be affected by the decisions made. Accounting profits is a general sum of earnings that a company makes. It does not tell us how and where did these earnings are earned or obtained. But, cash flows tells us in specific how did we come up with that earnings. No company would want to invest in something they do not know in specific. For example, if Company A were to invest into a small firm. They found out that their revenue has been excellent throughout the 5 years of investing into this small firm but only based on their accounting profits, not knowing where and how did they obtained these earnings. It turned out the firm has been using their investment in something illegal that could cost Company's A existence. If Company A decided to pay more attention into their cash flows, they would find out about it sooner and took the chance to save the company from risks. 

Total cash flows is the net amount of cash flowing in and out of a business. It defines a company's financial strength. But, when it comes to investments, we are more interested in the incremental cash flows than the total cash flows. This is because the incremental cash flows only shows the cash flows that are associated with the investment. This includes the effects of other investments in the company as well. Incremental cash flows must also be computed if there is a replacement project by subtracting existing project cash flows from the expected new projects. For example, Company A has been working on Project Pearl. But, they discovered a new project called Project Ruby. Project Ruby will need a bigger investment than Project Pearl but the total cash flows from Project Ruby will be triple of Project Pearl. Though Company A had been going steady with Project Pearl for over a few years now, they decided to upgrade into a much profitable project. But before they said yes to Project Ruby, Company A will first go through the incremental cash flows of investing with Project Ruby. Since they invested with Project Pearl first, they will calculate the loss or profit of eliminating the project. If the net present value of eliminating Project Pearl to invest in Project Ruby, then it is safe for Company A to upgrade to Project Ruby. If it is negative, then Company A will not take the risk to eliminate Project Pearl for investing in Project Ruby.

Forum 2

Companies often use debt when constructing their capital structure, which helps lower total financing cost. In addition to the relatively lower cost of debt financing, using debt has other advantages compared to equity financing, despite potential issues that using debt may cause, such as on going financial liabilities and potential bankruptcy risk. In general, using debt helps keep profits within a company and increases returns on equity for current company owners and helps secure tax savings.

Cost Reduction