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    Capital budgeting part of a long-term strategic planning

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    1. In your own words, explain the concept of cost of capital. How may cost of capital affect long-term financial decisions? Would a company prefer to have a high or low cost of capital? Why? What was the effect of cost of capital on long-term financial decisions for your company?

    2. Why is capital budgeting part of a company's long-term strategic planning process? What are the pros and cons of these methods:

    o NPV

    o Simple payback

    o IRR

    Which would you recommend using? Why? Would your recommendation differ based on the size of the company? If so, why? If not, why?

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    Solution Preview

    1. In your own words, explain the concept of cost of capital. How may cost of capital affect long-term financial decisions? Would a company prefer to have a high or low cost of capital? Why? What was the effect of cost of capital on long-term financial decisions for your company?

    WACC (Weighted Average Cost of Capital) is an expression of this cost and is used to see if certain intended investments or strategies or projects or purchases are worthwhile to undertake. (Valuebasedmanagement, 2009)

    It is the weighted average cost of all the funds of the organization such as debt and shares. It would consider the following factors:
    -Risk appetite of the management
    - Future Capital requirements
    -Degree of operating leverage
    -Economic scenario
    -State of business cycle
    -Cost of funds

    Cost of capital is a discount rate representing the sources of funds used by the organization. It affects long-term financial decisions considerably. There is an inverse relationship between WACC and firm's value. This is because lower WACC leads to higher present value of money. Hence minimal WACC maximize firm value. This we can further understand from present value of money. Present value is an ...

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