Question

:Prob 16: a : Firm's market value capital structure = security quantity * market value of the secu... Edit question Prob 16: a : Firm's market value capital structure = security quantity * market value of the security = 6.3m*74+0.35m*107+0.15m*1090=$667.15m b: The firm should use the WACC to discount the projects' cash flows. The WACC of the firm = We*Ce + Wp*Cp+Wd*Cd*(1-t) Ce = Req return = rf + B * mp = 0.043+1.09*0.068=0.11712 The WACC of the firm = (466.2/667.15)*0.11712 + (37.45/667.15)*0.058 +(163.50/667.15)*0.071*(1-0.34) = 0.096583 or 9.66%

Question 5 – Explain capital budgeting in your own words. Explain one capital budgeting method in detail and how Organic Produce Corporation’s weighted average cost of capital affects capital budgeting decisions.

Answer 1

Capital budgeting refers to the process of analysing different capital projects with the objective of selecting the best one or combination of the most profitable ones.

The net present value method is the most popular capital budgeting techniques and it is based upon the time value of money. Under this method the initial cost of capital is computed first. There after the present value of future cash flows arising from the project is calculated and the difference is the net present value that will be added to the business if the particular project is undertaken. The biggest advantage of this method is that it takes into account the time value of money by discounting future cash flows.

The discount rate used for computing the present value of future cash flows is the weighted average cost of capital of the business. Higher the cost of capital lower will be the present value of the future cash flows and vice versa. So if the cost of capital is lower the present value will be higher and the project will be more viable. If the actual cost of capital is lower than what has been used for computations or wrong decision will be taken and a profitable project may be rejected unreasonably.