Identification of Cash Flows Unfortunately, it is sometimes not easy to observe cash flows directly. Much of the information we obtain is in the form of accounting statements, and much of the work of financial analysis is to extract cash flow information from accounting statements. The following example illustrates how this is done. EXAMPLE 1.1 Accounting Profit versus Cash Flows The Midland Company refines and trades gold. At the end of the year, it sold 2,500 ounces of gold for $1 million. The company had acquired the gold for $900,000 at the beginning of the year. The company paid cash for the gold when it was purchased. Unfortunately it has yet to collect from the customer to
whom the gold was sold. The following is a standard accounting of Midland’s financial circumstances at year-end: By generally accepted accounting principles (GAAP), the sale is recorded even though the customer has yet to pay. It is assumed that the customer will pay soon. From the accounting perspective, Midland seems to be profitable. However, the perspective of corporate finance is different. It focuses on cash flows: The perspective of corporate finance is interested in whether cash flows are being created by the gold trading operations of Midland. Value creation depends on cash flows. For Midland, value creation depends on whether and when it actually receives $1 million. Timing of Cash Flows The value of an investment made by a firm depends on the timing of cash flows. One of the most important principles of finance is that individuals prefer to receive cash flows earlier rather than later. One dollar received today is worth more than one dollar received next year. EXAMPLE 1.2 Cash Flow Timing The Midland Company is attempting to choose between two proposals for new products. Both proposals will provide additional cash flows over a four-year period and will initially cost $10,000. The cash flows from the proposals are as follows:
At first it appears that new product would be best. However, the cash flows from proposal come earlier than those of . Without more information, we cannot decide which set of cash flows would create the most value for the bondholders and shareholders. It depends on whether the value of getting cash from up front outweighs the extra total cash from . Bond and stock prices reflect this preference for earlier cash, and we will see how to use them to decide between and . Risk of Cash Flows The firm must consider risk. The amount and timing of cash flows are not usually known with certainty. Most investors have an aversion to risk. EXAMPLE 1.3 Risk The Midland Company is considering expanding operations overseas. It is evaluating Europe and Japan as possible sites. Europe is considered to be relatively safe, whereas operating in Japan is seen as very risky. In both cases the company would close down operations after one year.
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