1. Manny Perez is trying to understand the term \"cost of capital.\" Define the
ID: 2383884 • Letter: 1
Question
1. Manny Perez is trying to understand the term "cost of capital." Define the term, and indicate its relevance to the decision rule under the annual rate of return technique.2. How is it possible for a company to suffer a net loss for a given year, yet produce a positive net cash flow from operating activities?
3. Cash flows from operating activities can be calculated using the indirect or direct method. Briefly describe how the two methods differ yet arrive at the same information about the net cash flows from operating activities.
4. Why is it important to report discontinued operations separately from income from continuing operations?
Explanation / Answer
1. Cost of capital refers to the opportunity cost of doing business (selling shoes, building house, etc) with a certain amount of capital. If you have $5000 of capital to start a business, its cost of capital is simply the next best project you could undertake. Most cost of capital measurements are defined by the rate of return you would earn on that next best project, annualized per year. 2. Income includes NON cash expenses. A NON cash expenses would be the depreciation on a piece of equipment, like a bulldozer. Depreciation is just an expense where cash DOES not go out the door. Think of it as the bulldozer is one year older and thus has one year less useful. This depreciation depressed earnings and can make it negative, but when you adjust for cash flow you DON't include deprecation, since no cash left. So if you have a ton of deprecation one quarter, its very easy to have negative net income and a TON of positive operating cash flow. 3. Indirect method means you start with the Net Income figure from the Income Statement and adjust it by adding back noncash expenses (like depreciation) and subtracting non cash gains. Basically you are indirectly adjusting an income measure to see how it changed the cash flow position. Direct method means you calculate cash flow from Operations directly by looking at the cash receipts for sales and the cash reductions. These are direct cash transactions. 4. Discounted operations should not be included with continuing operations because investors are concerned with what the business produce in the future. Once a part of the business is deemed discontinued it will not occur in the future so it needs to be separated from continuing operations. Hope this helps!
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