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Capital budgeting Process: WACC, payback, NPV, risk, ROA

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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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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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In a 561 word solution, the response presents good answers to all the questions about the capital budgeting process.

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See Also This Related BrainMass Solution

Depreciation

Attention: The equipment will be depreciated by the straight line method over the life of the project.

The support is the answer from a book but the depreciation is not a straight line. I do not have time to it now. It can be a guide in case it be needed.

Allied Food Products is considering expanding into the fruit juice business with a new fresh lemon juice product. Assume that you were recently hired as assistant to Allied's Fort Myers plant; Allied owns the building, which is fully depreciated. The required equipment would cost $200,000, plus an additional $40,000 for shipping and installation. In addition, inventories would rise by $25,000, while accounts payable would increase by $5,000. All of these costs would be incurred at t = 0. The equipment will be depreciated by the straight line method over the life of the project.
The project is expected to operate for 4 years, at which time it will be terminated. The cash inflows are assumed to begin 1 year after the project is undertaken, or at t = 1, and to continue out to t = 4. At the end of the project's life (t = 4), the equipment is expected to have a salvage value of $25,000.
Unit sales are expected to total 100,000 units per year, and the expected sales price is $2.00 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Allied's tax rate is 40%, and its WACC is 10%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied's other assets.
You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected.

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