Estimating Cisco’s Future Cash Flows Harvard Case Solution & Analysis

Estimating Cisco’s Future Cash Flows Case Solution

Benefits

It enables the investors to make comparisons with the industry’s dynamics, other companies and intra-firm comparisons. This, in particular, offers useful information about the company's financial situation in terms of economy.

It helps in the approval or disapproval of the company's acquisition, funding and operational decisions. The ratios assist in assessing and comparing the company's financial status as well as the outcomes of the management or investor’s decision.

Furthermore, it helps in the understanding the firm's market risk by measuring leverages, such as: operational and financial leverages. It helps in determining how profitable a business is, in terms of deferred loans and fixed cost deployment. It also gives you interesting information about the company's profitability, efficiency and total earning capacity. The pattern can be used to make strategic projections and forecasts, which helps the investors in making decisions. By financial stability, operational efficiency, solvency and long-term position; it also simplifies the dynamic accounting standards and financial records.

Drawbacks

The entire evidence used in ratio analysis is taken from the real historical data findings, which makes it difficult to extrapolate into the future. The information on the company's income statement is expressed in actual expense, while the information on the company's balance sheet is stated in historical cost, which can result in an unusual ratio performance. It depicts a link between the previous data and records, whereas, investors are more interested in  future and current data.

Changes in accounting policies used in recording and preparing financial statement can significantly affect the ratios, and comparing ratios prepared with different accounting policies statement can provide misleading results.

Ratios can be manipulated by the company to show better result than actual results of the company. By simple analysis, it cannot be detected if the ratios are manipulated or not. It is the  company’s responsibility that ratio analysis should accurately reflect the company’s actual performance and its true financial position in the market.

Horizontal Analysis

Horizontal analysis method is used when comparing any particular item of income statement and balance sheet. The trend or changes of each item of financial statements is calculated by the percentage difference in amount of current year to base year. In this method historical data can be used to predict any reporting period. It can be used as a comparison tool of financial performance with the company’s competitor.

Formula for Horizontal Analysis is

The Horizontal analysis of the company shows that the total revenue of the company has increased by 0.17% while total cost of sales has declined by 4.31%. And the gross margin has increased by 4.31% from year 2015 to 2016. Ultimately net profit margin has increased by 20%. The overall increase in revenue and decrease in cost is a positive indicator for the company. It can be concluded that the company will also perform better in the upcoming years, keeping the company’s historical performance under observation. (Appendix 2).

The following are the benefits and drawbacks to using such tools to forecast a company's potential profitability:

Benefits

It is very helpful for analysts and investors as it clearly identifies which items of financial statements are driving the company’s financial results.

It enables the investors to evaluate the major and relative improvements in the products and project them into the future. It also aids in the analysis of the current state of the pattern. It also helps in determining the company's ultimate liquidity and short-term liquidity positions.

Drawbacks

Choosing of base year is important in this analysis, as base year with lower performance will overestimate the performance of the company’s current period or period which is analyzed. The result would vary to a significant extent if the base year is changed.

As inflation or price levels adjust, it loses its usefulness, resulting in erroneous outcomes. Furthermore, it would not strictly adhere to accounting principles and concepts.

Discounted Cash Flow Analysis

Another tool used by the investors to predict the potential return on investment capital for the time value of money is discounted cash flow analysis. Time value of money is considered as the value of dollar is expected to decrease with time.The definition of present value of funds will be used by the investors to assess if the potential cash flows from an investment or operation are equal to or greater than the original investment.Since the DCF approach considers important considerations like cost of equity, WACC, and growth rate, it can provide the most accurate estimation of an asset's or business intrinsic value.

If the value calculated by DCF model is greater than current investment, opportunity should be availed. Formula for calculating DCF is

In this case future cash flows are predicted by add value of amortization and investment in plant and equipment to the amount of operating income in 2016 to reach cash flow of 2016. From 2017 to 2020 cash flows are increased at the growth rate of 4% and the discounted to bring it to current value at the discount rate of 8.5% (Appendix 3).

Following are the benefits and drawbacks to using such a tool to forecast a company's potential profitability:

Benefits

It is commonly used to assess the attractiveness of an investment based on the company's cash flows. The research also involves prospective projections as well as the internal cost of return, which is used to predict the feasibility of a possible project. It can be used to determine the company's potential worth and its profitability. Furthermore, the terminal value is useful in deciding the company's status. It also contains a company's inherent valuation as well as key observations about the business.

This method is least affected by short term market factors and non-economic conditions. Which is focused on a forecast of potential cash flows, and is thought to be more objective and reliable than many other subjective accounting policies.

It also indicates how much of the company's stock is undervalued or overvalued and whether the stock price is justified or not. It helps the investors in incorporating crucial improvements in the company's growth plan into the valuation formula, whichwould otherwise go unnoticed by other valuation models, such as: APV.

Drawbacks

The (DCF) estimation necessitates a vast number of assumptions, and it is vulnerable to even minor variations in those assumptions. It is a constantly shifting goal that necessitates continuous modification and caution. If the company's intrinsic value changes; the fair value will also change.

Other Methods of Analysis

Vertical Analysis

This method of financial analysis entails splitting different income statement elements by sales & expressing them as a percentage. The findings of this exercise should be compared to those of other firms in the same sector to see how well the business has been doing. This method is also known as a common-sized income statement because it helps an observer to compare-firms of various sizes by comparing their margins rather than their dollar amounts.

Scenario & Sensitivity Analysis

Performing scenario and sensitivity analysis as a means of assessing risk is another aspect of financial modelling and valuation. Since developing a formula to value a business entails-attempting to forecast the future, which makes it potentially risky.

Developing scenarios & doing sensitivity analyses will aid in determining what the company's worst-case and best-case futures might look like. These scenarios are often prepared through financial planning and analysis (FP&A) managers to aid in the preparation of the company’s budgets projections.

Investment analysts will use Goal Seek and Data Tables to see how resilient it is for a valuation to shift in expectations as they flow through the model.

Variance Analysis

The method of comparing real outcomes to a budget or prediction is known as variance analysis. It is a critical component of an operating company's internal planning and budgeting process, especially for practitioners in the departments of accounting and finance.

The method usually starts by determining whether a difference is beneficial or unfavorable, and then breaking it down to figure out what caused it.

Recommendation

Following a study of the key forecasting methods, several alternative methods were explored in order to refine Stark's approach, which employs the most effective instruments to evaluate the patterns in the market cash flows and income. We believe that Stark should focus heavily on ratio analysis to predict the company's performance, as this would provide a much clearer picture of the advertisement situation.It will help the investors in understanding the industry’s dynamic and how the companies work in a particular sector, which help in comparing the companies operating in the same sector. By the results, investor can interpret that in which company should he invest.

This makes pattern forecasting, which includes long-term company’s comparisons, easier. Stark will make fast decisions based on the critical matrix that prospective investors use when deciding whether or not to invest in a business. As a result, analyzing the ratio helps in decision-making and protecting the company's financial position. Furthermore, they would be able to assess the company's efficiency in terms of logistics and management.

appendix

Appendix 1

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