How Investment Risks and NPV affect Capital Budgeting Analysis and Decision Making
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How Investment Risks and NPV affect
Capital Budgeting Analysis and Decision
Making
Solange Sanchez
Corporate Finance – 11107
Dr. Wayne Morgan
2/11/2024
Capital Budgeting is an analysis run by businesses to help determine which fixed assets
purchases to make and/or accept. The analysis is crucial in instances where there are not enough
2
funds in a company to pay for every project that is being proposed. Oftentimes, lenders might
require this analysis if they are being asked for a loan to fund a project. The process of the
analysis is to review cash inflows and outflows to get a better understanding of potential
expected return on the investment and making a decision based on these projections.
The type of
project and amount of investment also affects how detailed the analysis has to be in the capital
budgeting process. For example, low-risk investments would be okay with an analysis that is not
overly detailed. However, high risk and high-volume investments would need a longer and more
detailed analysis in order to get a full understanding of the potential risks a project may have and
then decide whether to accept these risks and move forward with the project. Remember that low
risk typically refers to short-term projects while high risk usually involves projects that will take
a longer time to complete. This is because the longer the term the more likely circumstances
could change and affect the project and so the risk involved is higher. To put it simply, the level
of risk reflects the level and detail needed for the Capital budgeting analysis.
Now to dive into capital budgeting in more detail, let’s analyze the decisions around when
two mutually exclusive projects are being compared and how to decide which project to take one. In
the capital budgeting world, a short-term project would be perceived as higher under the NPV
criterion if the cost of capital is high, whereas a long term project might be seen as the better option
of the two if the capital is low. This is because when the cost of capital is high, projects that have a
short lifespan will tend to generate a higher Net Present Value because of the discounting effect. This
is primarily due to the fact that cash flows for these projects are received much sooner which reduces
the impact of discounting. On the other hand, projects that have a longer term will have a higher
NPV when the cost of capital is low because the discounting effect is not as prominent. Additionally,
since neither an increase or decrease in the cost of capital affect the internal rate of return, it would
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Related Questions
SECTION B Answer all the questions below:.
B1) Do you think capital budgeting is important? Justify?
B2) List all the techniques of Capital Budgeting? You think are relevant today?
B3) Do you think that these techniques are really helpful to financial managers?
B4) Do you think that these techniques can be used in situations like COVID-19?
B5) According to you which technique is better and why?
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Capital budgeting techniques aid businesses with investment decision-making. Many approaches can be used, with some being more advanced than others.
Describe the payback period approach to capital budgeting.
Explain 1 advantage and 1 disadvantage of the technique.
Explain why it would be wise for a financial manager to learn advanced capital budgeting techniques.
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SECTION B Answer all the questions below:.
B1) Do you think capital budgeting is important? Justify?
B2) List all the techniques of Capital Budgeting? You think are relevant today?
B3) Do you think that these techniques are really helpful to financial managers?
B4) Do you think that these techniques can be used in situations like COVID-19?
B5) According to you which technique is better and why?
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Having to decide on the purchase of a piece of machinery to improve productivity is part of the finance manager’s responsibility in ____________.
Question 11 options:
1)
short-term financial management
2)
capital raising
3)
capital budgeting
4)
preparing the accounts
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1. Interactions between financial market participants
Financial markets facilitate the transfer of excess funds from those who have them to those who need them.
In the following table, determine whether each financial market participant is a surplus unit or deficit unit.
Financial Market Participant
A state that is constantly running a budget deficit
A firm that issues equity securities to expand operations
A consumer that purchases equity securities from a new tech company
Surplus Unit Deficit Unit
S
An angel investor
Suppose Moonlit Productions needs to raise money to finance its new manufacturing facility, but their CFO does not want to part with any of the firm's
equity. In this case, Moonlit Productions would likely issue
securities to obtain the funding.
Which of the following are ways that Moonlit Productions could obtain funds to finance the expansion of its operations, given its stated preference in
the previous question? Check all that apply.
