The Herat Company believes it has found 10 projects, of which 7 have positive NPV's given the company's cost of capital. If the company were to invest in all of these projects it would require a capital expenditure of $65 million. According to NPV theory, the company should invest in all of these projects, because each has a positive return. The company however, has made the decision to limit its capital expenditure to $40 million. List and briefly discuss 3 practical explanations why the company might forgo these value adding projects.
Cost of Debt, Cost of Preferred Stock
This article deals with the estimation of the value of capital and its components. we'll find out how to estimate the value of debt, the value of preferred shares , and therefore the cost of common shares . we will also determine the way to compute the load of every cost of the capital component then they're going to estimate the general cost of capital. The cost of capital refers to the return rate that an organization gives to its investors. If an organization doesn’t provide enough return, economic process will decrease the costs of their stock and bonds to revive the balance. A firm’s long-run and short-run financial decisions are linked to every other by the assistance of the firm’s cost of capital.
Cost of Common Stock
Common stock is a type of security/instrument issued to Equity shareholders of the Company. These are commonly known as equity shares in India. It is also called ‘Common equity
The Herat Company believes it has found 10 projects, of which 7 have positive NPV's given the company's cost of capital. If the company were to invest in all of these projects it would require a capital expenditure of $65 million. According to NPV theory, the company should invest in all of these projects, because each has a positive return. The company however, has made the decision to limit its capital expenditure to $40 million. List and briefly discuss 3 practical explanations why the company might forgo these value adding projects.
Net Present Value is the difference between the present value of cash inflows and cash outflows. Positive Net Present value projects should be accepted since they bring and add value to the firm.
However, the firm might limit capital expenditure and might need to forego some positive NPV projects based on the following reasons:
1. High amount of capital expenditure reduces the Free cash flows available with the firm. In case of very high capital expenditure, the firm might be unable to have sufficient cash balances to meet its short term obligations. Hence, the firm might need to limit its capex and keep liquid resources.
2. The Net Present value of some projects might be positive but these projects might have very high initial cash out lay or investment. Example: The NPV of a project might be positive 500,000 but its initial investment or cash outlay could be 20 million. If we consider the profitability index of such a project then we get to know that the project might not be giving sufficient returns considering the initial investment and its risk.
Step by step
Solved in 2 steps
