You are the new chief financial officer (CFO) hired by a company. The chief executive officer (CEO) indicates that in the past, there was little rhyme or reason for the prior CFO to approve or disapprove of large capital projects or investments that various managers proposed. You mentioned to the CEO that there are three primary methods of capital budgeting, and they are as follows:
? Simple payback method
? Net present value method
? Internal rate of return (IRR) method
- Give your recommendation as to which method is most effective and why.
The expected return of the firm's contributors of capital and their respective share of the right side of the balance sheet are as follows:
? 33.3% common stock with an expected return of 15%
? 33.3% preferred shareholders with a 9% expected return
? 33.3% bondholders with a yield to maturity (YTM) of 6%
? A corporate tax rate of 40%
Given the previous information, answer the following questions:
? What is the firm's weighted average cost of capital (WACC)?
? If the firm wished to lower its WACC, how should it change the relative mix of the 3 contributors of capital? Explain your answer.
Exercise 3 (200-300 words).
You and the vice president of accounting will be meeting with the chief financial officer (CFO) to discuss critical areas of the operating budget for next year, as well as the capital budget.
The following issues are of a particular concern to the CFO:
-The company's working capital position
-The impact of some short-term notes that the company must pay off next year
-The company's current ratio
-Determining how to finance a major capital project (construction of a new production plant)
You and the vice president of accounting are meeting in preparation for the meeting with the CFO. Provide examples for and discuss the following topics:
-How working capital can impact a company's finances
-What the company can do to handle short-term debt that is coming due
-The current ratio, its implications, and what a good current ratio would be
-How businesses make capital budgeting decisions
The net present value method of capital budgeting is the most effective of the three listed method. According to academic literature, evidence supports that NPV method is more effected than the other methods as it computes the additional wealth that the firm can expect from its investment in the capital project while the IRR and simple payback methods do not.
Moreover, perhaps one of the most important advantage of NPV over IRR is that it can be used to evaluate projects with different discount rates. IRR uses only one discount rate in evaluating investments. Thus, this method can't even account for changing discount rates which is often seen in projects with very long economic life.
The choice of what method to use in evaluating investment decisions is very important. When management is deciding among dependent projects which is often the case with a firm which has limited capital budget, then the results of the NOV and IRR methods don't support one another (FAO Corporate Document Repository). Hence, it is best if the CFO indentifies the most effective method to use in cases ...
A simple payback method for chief financial officers.