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Budgeting Characteristics

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Critically evaluate budgeting as a tool for planning and control, making reference to readings you have undertaken. Refer to specific authors or examples where appropriate to support your discussion.

Suggested journal articles :
Howell, R. (2004) Turn your budgeting process upside down, Harvard Business Review, July, pp. 21-22.
Jehle, K. (1999) Budgeting as a competitive advantage, Strategic Finance, vol. 81, issue 4 (October), pp. 54-57

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Budgeting is a very effective and important tool for planning and control, largely due to the fact that budgeting allows a leader to ascertain what the true financial capabilities are within given operational parameters. Budgeting is very important in the situational analysis of a of any strategic business plan, or other strategic planning, due to the fact that a thorough situational analysis will help an individual to ascertain what the probable financial costs of engaging in a given course of action would be. Effectively budgeting based upon the probable scenarios contained within a situation analysis, which will provide a leader with information as to the probability of them being able to afford to engage in certain courses of action, based upon the contingencies within the given situation, and the budgetary ...

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This solution describes the importance of budgeting in strategic planning and control.

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Capital Budgeting and Cost of Capital

1. A project has an up-front cost of $100,000. The project's WACC is 12 percent and its net present value is $10,000. Which of the following statements is most correct?

a. The project should be rejected since its return is less than the WACC.
b. The project's internal rate of return is greater than 12 percent.
c. The project's modified internal rate of return is less than 12 percent
d. All of the above answers are correct.
e. None of the above answers is correct.

2. The regular payback method has a number of disadvantages, some of which are listed below. Which of these items is not a disadvantage of this method?
a. Lack of an objective, market-determined benchmark for making decisions
b. Ignores cash flows beyond the payback period.
c. Does not directly account for the time value of money.
d. Does not provide any indication regarding a project's liquidity.
e. Does not directly account for differences in risk among projects.

3. Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. In addition, you expect to sell the stock for $150 at the end of Year 2.

Question: If your expected rate of return is 16 percent, how much should you be willing to pay for this stock today?

4. Which of the following statements is correct?
a. The characteristics line is the regression line that results from plotting the returns on a particular stock versus the returns on a stock from a different industry.
b. The distance of the plot points from the characteristics line is a measure of the stock's discounted value risk.
c. "Characteristics line" is another name for the Security Market Line.
d. The distance of the plot points from the characteristics line is a measure of the stock's market risk.
e. The slope of the characteristic line is the stock's standard deviation.

5. A share of common stock has just paid a dividend of $2. If the expected long-run growth rate for this stock is 5%, and if investors required rate of return is 10.5%, what is the stock price?


6. Gary Wells Inc. plans to issue perpetual preferred stock with an annual dividend of $6.50 per share. If the required return on this preferred stock is 6.5%, at what price should the stock sell?

a. $90.37
b. $92.69
c. $95.06
d. $97.50
e. $100.00

7. You were hired as a consultant to Kroncke Company, whose target capital structure is 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 6%, the cost of preferred is 7.5%, and the cost of retained earnings is 13.25%. The firm will not be issuing any new stock. What is its WACC?

a. 9.48%
b. 9.78%
c. 10.07%
d. 10.37%
e. 10.68%

8. The Bingo Corporation is in the process of determining which of the following two projects that they may invest in. The details are provided below:
Project Cost of Capital Life of project Annual cash flow Initial cost Salvage Value

A 12% 20 Years $350,000 $1,250,000 $250,000

B 12% 20 Years $400,000 $1,400,000 $110,000

a. What is the payback period?
b. What is the net present value of the two projects?

c. What is the internal rate of return of the two projects?
d. What is the profitability index?
e. Which of the two projects would you choose and which criteria would you use?

9. Sorenson Stores is considering a project that has the following cash flows:

Year Cash Flows (end of period)

1 $2,000

2 $3,000

3 $3,000

4 $1,500

The project has a payback of 2.5 years, and the firm's cost of capital is 12%. What is the project's NPV?

a. $577.68
b. $765.91
c. $1,049.80
d. $2,761.32
e. $3,765.91

10. Thompson Stores is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year Cash Flow
0 ($1,000)
1 $300
2 $295
3 $290
4 $285
5 $270

a. 11.16%
b. 12.40%
c. 13.78%
d. 15.16%
e. 16.68%

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