WGU - D775 Section 4: Capital Budgeting

What is equity capital?

A significant type of capital in which companies sell ownership in their firm, and the proceeds from the sale of this ownership are capital that can be used to invest.

What is the major type of capital that comes from borrowed funds?

Debt capital

The formula for DFN is as follows:

DFN=projected total assets−projected total liabilities−projected owners' equity

When calculating the Discretionary Financing Need (DFN), we find the difference between which two things?

The firm's financing needs for a project and the funding currently in place.

Why is capital essential for companies?

It funds operations, expansion, and innovation by enabling the purchase of materials and hiring employees.

Capital is needed for operations, growth, and innovation.

What is equity financing?

Raising funds by selling shares of ownership.

Equity financing involves selling ownership stakes, offering shareholders profits, but no repayment guarantees.

When should a company need to raise new capital?

To fund growth, enter new markets, acquire businesses, or replace outdated equipment.

Companies need capital for growth, acquisitions, or operational improvements.

What does the discretionary financing need (DFN) indicate?

The amount of funding needed beyond current assets, liabilities, and equity to support future sales.

DFN measures the funding gap between projected needs and current resources.

What is a key difference between debt and equity financing?

Debt financing requires repayment with interest, while equity financing offers ownership stakes without repayment guarantees.

What is the return that is required by those who have provided the company capital?

Cost of capital

What is the cost of debt, and how is it used?

The cost of debt is the interest rate a company must pay back on the use of any debt financing and is used to help determine the total cost of capital.

What is the difference between the before-tax cost of debt and the after-tax cost of debt?

The before-tax cost is simply the interest rate on loans or bonds, while the after-tax cost is the interest rate on loans or bonds after the tax break associated with using debt financing is applied.

When referring to the required return, who is requiring the return?

Investors or shareholders

What is another term for systematic risk

Market-wide risk

Why do riskier companies have a higher cost of capital?

Investors and banks that provide capital to riskier companies will require higher returns and higher interest rates.

What does the cost of capital represent for a company?

The return required by investors who have provided the company with capital.

Why should a company prefer debt financing over equity financing?

It provides tax benefits because interest is paid before taxes.

Debt financing reduces taxable income by deducting interest payments, providing a tax advantage.

How is the after-tax cost of debt calculated?

By multiplying the before-tax cost of debt by (1 − tax rate)

What does a company's beta value indicate?

The exposure to market-wide risk compared to the overall market

Beta measures how a company's risk compares to the overall market, with 1.0 indicating market-level risk.

What happens when a company's cost of capital exceeds the return on a project?

The project is unprofitable and should not be undertaken.

If the project's return is less than the cost of capital, it cannot cover the required returns, making it unprofitable.

What is the name for the process by which businesses evaluate and decide on potential significant investments or expenditures?

Capital budgeting

What is the primary goal of capital budgeting?

To allocate resources efficiently to maximize profitability and shareholder value.

Capital budgeting aims to allocate resources efficiently to maximize profitability and shareholder value, as outlined in the chapter.

Why is the time value of money (TVM) important in capital budgeting?

It ensures future cash flows are discounted to reflect their present value (PV).

The TVM is used to discount future cash flows to their PV, helping assess project viability.

Which conclusion can be drawn if a project's present value (PV) of cash flows exceeds its cost?

The project is profitable and should be accepted.

When the PV of cash flows exceeds the project cost, it indicates profitability, making the project viable.

How does the return required by investors in a capital investment project account for risk?

It compensates investors for the uncertainty and potential variability in project returns.

The return required by investors, reflected in the cost of capital, accounts for the risk by compensating for the uncertainty and variability in the project's expected returns.

Why should a project with a present value (PV) less than its cost be rejected?

The project will not generate enough return to cover its cost of capital.

If the PV of cash flows is less than the project cost, it fails to cover the required return, making it unprofitable.

Cost of Capital

The return (in % terms) that is required by those who have provided the company capital.

Discretionary Financing Need (DFN)

The difference between a firm's total financing need for a project and the funding the company currently has in place.

