Forecasting and Financing Projects On the basis of the knowledge you gained from

Question

Forecasting and Financing Projects On the basis of the knowledge you gained from your readings, respond to the following questions: It can be difficult to accurately forecast a project's cash flows because many risk factors may be present. As an analyst, what will you do to increase the accuracy of the project's cash flow forecasts? Provide details of the techniques that you would use and explain why. Some firms use more debt in their capital structure than other firms. Some would argue that the use of debt in the capital structure enhances the owners' return on their investments. Others would say that the use of debt only increases the level of risk for the owners of the company. Which argument do you agree with and why? Explain your position. If debt is to be used when raising funds for a capital investment, how would you determine the proper level of debt? Explain your answer using examples

Explanation / Answer

              The following techniques can be used.

The distribution method involves estimating the cash flows for each item during a period & applying an appropriate portion of that cash flow to each day during that period. This can be done by using averages. Example: average percentage of invoices paid within a certain number of days after dispatch. Complex distribution method involves calculation of normal distribution probability curves, using mean & standard deviation values derived from historic data, appropriate mathematical formulae etc.

This expresses relationship between two variables. One being dependent on other. For example, relationship between cash inflows from sales & marketing expenditure. If there is regressive relationship, it is possible to consider scenarios such as impact on sales if marketing expenditure is increased by certain amount.

Techniques for trend included semi averages or least squares. A moving average method can also be used. The moving average or trend involves calculating group of averages, each group overlapping the next. By moving from one group to the next, an average value is calculated & applied against a time point. The resulting values are plotted in a graph to present a trend. Usually moving averages may be calculated to establish a trend between weekly cash flow & sales.

Use of debt can increase the return on equity for the company because when the amount of debt capital is increased relative to its equity capital, a company can increase its return on equity. This when net income is divided by shareholder’s equity, we can see that the company has higher return on equity because of its financial leverage.

Use of debt increases the level of risk for the owners:

Debt can be used by the organization. But there is a limit on that. This is because too much of debt increases the financial risk because it can leave the company unable to meet its debt obligations.

How to determine a proper level of debt:

In practice, many companies express their target debt level as that which will result in bond rating of A or higher. There are three major considerations for A rating.

For example, since the ford company hit difficulties in 1979, its debt has been downgraded three times in less than here years.

Further there are some general observations that a company’s exact payoff from debt financing depends on tax rates of both the company & investors & is therefore difficult to define. Also when the personal tax rate on equity is lower than that on interest income, the payoff is likely to be less than traditional financial theory. A final thing to be noted is that when a company has no taxable income to shelter, using debt financing would reduce its value.

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