Corporate finance - WACC - Cash Flow - Measuring Return on Investment Assignment

Corporate finance - WACC - Cash Flow - Measuring Return on Investment - discounted cash flow techniques - Financing Decisions - - Assignment Example Accounting earnings are obtained from the income statements prepared in accordance with the applicable accounting standards and frameworks, whereas cash flows are determined as the cash inflows and outflows generated from a certain project. There are some major factors, which constitute the differences between the accounting earnings and cash flows, such as: 1. Operating and Capital Expenditures Operating expenditures are considered as those expenses, which are directly linked with the revenues such as direct material, direct labor, overheads etc. Conversely, capital expenditures are those expenditures, which are incurred by the firm in order to develop the business infrastructure, e.g. purchasing a building, land, equipment etc. Under accounting earnings, operating expenditures are included in arriving at the final net income figure. However, capital expenditures are spread over the useful lives of those assets and then systematically depreciated. Under cash flow estimations, both o perating and capital expenditures are included in order to analyze the overall viability of the project. In short, the mainstream difference between the accounting earnings and cash flows is the exclusion of capital expenditures from the accounting earnings but its inclusion in cash flows. 2. ... However, due to low taxable income, the amount of tax is reduced substantially, which is in fact cash based expenditure. Under cash flow approach, depreciation, amortization and other non-cash expenses are not included, but the tax savings due to such non-cash expenses are included which lead to better cash flows. In short, non-cash expenses in deriving accounting earnings but they are excluded in cash flow approach. However, tax benefits are included as cash inflow in cash flow based approach. 3. Accrual versus Cash conventions Accounting earnings are purely established because of the relevant accounting standards and frameworks, such as GAAP and IFRS. These standards require the firms to draft their financial statements by utilizing accrual basis of accounting. Accrual basis of accounting states that, expenditure should be recognized in the financial statements in the period in which it is incurred, not in the period in which it is paid. Similarly, revenue is recognized in the fina ncial statements in the period in which it is earned, not in the period in which it is received. On the other hand, cash flow approach works on the principle of cash inflows and outflows in the periods in which they are received and paid. Therefore, the major difference between accounting earnings and cash flows is the accrual versus cash based conventions, which lead to material differences between the amounts of returns obtained under both approaches. B. INCREMENTAL VERSUS TOTAL CASH FLOWS In order to analyze the return on investment, another important way to analyze is to look whether the whole firm is benefitted from that piece of investment or not. Obviously, a firm is benefitted from the cash