Question

Need a solution on three topics below. 

1. If you were evaluating an investment opportunity, which technique would you use and why?

2. When evaluating investments, you can get data from engineering, marketing and sometimes accounting. Do you think any of these organizations have internal biases? If so, as a member of the finance department, how would you deal with them?

3. You have just discovered that your boss favors payback in evaluating investments. Should you try to talk him out of it or should you go along with his/her desires?

4. You are comptroller for your company. The CEO is a savvy individual with great instincts for the business. She strongly favors an investment that is only marginally acceptable at best. She has asked you to put together justification for it. What will you do?

5. Last year your company financed its investments by selling shares of common stock. This year the plan is to use debt. The after tax cost of debt is 5%, the cost of equity is 12% and the weighted average cost of capital is 9.5%. The first investment for this year is an expansion project. What cost of capital will you use and why?

6. The weighted average cost of capital can consist of debt, preferred stock and equity. Which of these sources is the most expensive and the least expensive and why?

7. Young companies usually finance their assets with equity. Why?

8. Equity financing can come from external or internal sources. Which of these is the least expensive and why?

Answer 1

The three statements that we have considered are #1,#3 and #5

#1. When evaluating an investment opportunity, it is important to calculate the net present value of the investment opportunity. The net present value calculates the present value of the future projected cash inflows and discounts the cost.

NPV = PV of future cash flows - Initial cost.

So, Net present value is the best technique to evaluate an investment.

#3. I would explain to my boss that payback period is not appropriate technique to evaluate the project. This is because payback period does not consider the time value of money. In reality each company has a cost of capital and we have to discount the cash flows based on the cost of capital and we cannot take them at face value. So, I would convince my boss to consider the net present value technique to evaluate the project.

#5. It is always necessary for us to use the weighted average cost of capital while evaluating projects and discounting the project cash flows. So the weighted average cost of capital (WACC) of 9.5% would be used. This is because the WACC considered the cost of debt on the debt capital and the cost of equity on the equity capital and averages them based on the individual weights of debt and equity of the firm. If we take either cost of debt only or cost of equity only, we result will be either too optimistic or too pessimistic. Hence we use the WACC in the evaluation.