Issue common stocks
Issue…
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Part AAttempt all the five questions. 1 Discuss various types of capital budgeting techniques. Also identify the most appropriate technique and justify with logical reasoning.2. The managers of a firm wish to expand the firm's operations and are trying to determine the amount of debt financing the firm should obtain versus the amount of equity financing that should be raised. The managers have asked you to explain the effects that both of these forms of financing would have on the cash flows of the firm. Write a short response to this request.3. Give some examples of ways in which manager's goals can differ from those of shareholders.4.You want to begin saving for your daughter’s college education and you estimate that she will need $150,000 in 17 years. If you feel confident that you can earn 8% per year, how much do you need to invest today?5. Brodax has $20 million in current assets and $10 million in current liabilities, while Smaland's current assets are $10 million versus $20…
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47
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Solving for the WACC
The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk.
Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address.
Consider the case of Turnbull Co.
Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%.
If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%.
If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead…
arrow_forward
Solving for the WACC
The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk.
Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address.
Consider the case of Turnbull Co.
Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%.
If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%.
If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock…
arrow_forward
Solving for the WACC
The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk.
Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address.
Consider the case of Turnbull Co.
Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%.
If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%.
Q1. If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock…
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Understanding the impact of debt in the capital structure
Suppose you are conducting a workshop on capital structure decisions and you want to highlight certain key issues
related to capital structure. Your assistant has made a list of points for your session, but he thinks he might have
made some mistakes.
Review the Ilist and identify which items are correct. Check all that apply.
Workshop Talking Points
An increase in debt financing beyond a certain point is
likely to increase the firm's cost of equity.
An increase in debt financing decreases the risk of
bankruptcy.
An increase in the risk of bankruptcy is likely to reduce a
firm's free cash flows in the future.
Risks of bankruptcy increase management spending on
perquisites and increase agency costs.
The pretax cost of debt increases as a firm's risk of
bankruptcy increases.
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Case Study: Identifying Errors in Capital Budgeting Decisions
Introduction:
Capital budgeting decisions play a crucial role in the financial success of a company, impacting its long-term viability. Managers strive to make accurate and informed decisions when evaluating potential investment projects. However, errors can occur, and it is essential to implement effective procedures to identify and rectify these mistakes. This case study explores various procedures and their efficacy in identifying errors in capital budgeting decisions.
Background:
Company XYZ, a manufacturing firm, recently implemented a capital budgeting decision involving a significant investment in upgrading its production facilities. The decision-making process was intricate, considering factors such as projected cash flows, discount rates, and risk assessments. Despite thorough analysis, the management recognizes the importance of post-evaluation procedures to identify potential errors and enhance…
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plz solve all theses questions!!
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Please do question 14, 15, 17, 18 please help me all of these questions. Last time, they answered just 1 question.
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B1) Do you think capital budgeting is important? Justify? B2) List all the techniques of Capital Budgeting? You think are relevant today? B3) Do you think that these techniques are really helpful to financial managers
B4) Do you think that these techniques can be used in situations like COVID-19? B5) According to you which technique is better and why?
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6. Solving for the WACC
The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC
is an appropriate discount rate only for a project of average risk.
Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address.
Consider the case of Turnbull Co.
Turnbull Co, has a target capital structure of 55% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and
its cost of preferred stock is 12.2%
of Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new
common equity, it will carry a cost of 16.0%
its current tax rate is 25%, how much higher will Turnbull's weighted average cost of capital (WACC) be if it has to raise additional common equity
capital by issuing new common stock instead of raising the…
arrow_forward
You can come across different situations in your life where the concepts from capital budgeting will help you in evaluating the situation and making calculated decisions. Consider the following situation:
The following table contains five definitions or concepts. Identify the term that best corresponds to the concept or definition given.
