In your own words answer Two of the financial management decisions that we learn
ID: 2791740 • Letter: I
Question
In your own words answer
Two of the financial management decisions that we learned this semester include: capital structure and capital budgeting. Describe each financial management process, their respective importance within an organization, and provide an example of a business transaction that would be relevant. Your discussion on capital structure should describe WACC and explain its role within capital structure as well as in capital budgeting as a hurdle rate. Also, discuss the capital budgeting techniques that are used to determine a project’s value over time including the advantages and disadvantages of each as well as how a firm decides whether to accept or reject a project if using NPV or IRR. Please refer to the Instructor Notes and any other resources that you find relevant. Please remember to cite sources if outside sources are utilized.
Following are the capital budgeting techniques to include:
Net Present Value
Internal Rate of Return
Payback Period
Explanation / Answer
Capital structure is a mix of debt, equity and preferred stock which finance the overall operations and growth of a firm. Capital structure is very important it shows the debt to equity ratio of a company. Company heavily financed by debt is having aggressive capital structure and company financed with low debt is having conservative capital structure.
Aggressive capital structure shows the risk inherent and thisay sometimes lead to higher growth. Conservative capital structure companies however have less growth.
WACC is weighted average cost of capital: which is calculated as market weights of different funding sources in capital structure divided by the total weight= weight of each component.
Market rate of return on each component is calculated as:
Debt: kd= interest(1- tax rate)
Preferred stock= dividend/ share price= Kp
Equity stock= CAPM model or dividend discounts model.
WACC = wd*kd+ wp*kp+ we* ke.
For.eg. capital structure has a mix 40 % debt and 60% equity which is then multiplied by cost of the respective components gives us WACC.
WACC us the minimum rate of return which the company has to earn in order to be profitable. Or it can also be described as hurdle rate for a project above which it is profitable and below this it is incurring losses.
WACC is the discount rate used for calculating present value of cash flows in capital budgeting.
Capital Budgeting: It is a process of evaluating different projects in a company. A formal process for the acquisition and investment of capital. It involves for vision making process by a firm to invest its current funds for addition, disposition and modification, replacement of its fixed assets.
Capital Budgeting techniques are:
NPV or Net Present Value: It involves discounting the cash in flows of a project using the WACC as Cost of capital and bringing them to present value and comparing it to the initial outlay of the firm. If the inflows are greater than Outlay then the project is having a positive NPV and the project is feasible.
Decision rule is accepting the project with positive NPV and rejecting the one with negative NPV.
IRR- Internal Rate of Retuen:-
The discount rate where project inflows are equal to outflows.
I.e. outflows= inflows/(1+irr)n
Decision rule is when irr> coc accept the project.
When irr<coc, reject the project.
3. Payback period: Time required by the project to recover the total initial outlay.
Lesser the payback period more feasible the project is. But this technique is somewhat partial, sometimes cash flows occur in later stage which is ignored in this technique, do the firm may avoid better projects.
The universal decision rule is NPV.