Questions and anwers on Financial management

QUESTIONS & ANSWERS

1. The decision to start your own firm and go into business can be thought of as a

capital budgeting decision.  You only go ahead if projected returns look attractive on

a personal and financial basis.@   Discuss this statement.

.1 ANSWER

The decision to start your own firm and go into business can indeed be thought of as

a capital budgeting decision.  You only go for it if projected returns look attractive

on a personal and financial basis.  Formally, capital budgeting is described as the

process of planning expenditures that generate cash flows expected to extend beyond

one year.  The choice of one year is arbitrary, of course, but it is a convenient cutoff

for distinguishing between classes of expenditures.  Examples of capital outlays are

expenditures for land, buildings, equipment and for additions to working capital (e.g.,

inventories and receivables) made necessary by expansion.  New advertising

campaigns or research and development programs are also likely to have impacts

beyond one year and come within the classification of capital budgeting expenditures.

Practically speaking, the firm is an investment project, so the decision to go

into business is a decision to fund a capital budgeting project.  Both monetary and

nonmonetary benefits are often vital considerations.  Nobody can afford to finance a

money-losing operation indefinitely, so self-finance businesses must cover out of

pocket costs and a reasonable rate of return on investment.  Still, many entrepreneurs

are attracted by the opportunity to  A run their own show,@  and take some of their

overall pay in the form of nonmonetary benefits, like work schedule flexibility or

personal satisfaction

2. What major steps are involved in the capital budgeting process?

Q18.2 ANSWER

Conceptually, the capital budgeting process involves six logical steps.  First, the cost

of the project must be determined.  This is similar to finding the price that must be

paid for a stock or bond.  Next, management must estimate the expected cash flows

from the project, including the value of the asset at a specified terminal date.  This is

similar to estimating the future dividend or interest payment stream on a stock or bond.  Third, the riskiness of projected cash flows must be estimated.  To do this,

management needs information about the probability distributions of the cash flows. 

Fourth, given the riskiness of projected cash flows and the cost of funds under

prevailing economic conditions as reflected by the riskless rate,  RF, the firm must

determine the appropriate discount rate, or cost of capital, at which the project= s

cash flows are to be discounted.  This is  equivalent to finding the required rate of

return on a stock or a bond investment.  Fifth, expected cash flows are converted to a

present value basis to obtain a clear estimate of the investment project= s value to the

firm.  This is equivalent to finding the present value of expected future dividends or

interest plus principal payment.  Finally, the present value of the expected cash

inflows is compared with the required outlay, or cost, of the project.  If the present

value of cash flows derived from a project exceed the cost of the investment, the

project should be accepted.  Otherwise, the project should be rejected.