Concept or Definition
Term
An example of externality that can have a negative effect on a firm
The cash flow at the end of the life of the project
Creates value for a company because it gives the company the right but not the obligation to take future action to increase its cash flows
The risk of a project without factoring in the impact of diversification
A risk analysis technique that measures changes in the internal rate of return (IRR) and net present value (NPV) as individual variables are changed
Marston Manufacturing Co. owns a warehouse that it is not currently using. It could sell…
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Capital budgeting can be affected by factors such as exchange rate risk, political risk, transfer pricing, and strategic risk. Select a mid- or large-sized business organization and explain how each of these factors can affect its capital budgeting. Which factor poses the greatest threat to your selected organization and why? What measures can stakeholders take to reduce adverse impacts of these factors?
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For businesses to continuously sustain in the competitive market, they need to expand their operations to relevant new dimensions. For this, they have to go for expansion, replacement and renewal of their capital assets. With regards to these situations, organizations need to deploy long term capital, and they have to decide in which of the alternatives they should fund. This scenario initiates the concept of capital budgeting.Required(a) Outline three (3) advantages and three (3) disadvantages of capital budgeting.(b) There are a number of capital budgeting techniques available. List four of the methods used.
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Please the question in its entirety!
3. Understanding the IRR and NPV
The net present value (NPV) and internal rate of return (IRR) methods of investment analysis are interrelated and are sometimes used together to make capital budgeting decisions.
Consider the case of Cold Goose Metal Works Inc.:
Last Tuesday, Cold Goose Metal Works Inc. lost a portion of its planning and financial data when both its main and its backup servers crashed. The company’s CFO remembers that the internal rate of return (IRR) of Project Omicron is 13.8%, but he can’t recall how much Cold Goose originally invested in the project nor the project’s net present value (NPV). However, he found a note that detailed the annual net cash flows expected to be generated by Project Omicron. They are:
Year
Cash Flow
Year 1
$2,400,000
Year 2
$4,500,000
Year 3
$4,500,000
Year 4
$4,500,000
The CFO has asked you to compute Project Omicron’s initial investment using the information currently…
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1 Why does WACC increase and IRR decrease as the capital budget increases? Are there any steps
management can take to reverse these trends?
2 How should a company prioritize all of its capital project opportunities?
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Capital Budgeting and Risk Analysis
Post a Response
Describe the most important capital budgeting techniques and how they are used to arrive at investment decisions.
Name at least two capital budgeting techniques (for example, NPV, IRR, Payback Period, et cetera)
How does a manager differentiate when to use capital budgeting versus simple return on investment (ROI) techniques?
Respond to a Peer
Be sure to respond to at least one of your classmates' posts.
Read a post by one of your peers and provide a substantive response, making sure to extend the conversation by asking questions, offering rich ideas, or sharing personal connections.
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1. Concepts used in cash flow estimation and risk analysis
You can come across different situations in your life where the concepts from capital budgeting will help you in evaluating the situation and making
calculated decisions. Consider the following situation:
The following table contains five definitions or concepts. Identify the term that best corresponds to the concept or definition given.
Concept or Definition
An example of externality that can have a negative effect on a firm
The cash flow at the end of the life of the project
The risk of a project without factoring in the impact of diversification
A risk analysis technique that measures changes in the internal rate of return (IRR) and
net present value (NPV) as individual variables are changed
Newcastle Coal Co. owns a warehouse that it is not currently using. It could sell the warehouse for $300,000 or use the warehouse in a new project.
Should Newcastle Coal Co. include the value of the warehouse as part of the initial…
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Question 2: What factors should you keep in our mind as a
financial manager when selecting methods of capital
budgeting? and Why is rebalancing between methods of
capital budgeting are important?
