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1. Why would a manager use the Weighted Cost of Capital for investment decisions when a specific project may be funded by a particular source of capital, (e.g. debt or equity)?
2. What capital budgeting process and evaluation does your organization (or one you can talk to) use? Specifically what Pay Back Period and NPV discount factor is used and how does the company adjust for risk? You will probably need to ask someone in the financial department on this one.
3. If a company had a ROA percentage lower than its cost of capital for a number of years what problems would you look for in the Capital budgeting process?
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In a 561 word solution, the response presents good answers to all the questions about the capital budgeting process.
1) Yes, it would be ideal to match a new investment in your company with a WACC based on an equity beta commensurate with the risk/return profile of that investment and benchmark the capital structure against similar enterprises in the same business or industry. This is extremely difficult in practice for 2 reasons.
a) Investors in your company cannot differentiate between returns from different projects. The obligations to bond holders and the returns to shareholders are a satisfied by the pool of cash flows the company produces. For example, although bonds are less expensive funding, we can't earmark returns from low risk operations to bond holders. The bond holders have a right to the specified cash flows, even if the bulk of the cash comes from high risk operations.period. Conversely, we can't justify a higher WACC or hurdle rate because of ...
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