Cashflow Analysis

Accounting focuses on the preparation of financial statements, which as seen in Part I., is the basis for analyzing the conditions of a corporation. It emphasizes net profits, which indicates how much money is available to shareholders as a result of the corporation's earlier activities. The focus is on the past. Finance, however, sees the world in a different way. It focuses on the future, or value creation by the firm. It tries to make sense of how much money would be generated in the future by putting down a certain amount of money now. Accordingly, finance concentrates on cash rather than profits. One important concept in the context of finance's focus on the future is the "time value of money." It is the concept that a unit of money received today is worth more than the same unit of money received at some future point. For example, if you want to buy a car and do not have the money, you must save until you have enough money. If you can borrow that money, however, you can have instant gratification: buying the car immediately. Looking from the other side, someone lending you the money has foregone the opportunity to spend the money now. She must wait until you pay her back. In other words, she is incurring an opportunity cost for not being able to use that money.

This is why we have interest. If the borrower is gratified and the lender sustains a cost for that transaction, the borrower must compensate the lender. The borrower must promise to pay back not only the money borrowed, but also some extra money over that amount as compensation, which is interest. The ratio of interest to the sum borrowed is the interest rate. A related concept to interest rate is "yield." Both refer to the rate of the amount of money obtained over the initial amount changing hands. The difference is that yield may include money other than the initially agreed interest (more on this later). Another related concept is "return." It is defined as money made or lost on an investment. When you put money away in an investment, you would expect to be compensated: time value of money at work. Accordingly, the expected return should always be positive, and for investments such as bank deposits and bonds, it is usually positive after money is returned, equivalent to interest on those deposits and bonds. Nevertheless, as regards investments in stocks or physical assets, one sometimes loses money when she tries to cash in, thus the definition, money made or lost. Returning to the importance of cash, finance offers a framework to look at an opportunity to spend or put away money (i.e., cash) and evaluate how relatively big or small money returned in the future will be. In doing so, finance will consider the fact that money on hand now is more valuable than money in the future, as seen above. For example, if money declines in value by ten percent per year, or money one year from now is worth ten percent less than today's money, $100 received now is equivalent to $110 becoming available one year from now. The rate of decline in value is called the "discount rate," and the value of future amount of money today is called the "present value." Finance regards any venture or investment worthwhile, if the present value of money coming in is greater than the present value of money going out. Looking at multiple periods, the decline in value for the second period will come on top of the decline for the first, the third on top of the second, and so forth. Accordingly, if the discount rate is expressed as the rate for decline in value for one period, it must be compounded. For example, the present value of $X under the annual discount rate of r

will be: (1+) for the first year, (1+)2 for the second year, (1+)3 for the third year and so on. In this regard, it should also be remembered that if the cashflow is to continue forever (a "perpetuity" 5), its present value will equal .

Determining the price of a bond shows how this process works. A bond is a financial instrument through which companies borrow money from the general public. A company will issue a bond in exchange for an amount of money, which is to be returned to the holder of the bond sometime in the future. Since the provider of the money (the buyer of the bond or the investor) incurs an opportunity cost for parting with her money, interest must be paid to her and it is usually paid semiannually in fixed amounts. The periodic payment is called the coupon. Coupon may also refer to the rate of annual payment to the face (par) value of the bond, thus a coupon of 8% on a bond with a face value of $10,000 means that $400 will be paid twice a year to the holder of the bond. The date when the money borrowed is returned to the holder of the bond (when the bond is redeemed) is called maturity. Usually, maturity coincides with the final coupon payment, and the bond is redeemed at face value. Looking at cashflows arising from a bond, one can see that a bond is essentially a bundle of cashflows arising on different future dates. 6 There are several semiannual cashflows arising from coupon payments and another cashflow at maturity equal to the bond's face value. This means that if one calculates the present values of those cashflows with an appropriate discount rate and aggregates them, the result should be the fair value, or price of the bond. Under the most basic approach, the discount rate is the yield investors expect for similar bonds. One needs to calculate the price of bonds (the amount paid for $100 face value in the case of US bonds), because bonds can change hands between its issue and maturity. Meanwhile, there are opportunities to calculate yields from prices 7, because one need to know the yield, on which investment decisions on bonds are usually made, after looking at prices at which bonds are traded. Q6: Suppose that a machine costing $1 million will wear out in five years. Suppose also that widgets produced by that machine will bring in sales of $1 million a year, and the materials and labor costs for producing the widgets will amount to $700,000 a year. From the accounting perspective, disregarding general administrative expenses, interest payments and taxes, net profits generated per year by running the machine is not $300,000, but $ (a) , because (b) . On the other hand, from the finance perspective, one must compare the initial $1 million investment in the machine with the present value of cash generated every year, which is $ (c) per year. If a discount rate of 20% is used to evaluate the investment, the net present value is $ (d) (round to the nearest unit), and it is (e) to pursue the investment.

Q7: Regarding a "perpetuity," (UL5), the share of a company can be regarded as a form of perpetuity, because it entitles the holder to a stream of dividends which is expected to continue for the foreseeable future. If one follows this thinking, the fair value for a share of a company which pays out four dollars dividends every year should equal $ (a) (round to the nearest unit), if the discount rate is ten percent. If in this case, the dividend is to grow by two percent every year, the fair value should equal $ (b) (round to the nearest unit). Q8: Looking at bonds as a bundle of cashflows (UL6), a bond issued on August 15, 2020 and maturing on August 15, 2025, will usually have (a) coupon payments and one payment for the face value. In that case, and if the coupon is 5 percent, a holder of $10,000 in face value will receive coupon payments of $ (b) on (c) and August 15 of each year. When people expect a yield of 5.1% at the time of issue for an equivalent bond, the present value of cashflow at maturity is worth $ (d) (round to two decimal places). Calculating the present value of other cashflows and aggregating them enables one to arrive at the fair issue price of $ (e) (result from Excel "PRICE" function, rounded to two decimal places). Q9: Regarding UL7, assume that a bond traded on August 15, 2020. If that bond was to mature on August 15, 2030, and had a coupon of 6%, and traded at 103.45, its yield was (a) %(rounded to two decimal points). When US Treasuries (bond issued by the US Federal Government) of the same maturity had a yield of 4.38% on that day, the spread was (b) basis points.