Two of the financial management decisions that we learned this semester include

Question

Two of the financial management decisions that we learned this semester include capital structure and capital budgeting. Describe each financial management process, their respective importance within an organization, and provide an example of a business transaction that would be relevant. Your discussion on capital structure should describe WACC and explain its role within capital structure as well as in capital budgeting as a hurdle rate. Also, discuss the capital budgeting techniques that are used to determine a project’s value over time including the advantages and disadvantages of each as well as how a firm decides whether to accept or reject a project if using NPV or IRR.

Explanation / Answer

Capital Structure:-

Capital Structure means the pattern of capital employed in an organization. It is the financial plan of the organization in which various sources of capital are mixed in such proportions that those provide a distinct capital structure most suitable for the requirements of the particular organization. Capital Structure is the permanent long-term financing that is represented by long-term debt, preference share capital, equity share capital and retained earnings.

Conclusion:- Capital structure is the combination of debt and equity securities that comprise a organization's financing of its assets.

Weighted average cost of capital (WACC):-

Weighted average cost of capital (WACC) is the average of the costs of each source of finance employed by the company properly weighted by the proportion they held in the capital structure of the company.

WACC = Weight of equity share capital * Cost of equity share capital + Weight of debt * Cost of debt + Weight of Preference Share capital * Cost of preference share capital + Weight of retained earnings * Cost of retained earnings.

Capital Budgeting:-

Capital Budgeting decision involve the entire process of decision making relating to acquisition of long term assets whose returns are expected to arise over a period beyond one year. Capital Budgeting decision carry high degree of risk and uncertainity. It involve huge amount of fund investment in the project.

Techniques of Capital Budgeting:-

a) Pay Back Period

b) Net Present Value

c) Accounting rate of return

d) Profitability Index

e) Internal rate of return.

Net Present Value (NPV):- NPV of an investment proposal may be defined as the sum of the present value of all the cash inflows less the sum of present values of all the cash outflows associated with an investment proposal.

Advantages:- 1) It recognizes time value of money. 2) It is based on Cash flow rather than accounting profit.

Disadvantages:- 1) Calculation is complicated. 2) It does not provide own rate of return. It evaluate the proposal against the minimum rate of return.

Decision rule:- The investment proposal which have high NPV is accepted in case of mutually exclusive decision. In case of Accept reject decision, the investment proposal which have positive NPV or Zero NPV is selected.

Internal rate of return (IRR):- IRR is the discount rate at which the present value of cash inflows and present value of cash outflows is equal.

Advantages of IRR:- 1) All Cash flow are considered. 2) It consider time value of money.

Disadvantages of IRR:- 1) Tedious Calculation 2) It is assumed in such method that all fund earn rate equals to internal rate of return which is not correct.

Decision rule:- The investment proposal which have high IRR is accepted in case of mutually exclusive decision. In case of Accept reject decision, the investment proposal which have higher IRR than the required rate of return is selected.

In case of Conflict between NPV and IRR:-

In case of conflict, decision regarding acceptance of investment project is to be taken on the basis of NPV technique rather than IRR method. NPV takes into account both the quality and the scale of investment while IRR takes into account only the quality of the investment. The objective of financial management is to maximize the wealth of the firm. So the NPV method is superior than the IRR method.

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