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DETERMINING EXTERNAL FINANCING NEEDS AND MEASURES OF RETURN ON INVESTMENT

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1- Describe how organizations determine the need for external financing.

2- Critically discuss each of the following methods for measuring return on investment: payback period, average rate of return, net present value, and internal rate of return.

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Solution Summary

This report provides a discussion of situations in which external financing may be needed. Among such situations include corporate profitability level, business growth plans and opportunities, and expected volume of sales. Other indicators are computed financial ratios such as debt ratio or debt-to-equity ratio. Some of the common capital budgeting techniques were also described in terms of the information that they provide and their respective limitations.

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DETERMINING EXTERNAL FINANCING NEEDS AND MEASURES OF RETURN ON INVESTMENT

INDICATORS OF EXTERNAL FINANCING NEEDS
Keown et al. (2002) noted that in situations when internally generated funds will not be sufficient to finance all of the forecasted expenditures, a firm may find it necessary to attract large amounts of financial capital externally or otherwise forego the project.
Among the indicators of external financing needs are the following:
1. Business growth
According to Keown et al. (1998), growing firms require expenditures for new assets which outstrip the firm's ability to finance those purchases using internally generated profits. This means that the firm must go out and borrow the additional funds or issue new equity.
2. Increase in forecasted volume of sales and expense
This may require the company to decide in favor of increasing level of production. Correspondingly, the need for factors of production will increase. This would mean additional financing needs that may be filled either internally or externally. Low debt ratio or debt-to-equity ratio may indicate that there is still a room for additional external financing. Prospective supplier of funds may still find it feasible to lend to ...

Solution provided by:
Elisa Valdez, PhD
Education
  • Bachelor of Science in Business Administration, University of the Philippines
  • Master in Business Administration, Saint Mary's University
  • Doctor of Philosophy in Education, University of the Philippines
  • Doctor in Business Adminstration (IP), Polytechnic University of the Philippines
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