FINE 2000 Chapter Notes - Chapter 1-2: Sole Proprietorship, Limited Liability Partnership, Capital Budgeting

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25 Mar 2016

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Document Summary

Chapter 1: goals and governance of the firm. There are two kinds of decisions, capital budgeting decision and investment decision which determine real assets the firm should acquire. The financial manager has to help the firm identify promising projects and how much to invest in each project for the purpose of capital investment projects. How you allocated budget throughout investments and decide is called the capital budgeting decision. You can invest in research and development, patents and trademarks. The financing decision is the second critical responsibility for the financial manager. Capital structure is the choice between debt and equity financing. decision. Here capital refers to the firms sources of long-term financing. A firm that is seeking to raise long-term financing is said to be raising capital. With investments you acquire risk, thus it is important to weigh out the risk and returns. Flow of cash between investors and the firm"s operation: Real assets are used to produce goods and services.

Related Questions

Capital budgeting involves choosing projects that add value to the firm. The net present value (NPV), internal rate of return (IRR) and payback period methods are the most common approaches to project selection. At its core, capital budgeting is measuring an accounting of costs versus benefits. In a way, all business decisions are a series of capital budgeting decisions. Get it wrong, and you can destroy a company.

The capital budgeting tools help financial managers decide on the desirability of the projects. In the real world, however, managers sometimes will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods.

For example, consider the two mutually exclusive projects below.

Investments	Cost	Cash Flow 1	Cash Flow 2
Project A	$ 50	$ -	$ 100
Project B	$ 50	$ 50	$ 25

According to the payback period, project B should be selected. Although both projects cost the same, project B has a payback period of one period, while project A will payback in roughly 1.5 periods.

Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20.

This example illustrates the limitations of the payback period method. Even though the payback period method points to project B, the NPV method points to project A since it has more than twice the NPV value to that of project B. Yet the manager may choose project A. Why?

It may be that the project stakeholder is requesting a quicker return in cash.

For this discussion, create an example problem where two (or more) methods contradict each other. What would be the "appropriate" choice (which project would you choose)? In what cases would you not choose the "best" choice?

bluelizard621

Concept of cost of capital Mace Manufacturing is in the process of analyzing its investment decision making procedures. Two projects evaluated by the firm recently involved building new facilities in differnt regions, North and South. The basic variables surrounding each project analysis and the resulting decision arctions are summarized in the following table

a. an analyst evaluating the North facility expects the project will be financed by debt that costs the firm 7%. What recommendations do you think thes analyst will make regarding the investment opportunity?

b. Another analyst assged to study the South facility believes that the funding for that project will come from the firm's retained earnings at a cost of 16%. What recommendations do you think thes analyst will make regarding the investment opportunity?

c. Explain why the decisions in part a and b may not be in the best interest of the firm's investors.

d. If the firm maintains a capital structure containing 40% debt and 60% equity, find it weighted average cost using data in the table.

e. If both analysts had used the weighted average cost calculated in part d, what recommendations would they ahve made regarding the North and South facilities?

f. Compare and contrast the analyst's initial recommendation with your finding in part e. Which decision method seems more appropriate? Why?

Basic Variables	North	South
Cost	$ 6,000,000	$ 5,000,000
Life	15	15
Expected Returns	0.08	0.15
Least Cost Financing
Source	Debt	Equity
Cost (after-tax)	0.07	0.16
Decision
Action	Invest	Don't Invest
Reason	.08>.07	.15<.16