This is calculated by determining the weight average cost of capital. Similarly the cost of capital is made up of equity and debt. Hence for the firm to maximise profit and obtain shareholders wealth the organisation must sell goods, contributing to the total revenue minus the total cost. Therefore the remainder or excess surplus is known as profit maximisation. In light of this when profits are maximised the firm make decisions to access shareholders wealth through the means of equity.
Also, they pointed the graph that every firm should use in order to find their optimal WACC. Pratt and Grabowski ( 2008 ) state that the WACC should be found when dividing DEBT/ TOTAL CAPITAL and that represents for one company ideal and optimal WACC. Also, they state that WACC should be higher than the cost of debt but lower than cost of equity, rather it should be somewhere in the middle of these two, depending if the amounts of debt and equity are the same. The WACC calculation will give us the discount rate at the end. That rate represents how much we are on average paying interest for the money we have borrowed from various sources.
This is known as “arms-length” trading , because it is the product of genuine negotiation in a market. This arm’s length price is usually considered to be acceptable for tax purposes. But when two related companies trade with each other, they may wish to artificially distort the price at which the trade is recorded, to minimise the overall tax bill. This might, for example, help it record as much of its profit as possible in a tax haven with low or zero taxes. Tax law starts from the assumption that the application of the arm’s length standard will reduce the interference of tax effects with bona fide business decisions taken by the corporate management.
Throughout the case, it can be seen how Cendant Corporation was performing activities that dealt with the interactions of income smoothing. The main cause of performing with Income Smoothing was to make their shareholders and investors believe that they had a professional and ethical operation running. Income smoothing can best be represented as how either gains or losses from a certain period are taken into a good or bad period with losses or no profits. Income smoothing throughout this case was used as an unethical practice performed by Cendant Corporation to achieve financial stability and falsify numbers to make the investors believe they had premium stocks when in reality it wasn’t what was really occurring which would then lead to the
Conservatism magnifies lower revenue and this is not just considered as a practical reason for the undesirable conservatism, it generates disorders in the process of recognizing revenue. Lafound and Watts, “states that conservatism is a conflict of interest among investors and creditors and they prefer to use less conservative approaches”. However, IASB and FASB conclude that conservatism should be excluded from the qualitative characteristics of accounting information (Chi 2008). Nevertheless, if these demands are carried out, this exclusion can change the development of future accounting standards. If the FASB was successful in eliminating conservatism, then it would increase information asymmetry between investors, not reduce it.
As a result of the time value of the money, NPV considers the compounding of the discount rate over the span of the project. The NPV of a project mirrors how much cash inflow or outflow and it measures up to or surpasses the amount of project capital required to reserve it. An organization utilize NPV as a method for contrasting their relative profitability with assurance that exclusive the most lucrative endeavors are sought while evaluating numerous projects. A higher NPV shows that the project is more fruitful. The forecasted cash outflow and inflow for every period must be recognized and additionally the expected discount rate in order to compute NPV.
One cannot rule out investor psychology in causing this effect. This paper attempts to assess the relative importance of prospect theory and other explanations for the disposition effect. When one takes the purchase price as the reference price in the value function, then the implication of prospect theory is that the tendency to sell a stock should decline as the stock price moves away from the purchase price irrespective of the direction. The regressions are run for different holding periods, and they include a host of control variables, such as past returns. In contrast to the mean-reversion hypothesis, outperformance actually decreases selling for loss-making positions.
(Tudor and Mutiu, 2006, p.2). Another benefit of using cash flow is that this method can also be viewed as a method of measuring firm’s performance in some extent. According to Marshall (2014), there are there categories under cash flow basic: cash flows from operations, cash flow from investing and financing activities. These there approaches will explain users the overall change of cash during the year. If the cash from operations exceeds cash flows from investment, that reflect a good sign of firm’s performance.
1) Sources of capital to be included when estimating Harry Davis’s WACC: The WACC is primarily used for making long-term investment decisions that is capital budgeting. The WACC should include the types of capital used to pay for long-term assets like as long-term debt, preferred stock and common stock. Short-term capital consists of account payable, accruals, short-term debts and note payable. WACC should include short-term debt component if the firm is using short-term debt to acquire fixed assets rather than just to finance working capital needs. Non-interest bearing debt is not included in cost of capital estimate as theses funds are netted out when determining investment needs which is net rather than gross working capital is included
Furthermore historical cost is more relevant for investor to make a wise decision because they are relying on the factor of “how much has already been earned rather than how much they can earn”. Mostly some of people like to use this approach because it helps to minimize the risk of manipulation of figures by the managers. However there are some disadvantage from applying historical cost approach which is we are unable to guarantee the quality of the information