FINANCE (MBA)

Finance (MBA)



Finance (MBA)

Question 1)

(a)

Calculating Kce:

= RFR + b(Rm-RFR)

= 0.03 + 1.2(0.10)

= 15%

Calculating WACC:

= wd(kd)(1-t) + We(kce)

= 0.06(0.4) + 0.6(0.15)

= 0.024 + 0.09

= 11.4%

Four Methods of Capital Budgeting Analysis

In this section, we discuss four popular methods of analyzing potential capital investments:

1. Payback period

2. Rate of return (ROR)

3. Net present value (NPV)

4. Internal rate of return (IRR)

The first two methods, payback period and rate of return, are fairly quick and easy and work well for capital investments that have a relatively short life span, such as computer equipment and software that may have a useful life of only three to five years. Payback period and rate of return are also used to screen potential investments from those that are less desirable. The payback period provides management with valuable information on how fast the cash invested will be recouped. The rate of return shows the effect of the investment on the company's accrual-based income.

However, these two methods are inadequate if the capital investments have a longer life span. Why? Because these methods do not consider the time value of money. The last two methods, net present value and internal rate of return, factor in the time value of money so they are more appropriate for longer-term capital investments, such as Smart Touch's expansion to manufacturing DVDs. Management often uses a combination of methods to make final capital investment decisions. Capital budgeting is not an exact science. Although the calculations these methods require may appear precise, remember that they are based on predictions about an uncertain future—estimates. These estimates must consider many unknown factors, such as changing consumer preferences, competition, the state of the economy, and government regulations. The further into the future the decision extends, the more likely that actual results will differ from predictions. Long-term decisions are riskier than short-term decisions.

(b)

Discounted Cash Flow analysis

Generally accepted accounting principles (GAAP) are based on accrual accounting, but capital budgeting focuses on cash flows. The desirability of a capital asset depends on its ability to generate net cash inflows—that is, inflows in excess of outflows—over the asset's useful life. Recall that operating income based on accrual accounting contains noncash expenses, such as depreciation expense and bad-debt expense. The capital investment's net cash inflows, therefore, will differ from its operating income. Of the four capital budgeting methods covered in this chapter, only the rate of return method uses accrual-based accounting income. The other three methods use the investment's projected net cash inflows.

What do the projected net cash inflows include? Cash inflows include future cash revenue generated from the investment, any future savings in ongoing cash operating costs resulting from the investment, and any future residual value of the asset. How are these cash inflows projected? Employees from production, marketing, materials management, accounting, and other departments provide inputs to aid managers in estimating the projected cash flows. Good estimates are a critical part of making the best decisions.

To determine the investment's net cash inflows, the inflows are netted against ...