Question

Smith Inc. is a public company but is tightly controlled by Joe Smith. Mr. Smith is quite confident about his ability to evaluate investments in all aspects of the business. The situation at Smith Inc. is quite different from that at Jones Inc., although they share a similar line of business. Jones Inc. has a much less powerful CEO, Fred Jones, who delegates much more control to the firm’s divisional heads. Mr. Fred meets with the divisional heads to make a capital allocation choices as a group.

1. Discuss how and why Smith Inc. and Jones Inc. might have different approaches for determining the discount rates used to evaluate their projects.

2. Discuss three sources of difference between “Cash provided by operations” and “Free Cash Flows.”

Answer 1

1.Discount rate which are associated with discounting of the cash flows could be different in various kind of firms because of their different assumption and risk adjustment related to rate of discounting.

Smith inc and Jones inc might have different approaches for capital budgeting for discount rate because both have different level of control mechanism in the organisation, and they both have a different approach to the risk weighting of projects undertaken by them so it can be evident through various approaches where a simple weighted average cost of capital is preferred and where risk weighted cost of capital method is preferred.

Discounting rates generally differ on the basis of various assumptions that has been incorporated into the discount rate and these can include project failure risk, interest rate risk, risks of inflation, control risks, default risk, and credit related risk so these risks can have different risk weighting in different calculations of cost of capital while ascertainment of the rate of discount,so because of these factors the discounting rate in both firm can differ significantly