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Capital Budgeting: Relationship Between Required Return

What are the relationships between required return, cost of financing, and investment decisions.

Why does capital budgeting rely on analysis of cash flows rather than on net income?

The term "Capital Rationing" is a constraint on the amount of funds that can be invested in a given period by a firm. Explain why at times management may place an artificial constraint on the funds that can be invested in a given period. Give examples.

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What are the relationships between required return, cost of financing, and investment decisions.

The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor's opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor's opportunity cost), investors will not invest in the firm's debt and equity. As a result, the firm's value (both their debt and equity) will decline.

Also the investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.

Decisions like the change in the methods of sales distribution, or an advertisement campaign or research and development programs have long-term implications for the firm's expenditures and benefits, and ...

Solution Summary

This solution explains the relationships between return, cost of financing, and investment decisions.

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