Your cash flow statement and forecast can help you to identify financial opportunities or risks and ensure your business is heading in the direction you want. Use financial statements to monitor cash flow.You may need a strategy to cover a potential temporary cash shortage to gain the long-term benefit. For example, an advertising campaign will increase your expenses (and lower your cash flow), but the resulting extra sales may increase your revenue (and raise your cash flow again). When making decisions on specific objectives or purchases, consider how this could impact on your cash flow. Review how a decision may impact on cash flow.The exact point where the effect on the required return dominates would vary from firm to firm.When you have a good understanding of your cash flow, you can use that information to measure your performance and make informed decisions. However, as risk rises, at some point the effect of the increased required return dominates, and increasing risk will decrease the stock price.īelow is a general example. The following interactive application gives you a general idea of how a stock's price reacts to increasing risk.Īs you increase risk, both expected cash flows and the required return on equity increase, however the effect of increasing expected cash flows dominate, and the stock price increases. In this way, the goal of financial management naturally limits risk. Generally, at a certain point, the increase in the cost of equity will always more than offset the increase in increased dividends. The firm thus should not take on the additional risk. However, what if to increase dividends to $14, the firm's cost of equity becomes 11%. Then the value of the stock is $133.33, and management of the firm should take the additional risk. Say the firm can pay $12 in dividends annually, but it will increase their cost of equity capital to 9%. So how does this limit risk? A firm may increase risk to increase the value of the stock. See this presentation on stock valuation for a more detailed treatment.If we assume `k = 8\%`, then the value of the firm's stock is $125. Where k is the firm's cost of equity capital (which increases with the risk the firm takes). So, for example, say a company expects to pay $10 in dividends per share every year forever. The value of a stock* (or any asset) is the sum of all the stock's discounted expected future cash flows (dividends), where the discount rate reflects the risk taken to earn those cash flows. In fact, you can see maximizing cash flow or profit will simply instruct management to borrow as much as possible and use it all to buy houses (take on as much risk as possible). You can invest $1,000 each in 100 houses. In this case you expect to earn $1,000 cash flow (or profit) over the year. You will sell all investments at the end of the year.Īssume interest rates and taxes are 0% (this is only saves us from immaterial calculations). You are able to borrow up to a maximum of 100-to-1 leverage. There are 100 houses, each house costs $100,000, and their prices will increase by 1% over the next year. Your company has $100,000 to invest in houses. Thus, setting these as goals of management, may lead management to take excessive risks (because risk isn't even considered).Īs an example, say the goal was to maximize cash flow. They consider reward (profit and cash flows) without considering the risk it takes to maximize them. That is the problem with these possible measures. You can't have one without the other, and so you can't consider the reward without also considering the risk you must take to earn that reward. In finance and investments risk is balanced with reward. The larger problem with measures such as maximizing profit or cash flowsis that the they lack balance. Maximizing shoreholder wealth is not ambiguous. In other words these measures are ambiguous. Relatively minor problems with these goals relate to how to measure the cash flows-should they be the average cash flow over some period (and what period)? Some might offer goals such as maximize cash flows or maximize profit. We'll also explain why this measure makes sense, and limits excessive risk-taking. We'll discuss the drawbacks of other potential measures. The goal of financial management is to maximize shareholder wealth. For public companies this is the stock price, and for private companies this is the market value of the owners' equity.
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