Required Return

The return required by investors or those who have provided capital to a company.

Cost of Debt

The interest rate a company must pay back on the use of any debt financing.

Capital Budgeting

The process by which businesses evaluate and decide on potential major investments or expenditures.

Systematic Risk

Market-wide risk

After-Tax Cost of Debt

The interest rate on loans or bonds after the tax break associated with using debt financing is applied

Debt Capital

A major type of capital that comes from borrowed funds

Equity Capital

A major type of capital in which companies sell ownership in their firm, and the proceeds from the sale of this ownership is capital that can be used to invest

Cost of Equity

The return required by investors

What does a positive net present value (NPV) indicate about an investment project?

The project is expected to generate returns greater than its cost of capital.

A positive NPV shows the project's returns exceed its cost of capital, making it profitable.

How is the internal rate of return (IRR) defined in capital budgeting?

The discount rate at which the net present value (NPV) of a project equals zero.

IRR is the discount rate that makes the NPV of a project zero, showing the break-even rate of return.

What does a profitability index (PI) greater than one suggest about a project?

The project's discounted cash inflows exceed its initial investment cost.

A PI greater than one means discounted cash inflows exceed the project cost, indicating profitability.

Why do companies use the net present value (NPV) method in capital budgeting?

It accounts for the time value of money (TVM) when assessing project profitability.

NPV considers the TVM, making it a reliable tool for evaluating project profitability.

When should a company reject a project based on its internal rate of return (IRR)?

When the IRR is lower than the company's cost of capital, it indicates insufficient returns

A project with an IRR below the cost of capital fails to meet the required return, making it unviable.

_________ risk is also called market-wide risk.

SYSTEMATIC

Capital __________ is the process of evaluating major investments or expenditures.

BUDGETING

____ capital is capital obtained from borrowed funds.

Debt

_______ capital is capital from selling ownership in the firm.

EQUITY

________ return is another name for the cost of equity.

REQUIRED

Cost of _______ is the return required by those who have provided a company with capital.

CAPITAL

The cost of equity is the required return by _________.

INVESTORS

The ________ rate on loans is widely used as the cost of debt.

INTEREST

The difference between total financing need and the current funding

discretionary financing need (DFN)*

The _______-tax cost of debt accounts for the tax break associated with using debt financing.

AFTER

A family-owned manufacturing business wants to expand its production capacity.

Why might this company choose debt financing?

To maintain ownership control.

Debt avoids ownership dilution, whereas equity financing involves selling shares of ownership in the company.

Why might a biotech start-up have a higher cost of equity compared to an online retail company?

To compensate investors for the higher risk associated with the start-up's operations.

The biotech industry involves greater uncertainty and risk, requiring higher returns to attract equity investors.

When would a company experience the greatest discretionary financing need (DFN)?

Inventory is high, accounts receivable are high, accounts payable are low.

High levels of spontaneous assets, such as inventory and accounts receivable, and low levels of spontaneous liabilities, such as accounts payable, will increase DFN.

A 50-year-old diversified healthcare conglomerate issues long-term bonds for strategic acquisitions.

Long-term bonds are less costly than using equity to finance acquisitions.

A manufacturing company is evaluating two potential projects: upgrading its production facility or expanding its distribution network. The company wants to determine the rate of return at which each project's Net Present Value (NPV) would be zero, helping it decide which project offers the better return on investment.

Which financial metric should the company use to make this determination?

Internal rate of return.

The internal rate of return (IRR) is the discount rate that makes the NPV of a project equal to zero. It helps the company assess the profitability of the projects and compare them based on their rate of return.

A company is considering investing in a new automated production line to increase efficiency and reduce long-term operating costs. As part of the decision-making process, the company must evaluate whether the investment will provide sufficient financial returns.

What should the company primarily assess when deciding on this capital investment?

Expected future cash flows and costs.

The company should assess the expected future cash flows (revenues and cost savings) and the ongoing costs associated with the investment to determine if the investment will generate a positive return.