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Capital Budgeting, Cost of Capital, Credit Policy

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1. A company has a debt ratio greater than the industry average. How would an investor evaluate the implications of this higher debt ratio in making an investment decision in this company's common stock?

2. In your opinion, what are the major factors determining the kind of financing for working capital a company can secure?

3. A company has three capital budget projects for the upcoming fiscal year all of equal risk, and having equal NPV, Pay Back Period and IRR which is above the firm's current cost of capital. Only two can be funded from the current capital structure and funds available. The third project must be funded by raising more debt at a cost that will increase the overall cost of capital. Should the company raise the additional funds? YES NO Explain your answer.

4 In the last few years, many large corporations, such as General Motors, [and now Quest and Lucent] have written off large amounts of their non-performing (or poorly performing) assets as they have shrunk their operations [and recognized decreased value]. What is the impact of these asset impairment write-offs on the future return on assets, future return on common equity, and future financial leverage ratios? What impact would you expect these write-offs to have on the market value of the firm's equity securities? Why?

5. Your company wants to increase sales by extending credit to customers with less than a top credit rating. How would you evaluate this decision?

6. You are evaluating two capital investment proposals. One is a new product line that requires an investment of $500,000. The second is a cost saving new machine that requires an investment of $375,000. If you only had funds to do one or the other, explain how capital budgeting concepts would assist you in making the decision.

7. Why is Net Present Value (NPV) used for investment decisions?

8. You are a board member for a company considering cutting the quarterly dividend payment to shareholders. What are your concerns for the company and shareholders?

9. A company has a cost of capital greater than the industry average. What are several of the most significant reasons for this?

10. What are the major considerations for an established, and already public company, in its efforts to raise additional equity capital?

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Solution Summary

The solutions consists of answers to 10 questions on Corporate Finance that discuss issues like Cost of Capital, Credit Policy, Working Capital Financing, Dividend payments, Capital Structure, Impact of write off of non performing assets.

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1. A company has a debt ratio greater than the industry average. How would an investor evaluate the implications of this higher debt ratio in making an investment decision in this company's common stock?

When the debt ratio is greater than the industry average there is reason for concern in the form of financial distress for the investor who wishes to invest in company's stock. Financial distress happens when the firm cannot meet its obligations to the creditors. The highest form of financial distress is bankruptcy and liquidation of the business. The prospect of financial distress reduces the present value of the firm. The risk and cost of financial distress increase as borrowing increases. Thus the investor would weigh the additional risk and demand a higher rate of return in such a company.

2. In your opinion, what are the major factors determining the kind of financing for working capital a company can secure?

The type of stock inventory (marketability, perishability, price stability, physical control) that a company has determines inventory financing for working capital.
Short term borrowing for financing working capital: Lenders lend on the basis of the cash-flow capacity of the borrower. Collateral is an additional but secondary consideration.
Pledging accounts receivables can be a means of short term financing. Factoring receivables can be a major source of working capital financing.

Asset-backed public offerings. Public offerings of securities backed by receivables as collateral is a recently employed means of short-term financing. The creation of asset-backed securities is referred to as securitization of assets.

3. A company has three capital budget projects for the upcoming fiscal year all of equal risk, and having equal NPV, Pay Back Period and IRR which is above the firm's current cost of capital. Only two can be funded from the current capital structure and funds available. The third project must be funded by raising more debt at a cost that will ...

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