Question

(1) What is capital budgeting?
(2) Explain the difference between independent project and mutually exclusive project.
(3) Identify six methods to rank a project or methods used in capital budgeting.

(4) Identify three methods to estimate the cost of equity?
(5) Do you agree that the three methods will give similar results when the cost of equity is estimated?

Answer 1

Answer(1):

Capital budgeting- Capital budgeting is the budget of capital. It is the study of capital expenditures and decisions related to it. Capital budgeting is process of taking investment decision by analyzing the project's cash flows and worth.

Purchasing fixed assets, equipment, machinery and setting up plant come under capital budgeting decision.

Objectives of Capital budgeting - Are as following:

Choosing the best project- Different projects are evaluated and analyzed and most profitable project is chosen.

Minimizing expenditures- Objective of capital budgeting is to minimize expenditures. Expenses are estimated so that these can be controlled.

Maximizing profit- This is very important objective. Profit is the foremost thing for any business. Companies work for profit motive.

Answer(2):

Difference between independent and mutually exclusive projects- Are as following:

Independent project- If the cash flow of one project is not affected by the acceptance of the other project then two projects may be accepted.

Mutually exclusive project- If the cash flow of one project is affected by if other project is accepted then only one out of the two projects will be accepted.

Answer(3): Methods of capital budgeting- Are as following:

Payback period- This method tells the time duration by which initial cost of project will be recovered.

Discounted payback period- This is same as payback period but the cash flows are discounted.

Accounting rate of return- It is calculated as projected total net income(not discounted) divided by initial or average investment.

Net present value- It is the difference between cash outflows and cash inflow of a project. A positive NPV is favorable for the project.

Internal rate of return- It is the discount rate at which net present value of a project becomes zero.

Profitability index- It is the ratio between present value of future cash flow of a project and initial investment of a project.

Answer(4): Three methods of cost of equity-

(a): CAPM- Re = Rf + Beta (Rm-Rf)

Where:

Re = Cost of equity

Rf = Risk free rate of return

Beta- measure of systematic risk

Rm = Market return

(b): Dividend discount model-

Ke = (D1 / P0) + g

Ke = Cost of equity

D1 = Next dividend

P0 = Price of stock

g = growth

(c): Bond yield plus risk premium- It is based on the fact that cost of equity is higher than the yield required on debt.

Cost of equity = Pre-tax cost of debt + Risk premium