[SOLVED] Cash Flow Study

After reading the “Ethical Issues” box on page 330 of the required text, devise a plan that will minimize or reduce the impact of these cash flow estimation biases on effective decision-making. The CFO of a firm you just started working for claims “we always have, and always will, use the weighted average cost of capital (WACC) as the rate to discount future expected cash flows from our proposed capital budgeting projects”. What do you think of this strategy? Read section 11-4, pages 399 – 404 in the required text carefully. Your initial post should be at least 200 words, formatted and cited in current APA style with support from at least 2 academic sources.  You should respond to at least two of your peers by extending, refuting/correcting, or adding additional nuance to their posts. Your reply posts are worth 2 points  student  After reading the “Ethical Issues” box on page 330 of the required text, devise a plan that will minimize or reduce the impact of these cash flow estimation biases on effective decision-making. It is human to exercise bias behavior based on our belief, and desires. When producing cash flow estimates as the case explains managers may exercise bias behavior because compensation may be tied to the span of the job responsibilities. Some of the decision bias include: Anchoring, Framing, Availability Heuristic, Confirmation Bias, Commitment Escalation, and Hindsight Bias. Several factors must be taken into consideration when preparing a cash flow estimation in order to minimize biases on effective decision-making. Robert Wolf in his article “How to Minimize your Biases when making Decision” suggest to consider the following: Search relentlessly for potentially relevant or new disconfirming evidence Accept the “Chief Contrarian” as part of the team Seek diverse outside opinion to counter our overconfidence Reward the process and refrain from penalizing errors when the intentions and efforts are sound Reframe or flip the problem on its head to see if we are viewing the situation in either a positive or negative framework Redefine the problem from here on out and ignore the old problem to avoid escalation of unnecessary commitment Develop systemic review processes that leave you a committed “out” possibility when trying to “cut the losses” Avoid the potential for escalation or further emotional investment in faulty decisions engendered by premature “public” commitment. Throughout the process, it’s crucial to recognize that most risk does not manifest itself from some exogenous contingent event, but rather is driven by the behaviors and decisions of people. It is only by exercising the intellectual rigor to challenge our current views of the future and long-lived underlying assumptions The CFO of a firm you just started working for claims “we always have, and always will, use the weighted average cost of capital (WACC) as the rate to discount future expected cash flows from our proposed capital budgeting projects”. What do you think of this strategy? Read section 11-4, pages 399 – 404 in the required text carefully. Most firms combine debt and equity financing, the WACC helps turn the cost of debt and cost of equity into one meaningful figure. It only makes sense for a company to proceed with a new project if its expected revenues are larger than its expected costs in other words, it needs to be profitable. The discount rate makes it possible to estimate how much the project’s future cash flows would be worth in the present. Christina Majaski explains in her article “Cost of Capital vs. Discount Rate: What’s the difference?” that “Setting the discount rate isn’t always straightforward. Even though many companies use WACC as a proxy for the discount rate, other methods are used as well. In situations where the new project is considerably more or less risky than the company’s normal operation, it may be best to add in a risk premium in case the cost of capital is undervalued or the project does not generate as much cash flow as expected.” Therefore we could conclude that not all the projects will have the same risk as WACC. There could be projects with less risk and there could be projects with higher risk which should have a higher discount rate. If a business uses the same WACC for all new projects it will wrongly accept the risky project and therefore result in too much losses and reduction in shareholder’s wealth. Reference: Majaski, Christina. (2020) Cost of Capital vs Discount Rate: What’s the Difference?. Retrieve from: https://www.investopedia.com/ask/answers/052715/what-difference-between-cost-capital-and-discount-rate.asp student 2 After reading the “Ethical Issues” box on page 330 of the required text, devise a plan that will minimize or reduce the impact of these cash flow estimation biases on effective decision-making. Behavioral economics suggests that decision making has some of the most prevalent biases that creep into all kinds of risk or reward whether personal as well as professional. Cash Flow decision making not only has to consider human biases, but also those of the customers, employees and competitors. Specifically, in this case, some biases and reality are to accurately estimate the discount rate and cash flows throughout the economic life of the project. The timing of discounted cash flows will become important the longer the economic life of a project lasts and the more uncertain the payback period will become. Also, the most of the forecast could be run using a simulation method based on past experience or market behavior through software, if the company did not have a financial analyst to oversee the cash flow estimation process. The CFO of a firm you just started working for claims “we always have, and always will, use the weighted average cost of capital (WACC) as the rate to discount future expected cash flows from our proposed capital budgeting projects”. What do you think of this strategy? Many companies estimate the rate of return required by investors in their securities and use the company WACC to discount the Free Cash Flows on all new projects. But the company WACC rule can also get the firm into trouble if the new projects are more or less risky than its existing business. WACC can be used as a hurdle rate against which to assess ROIC performance. It also plays a key role in economic value added (EVA) calculations.  Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. I think is correct the CFO strategy of using WACC as a discount rate to discount the future expected future cash flows from the proposed capital budgeting projects.     Reference McClure, Ben. (May 21, 2019). Investors Need a Good WACC. Retrieved from: https://www.investopedia.com/articles/fundamental/03/061103.asp  (Links to an external site.) Moyer, R.C., McGuigan, J.R., & Rao, R. (2018). Contemporary financial management (14th  ed.) Mason, OH: Cengage-Southwestern. Section 11-4, pages 399 – 404

 

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