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SEE MORE QUESTIONS
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Related Questions
- SECTION B Answer all the questions below:. B1) Do you think capital budgeting is important? Justify? B2) List all the techniques of Capital Budgeting? You think are relevant today? B3) Do you think that these techniques are really helpful to financial managers? B4) Do you think that these techniques can be used in situations like COVID-19? B5) According to you which technique is better and why?arrow_forwardCapital budgeting techniques aid businesses with investment decision-making. Many approaches can be used, with some being more advanced than others. Describe the payback period approach to capital budgeting. Explain 1 advantage and 1 disadvantage of the technique. Explain why it would be wise for a financial manager to learn advanced capital budgeting techniques.arrow_forwardSECTION B Answer all the questions below:. B1) Do you think capital budgeting is important? Justify? B2) List all the techniques of Capital Budgeting? You think are relevant today? B3) Do you think that these techniques are really helpful to financial managers? B4) Do you think that these techniques can be used in situations like COVID-19? B5) According to you which technique is better and why?arrow_forward
- Having to decide on the purchase of a piece of machinery to improve productivity is part of the finance manager’s responsibility in ____________. Question 11 options: 1) short-term financial management 2) capital raising 3) capital budgeting 4) preparing the accountsarrow_forward1. Interactions between financial market participants Financial markets facilitate the transfer of excess funds from those who have them to those who need them. In the following table, determine whether each financial market participant is a surplus unit or deficit unit. Financial Market Participant A state that is constantly running a budget deficit A firm that issues equity securities to expand operations A consumer that purchases equity securities from a new tech company Surplus Unit Deficit Unit S An angel investor Suppose Moonlit Productions needs to raise money to finance its new manufacturing facility, but their CFO does not want to part with any of the firm's equity. In this case, Moonlit Productions would likely issue securities to obtain the funding. Which of the following are ways that Moonlit Productions could obtain funds to finance the expansion of its operations, given its stated preference in the previous question? Check all that apply. Issue common stocks Issue…arrow_forwardPart AAttempt all the five questions. 1 Discuss various types of capital budgeting techniques. Also identify the most appropriate technique and justify with logical reasoning.2. The managers of a firm wish to expand the firm's operations and are trying to determine the amount of debt financing the firm should obtain versus the amount of equity financing that should be raised. The managers have asked you to explain the effects that both of these forms of financing would have on the cash flows of the firm. Write a short response to this request.3. Give some examples of ways in which manager's goals can differ from those of shareholders.4.You want to begin saving for your daughter’s college education and you estimate that she will need $150,000 in 17 years. If you feel confident that you can earn 8% per year, how much do you need to invest today?5. Brodax has $20 million in current assets and $10 million in current liabilities, while Smaland's current assets are $10 million versus $20…arrow_forward
- 47arrow_forwardSolving for the WACC The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk. Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address. Consider the case of Turnbull Co. Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%. If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead…arrow_forwardSolving for the WACC The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk. Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address. Consider the case of Turnbull Co. Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%. If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock…arrow_forward
- Solving for the WACC The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk. Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address. Consider the case of Turnbull Co. Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%. Q1. If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock…arrow_forwardUnderstanding the impact of debt in the capital structure Suppose you are conducting a workshop on capital structure decisions and you want to highlight certain key issues related to capital structure. Your assistant has made a list of points for your session, but he thinks he might have made some mistakes. Review the Ilist and identify which items are correct. Check all that apply. Workshop Talking Points An increase in debt financing beyond a certain point is likely to increase the firm's cost of equity. An increase in debt financing decreases the risk of bankruptcy. An increase in the risk of bankruptcy is likely to reduce a firm's free cash flows in the future. Risks of bankruptcy increase management spending on perquisites and increase agency costs. The pretax cost of debt increases as a firm's risk of bankruptcy increases.arrow_forwardCase Study: Identifying Errors in Capital Budgeting Decisions Introduction: Capital budgeting decisions play a crucial role in the financial success of a company, impacting its long-term viability. Managers strive to make accurate and informed decisions when evaluating potential investment projects. However, errors can occur, and it is essential to implement effective procedures to identify and rectify these mistakes. This case study explores various procedures and their efficacy in identifying errors in capital budgeting decisions. Background: Company XYZ, a manufacturing firm, recently implemented a capital budgeting decision involving a significant investment in upgrading its production facilities. The decision-making process was intricate, considering factors such as projected cash flows, discount rates, and risk assessments. Despite thorough analysis, the management recognizes the importance of post-evaluation procedures to identify potential errors and enhance…arrow_forward
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