Question

Give an example of a capital budgeting decision, capital structure decision, and a working capital management decision.

Answer 1

Capital budgeting decision entails decision making with regards to potential investments and expenses by comparing the financial feasibility of each investment or expenses through its cash flows. An example of capital budgeting decision – Suppose that a company wants to invest in a new project. It has two options before it – Option A and Option B. The company’s discount rate is 11% and its cash flows are:

Year	Cash flows of A	Cash flows of B
0	-              100,000	-              125,000
1	25,000	15,000
2	35,000	25,000
3	10,000	35,000
4	15,000	45,000
5	55,000	55,000

Using the above data the company can determine its payback, , NPV, IRR etc to see which project is better.  

Year	Cash flows of A	Cash flows of B	1+r	PV of A	PV of B
0	-              100,000	-              125,000	1.11	-     100,000	-     125,000
1	25,000	15,000		22,522.52	13,513.51
2	35,000	25,000		28,406.79	20,290.56
3	10,000	35,000		7,311.91	25,591.70
4	15,000	45,000		9,880.96	29,642.89
5	55,000	55,000		32,639.82	32,639.82
			NPV	762.01	-   3,321.51

From the above analysis we can see that the company should invest in project A as its NPV is positive.

Capital structure decisions entail determining the quantum of different forms and sources of capital. This primarily involves determining the balance between debt and equity i.e. what should be percentage of debt in total capital and what will be the percentage of equity in total capital. For example suppose that a company’s current capital structure comprises of 45% debt, 45% equity and 10% preference shares. The company wants to raise $10,000,000 to finance its entry into a new market and capital structure decision will involve in what form this capital should be raised i.e. as debt, or as equity or as preferred shares and the mix of these options. The company can do an EBIT-EPS analysis or ROI-ROE analysis for this.

Working capital management decision entails management of inventories, accounts receivables and payables, and cash in such a manner that will ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. An example of working capital management decision will be evaluating the company’s trade and credit terms so as to optimize its operating cycle and cash cycle. Suppose that a company offers credit on terms 1/10, n/30. This means that it will offer 1% discount on all payments done within 10 days and that all payments should be done within 30 days. Thus payments done after the 10^th day will not attract any discount. The company now wants to reduce its cash cycle and hence is looking to revise its trade terms. This is an example of working capital management decision.