Using A Timeline: The Financial Manager At Starbuck Industri

Using a time line The financial manager at Starbuck Industries is Consi

Using a timeline the financial manager at Starbuck Industries is considering an investment that requires an initial outlay of $25,000 and is expected to result in cash inflows of $3,000 at the end of year 1, $6,000 at the end of years 2 and 3, $10,000 at the end of year 4, $8,000 at the end of year 5, and $7,000 at the end of year 6.

Draw and label a time line depicting the cash flows associated with Starbuck Industries’ proposed investment.

Use arrows to demonstrate, on the time line in part a, how compounding to find future value can be used to measure all cash flows at the end of year 6.

Use arrows to demonstrate, on the time line in part b, how discounting to find present value can be used to measure all cash flows at time zero.

Which of the approaches—future value or present value—do financial managers rely on most often for decision making? Why?

Paper For Above instruction

The decision-making process in investment analysis predominantly hinges on the principles of present value and future value, which are fundamental concepts in financial management. To elucidate these concepts, it is instructive to examine a proposed investment at Starbuck Industries, which involves an initial outlay of $25,000 and a series of projected cash inflows over six years.

Part A: Drawing and Labeling a Time Line of Cash Flows

The initial step entails depicting a time line that visually represents the cash flows associated with the investment. Beginning at year zero, the timeline marks an initial outlay of -$25,000. Subsequently, at the end of each year, the anticipated cash inflows are positioned: $3,000 at year 1, $6,000 at years 2 and 3, $10,000 at year 4, $8,000 at year 5, and $7,000 at year 6. This visual can be arranged as follows:

- Year 0: -$25,000 (initial investment)

- Year 1: +$3,000

- Year 2: +$6,000

- Year 3: +$6,000

- Year 4: +$10,000

- Year 5: +$8,000

- Year 6: +$7,000

This chronological arrangement provides a foundation for analyzing the investment's viability via different valuation techniques.

Part B: Using Future Value (FV) to Measure Cash Flows at Year 6

The use of future value involves compounding all cash inflows to a common future point—in this case, year 6. Each cash inflow received in a specific year is compounded forward using a chosen interest rate, enabling the sum of all compounded cash flows to be evaluated at year 6.

For example, assuming a certain annual interest rate (say, 8%), the future value of each cash flow at year 6 is calculated as:

- Cash inflow at year 1 compounded for 5 years: $3,000 * (1 + r)^5

- Cash inflows at years 2 and 3 compounded for 4 and 3 years respectively.

- Cash inflow at year 4 compounded for 2 years.

- Cash inflow at year 5 compounded for 1 year.

- Cash inflow at year 6 remains as is, since it is already at year 6.

Graphically, arrows can be used on the timeline to demonstrate that each cash flow is moving forward in time, being multiplied by the compound interest factor, and summed at year 6. This approach helps determine the accumulated value of all cash inflows if the investment is held until year 6, providing insight into its potential growth.

Part C: Using Present Value (PV) to Measure Cash Flows at Time Zero

Conversely, discounting involves calculating the present value of all future cash inflows as of year 0, using a discount rate that reflects the opportunity cost or required rate of return. Each cash inflow at year t is discounted back to present by dividing by (1 + r)^t:

- PV of cash inflow at year 1: $3,000 / (1 + r)^1

- PV of cash inflows at years 2 and 3: $6,000 / (1 + r)^2 and $6,000 / (1 + r)^3

- PV of year 4 inflow: $10,000 / (1 + r)^4

- PV of year 5 inflow: $8,000 / (1 + r)^5

- PV of year 6 inflow: $7,000 / (1 + r)^6

Arrows on the timeline depict each future cash flow moving backwards to year 0 via discounting, illustrating how the present value of all inflows sums to compare against the initial outlay of $25,000. This helps determine whether the investment is worthwhile based on the criterion of net present value or other valuation metrics.

Part D: The Preference for Present Value or Future Value in Decision Making

Financial managers predominantly rely on the present value approach. This preference stems from the necessity to evaluate whether an investment's current cost is justified by its expected future benefits, aligning with the time value of money principle. Present value calculations enable managers to determine the net worth of a project today, considering the opportunity cost of capital; a project is accepted if its net present value is positive.

Future value calculations, while useful for understanding how an initial investment could grow over time, are less frequently used for decision-making because they do not account for the time value of money in the same comprehensive manner. They are more suited for planning or projecting growth of current holdings rather than assessing whether an investment adds value relative to its initial cost.

In conclusion, the reliance on present value is more prevalent among financial managers because it aligns with the fundamental goal of maximizing value and making informed investment decisions based on current worth rather than future projections alone. Both methods are essential, yet the present value technique offers a more accurate and practical basis for evaluating investments.

References

  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
  • Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2019). Fundamentals of Corporate Finance (12th ed.). McGraw-Hill Education.
  • Damodaran, A. (2010). Applied Corporate Finance (3rd ed.). John Wiley & Sons.
  • Fitzgerald, J., & Brimacombe, D. (2017). Fundamentals of Financial Management. Pearson.
  • Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance (12th ed.). McGraw-Hill Education.
  • Investopedia. (2023). Time Value of Money. https://www.investopedia.com/terms/t/timevalueofmoney.asp
  • Khan, M. Y., & Jain, P. K. (2014). Financial Management: Text, Problems and Cases. McGraw-Hill Education.
  • Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson.
  • Higgins, R. C. (2018). Analysis for Financial Management (11th ed.). McGraw-Hill Education.
  • Franklin, G. M., & Engle, R. F. (2020). Financial Decision Making. Routledge.

Related Assignments