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Project 5: Cost of Capital, Risk/Return, and Capital Budgeting
MBA 620 9047 Financial Decision Making (2232)
Project 5: Cost of Capital, Risk/Return, and Capital Budgeting
1. How would you assess the evolution of the capital structure
of LGI? Reflecting on your work in Project 1, would you consider the risk exposure under control? If not, what are your recommendations? LGI’s capital structure evolution looks to be on the positive side given it moves forward with the
changes proposed throughout the 5 projects. A company’s capital structure is the mix of debt and equity the company uses to finance its business (Clayman et al., 2012). Securing the sale of its underperforming assets for the Bowie plant will help in generating much needed cash flow to the company to divert its investment activities towards the acquisition of a robotics-based sorting and distribution equipment to facilitate a more cost-effective operations at its Largo facility. This will help the company utilize its resources efficiently and help in maximization of profit for possible investment and development opportunities in the near future. Reflecting on the data calculated for LGI in Project 1, we can consider that the risk exposure for the company was not under control. The company’s long-term debt and current liabilities continues to see a rise over the course of the three years period as calculated on its balance sheets. The debt-to-equity (D/E) ratio for LGI was recorded higher than the industry average of 0.27 for three consecutive years at 0.33, 0.31, and 0.30. ‘Lenders and debt investors prefer lower D/E ratios as that implies there is less reliance on debt financing to fund operations – i.e. working capital requirements such as the purchase of inventory (Wall Street Prep, n.d.). It is crucial for LGI to improve its debt management to keep its control its risk exposure. The Income
statement for the company reflects continuing decline in its net sales resulting in decline of its profit from $968 million in 2018 to $613 million in 2020. LGI needs to increase and utilize all of its resources to its optimum to increase its sales and revenue to meet its debt obligations.
Project 5: Cost of Capital, Risk/Return, and Capital Budgeting
2. What kind of information do you find valuable in CAPM
to guide you in assessing the risk of LGI compared to other firms and the market in general?
Capital Asset Pricing Model (CAPM) describes the relation between risk and expected return. It defines the relation of systematic risk and return as linear and that the risk-free rate of return is
the appropriate return for an asset with no systematic risk (Parrino et al., 2021). This model is used in the finance sector to assess the rate of return needed for an investment with a particular amount of systematic risk. Utilizing the CAPM is valuable in assessing LGIs risks against its competitors in the industry. The expected return for a portfolio can also be predicted using the CAPM (Parrino et al., 2021). The
expected return calculated by the CAPM can be used a benchmark for assessing whether the expected returns for individual assets are sufficient. When the expected return is lower than that CAPM predictions the investment is not profitable and conversely an investment is profitable when the expected return is higher (Parrino et al., 2021). It also helps in assessing the pricing of LGIs assets and the associated risks of the volatile market conditions. Analyzing the expected return on LGIs assets at various Beta points and systematic risks depending on the
market portfolio helps its managers to make sound financial decisions. This information is also crucial to its investors in assessing the risks with LGI in comparison to other companies in the industry to determine if the investment is worth the risk based on the expected rate of return.
3. Identify and differentiate the stakeholders of LGI and explain how each one should perceive and weigh the risk
and/or return
of the firm.
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