Question

TOPIC #2: Which one of the three cash flow methods of accepting projects would you recommend to a small restaurant owner who is confronted with an investment decision to either lease or buy a restaurant building in a small town? Please use real world examples in your post.

Be very detailed and add examples.

Answer 1

Answers.-

First of all we should understand

There is two method of cash flow statment.

Direct Method

Indirect Method

The analysis broken down in three areas.- cash flow from opertaing activities, cash flow from investing activites and cash flow from fimamcing activites.

Before you start a creating cash flow statment you need to decide how to record cash flow from operating activites either the direct method or indirect method.

Direct method:-

Using the direct method, you list cash flow in the operating activities section, based on actual cash the business has received or paid during the period.

Examples of cash receipts and payments used in the direct method include:

• Receipts from customers
• Payments to suppliers
• Payments to employees
• Interest payments
• Tax payments

The indirect method is generally easier to use, as it relies on information already gathered in the income statement and balance sheet. Net income is adjusted to convert it from an accrual to a cash basis by:

• Adding back non-cash transactions, like depreciation, provisions made for losses or bad debts, and losses recorded on the sale of an asset.
• Adjusting for changes in balances of current assets (excluding cash) and current liabilities between the start and end of the period. Current assets include inventory and accounts receivable (or debtors).

Calculating cash flow using the indirect method utilises figures taken directly from existing reports, which is why most businesses prefer the indirect method.

The evaluation of lease financing decisions from the point of view of the lessee involves the following steps:

(i) Calculate the present value of net-cash flow of the buying option, called NPV (B).

(ii) Calculate the present value of net cash flow of the leasing option, called NPV (L)

(iii) Decide whether to buy or lease the asset or reject the proposal altogether by applying the following criterion:

(a) If NPV (B) is positive and greater than the NPV (L), purchase the asset.

(b) If NPV (L) is positive and greater than the NPV (B), lease the asset.

(c) If NPV (B) as well as NPV (L) are both negative, reject the proposal altogether.

Buying equipment affects the investing cash flow and operating cash flow sections of the cash flow statement:

1. Purchasing equipment using cash is recorded as a cash outflow.
2. If you choose to purchase equipment via a line of credit or small business loan, monthly principal payments would also affect investing cash flows. Be sure to account for the down payment amount which is typically required with this option.
3. Insurance and maintenance costs would impact operating cash flows.

On the other hand, a lease payment only affects operating cash flows. There is no need to worry about maintenance costs, etc. as these are handled by the lessor under the terms of the contract.

Example:-

You can purchase a $50,000 piece of equipment by putting 25 percent down and paying off the balance at 10 percent interest with four annual installments of $11,830. The equipment will be used in your business for eight years, after which it can be sold for scrap for $2,500.

The alternative is that you can lease the same equipment for eight years at an annual rent of $8,500, the first payment of which is due on delivery. You'll be responsible for the equipment's maintenance costs during the lease.

You expect that your combined federal and state income tax rate will be 40 percent for the entire period at issue. You further assume that your cost of capital is 6 percent (the 10 percent financing rate adjusted by your tax rate).

The following tables demonstrate how you can use a cash flow analysis to assist you with a lease-or-buy decision. In this case, if cost were the sole criterion for the decision, you would be inclined to purchase the asset because in current dollars, the cost of purchasing is $32,204, while the cost of leasing is $34,838. Even if cost isn't your sole criterion, a cash flow analysis is useful because it can show you how much you're paying for non-cost factors that may dictate your decision to lease.

Cash Flow Analysis of Purchase

This analysis assumes the financed purchase of a $50,000 piece of equipment for 25 percent down, interest at 10 percent, and four annual payments of $11,830 (all payments are made on the last day of the year).

Interest is deemed to accrue on the outstanding balance of the loan at the end of each year and is computed as follows (the last column shows the portion of each annual payment that goes to principal and that reduces the outstanding loan):

Year End	Outstanding Loan	Interest	Principal
1	37,500	3,570	8,080
2	29,420	2,942	8,888
3	20,532	2,053	9,777
4	10,755	1,075	10,755

Depreciation is computed on the basis of the 200 percent declining balance method.

(A)	(B)	(C)	(D)	(E)	(F)	(G)	(H)
Year	Cash Payments	Prior Year's Interest	Prior Year's Depreciation	Tax Savings [40% x (C + D)]	Net Cash Flow [B - E]	Discount Factor (6% Cost of Cap.	Present Value [F x G]
1	12,500	0	0	0	12,500	1.0000	12,500
2	11,830	0	10,000	4,000	7,830	0.9434	7,387
3	11,830	3,750	16,000	7,900	3,930	0.8900	3,498
4	11,830	2,942	9,600	5,017	6,813	0.8396	5,720
5	11,830	2,053	5,760	3,125	8,705	0.7921	6,895
6		1,075	5,760	2,734	(2,734)	0.7473	(2,043)
7			2,880	1,152	(1,152)	0.7050	(812)
8
9	(2,500)			(1,000)	(1,500)	0.6274	(941)
Net Cash Flow	32,204

Cash Flow Analysis of Leasing

This analysis assumes that equipment costing $50,000 will be leased for eight years for an annual rent of $8,500, with the first payment being due on delivery and the following payments being due on the first day of each subsequent year. The business is assumed to have a combined federal and state income tax rate of 40 percent (tax benefits are computed as of the first day of year following the year for which the rental deduction was claimed) and a 6 percent cost of capital.

(A)	(B)	(C)	(D)	(E)	(F)
Year	Lease Payment	Prior Year's Tax Savings [40% x B]	Net Cash Flow [B - C]	Discount Factor (6% Cost of Capital)	Present Value [D x E]
1	8,500		8,500	1.000	8,500
2	8,500	3,400	5,100	0.9434	4,811
3	8,500	3,400	5,100	0.8900	4,539
4	8,500	3,400	5,100	0.8396	4,282
5	8,500	3,400	5,100	0.7921	4,040
6	8,500	3,400	5,100	0.7473	3,811
7	8,500	3,400	5,100	0.7050	3,596
8	8,500	3,400	5,100	0.6651	3,392
9		3,400	(3,400)	0.6274	(2,133)
Net Cash Flow	34,838

Crux

Resturant owner should buy or lease building as per above theroticle planning.

he best method will depend on the information you need from the cash flow statement.

The indirect method is simpler – it uses readily available information from a business’s accounting software to show profits converted into cash. However, even after you’ve made the necessary adjustments, you won’t have the precise overview of cash flows that the direct method provides.

While the direct method requires more work, it is typically preferred by investors and creditors – it shows where the business is collecting money from and who it is paying it to, as well as the exact cash amounts for each transaction.

Regardless of the method you choose, both are useful in providing a clear and accurate view of a business’s liquidity.