Question

Conduct a comparative analysis of the capital budgeting process for new projects versus replacement decisions. The objective is to maximize shareholder wealth.

Question: Identify the steps to the process such as the formulation of cash flows, the development of the cost of capital (i.e., weighted average cost of capital), and the calculation of decision metrics, including the net present value and the internal rate of return.

Answer 1

Steps to process would be as follows-

A. Analysing the past trend in relation to ascertainment of the cash flow structure of the company.

B. Determination of growth rate to the cash flows and prediction of the future cash flows of the company.

C.then the cost of capital is to be predicted by assignment of weights to the cost of equity and cost of debt.

D. Interest element is to be deducted with the corporate taxes while calculation of post tax cost of debt.

E. Ascertainment of the present value using net present value method by discounting cash flows to the present by using cost of capital as a discounting rate

F. Comparison of of cash outflows with the cash inflows to find out the net cash flows according to net present value method

G. Ascertainment of internal rate of return between the cash inflows and cash outflows.

H. Decision making regarding internal rate of return by comparison of internal rate of return with cost of capital and if the cost of capital is higher , project should not be accepted and vice versa.

I. If Net present value is positive the project is to be accepted, and vice versa