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Finance for Managers Essay

In the evaluation of a firms profitability, future growth prospects and performance, finance managers have to be very certain about the parameters and assumptions they choose for the process. While the methods of financial management may be similar globally, it is the responsibility of the manager to make sure that the assessment be as accurate as possible so that no unaccounted risks or problems occur after the decision making process. With the recent financial crisis, the whole financial services industry has come under heavy scrutiny and critique.

It is baffling when one thinks how such large and time-proven institutional investors could invest in sub-prime mortgage financing without considering the actual default risk probability. Managers have to be extremely careful when analyzing and forecasting returns of investment options as a the consequences of a wrong decision can be felt not only by the investors, but can affect other businesses as well as society, just like the recessionary phase the world is witnessing at this moment. Nevertheless, financial management is essential for all businesses, and there is dependency on proper financial management for growth and profitability.

Taking the case in sight, this paper will try to demonstrate how investment options are evaluated and what

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aspects are taken into assessment. A. Should Caledona focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows, incremental profits, total cash flows or total profits? B. How does depreciation affect cash flows? C. How do sunk costs affect determination of cash flows? When evaluating investment options, managers and investors are interested in looking at the Economic Value that arises of the proposal.

For this reason, the focus of capital-budgeting decisions is on cash flows and not accounting profits (Khan, Khan & Jain, 2007). The most basic reason of choosing cash flows over profit figures is due to non-cash expenditures which are included in the calculation of profit. For instance, capital intensive firms, such as in the manufacturing industry, have high depreciation expense charges in their profit & loss account, and while this reduces the profit figure it is mostly for purposes of legal tax-reduction and does not have a direct effect on cash flow.

When assessing the return of an investment, the actual generation of cash is taken into account, as it is what matters to the firm, being the investor, over accounting profits. Using cash flow for analysis also erases some accounting ambiguity associated with accounting profit. These ambiguities arise due to differences of methods applied in areas such as depreciation expense calculation and inventory valuation amongst others. This gives rise to differences in the calculation of net income based on different measures.

Also, an important element of investment appropriateness is the Time-Value of Money. When taking cash flows to calculate return, it is based on actual cash received and spent by a firm rather than just accounting entries, such as revenue and expenditure recorded under accounts received and payable which may be paid at a much later date (Drake, Fabozzi, Peterson, 2002). Firms also choose to focus on incremental cash flows as they provide details of additional cash flow generated by the investment, and not just total cash flows.

Incremental cash flows are better suited to measuring the returns of the investment based on the above information. Depreciation has to be added back into the EBIT figure for calculation of free cash flow, since it is a non-cash expense. The effect of depreciation on cash flows is an indirect one, as it affects the taxes paid by the firm. Taxes are calculated on the accounting profit figure, which is reduced by depreciation for a smaller tax figure. Therefore the effect of depreciation is actually a reduced tax expense.

Sunk costs are incurred cost with regard to a proposal, regardless of whether investment is made in the said project or not. Therefore, sunk costs are not incremental costs and are not considered when an investment is made. For instance, if a textile firm undergoing expansion wants to use a weaving loom purchased at an earlier date, the cost of that loom will not be taken into account as it is not an incremental cash flow, and is a sunk cost because it has been paid for regardless of its use in the new project (Cabral, 1995).

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