Assessed Discussion Question 1. Define what we mean by the firm’s financing decision and the firm’s investment decision. What entities are on the “other side” of these decisions? Financing decision refers to those decisions related to the liabilities and the stockholders equality sides of the firm’s position statement especially concerning decision on to issue bond. Firms’ investment decision refers to those decisions concerned with the asset side of the firm’s balance sheet dealing with the strategic process of on determining long-term future cost and benefits in areas of decision of offering a new product, new investment and so on.
It shows the relationship between present and future. Firms use financing decision for at least three main reasons. The financing decision helps firms in providing an important insight in to the ways of estimating the cost of capital. Second, it helps to avoid making mistakes in the firm’s operation process. Third, it can provide good foundation for understanding how and why the financing decision affect capital the value of the firm in certain an imperfect capital markets. 3. What are the two factors on which present value depends?
Present values is defined as the value on a given date of a future payment or serious of payments discounted to reflect the time value of money and other related factors such as investment risk. Present value depends on both the expected cash follows and the cost of capital. The increase and decrease of present value depends on both elements. For instance, if the cost of capital increases, the present value will decrease even though the expected cash flow does not change. In the similar manner, present value will increase when expected cash flow increases even when the cost of capital has not changed.
There are also situations when present value remains constant when there are changes in the expected cash flows and cost of capital (required return). Therefore, when the changes exactly offset, it creates principle of risk – return trade – off and present value thus remains constant. 4. Distinguish between operating leverage and financial leverage. Operating leverage is defined as the relative mix of costs (fixed and variable) needed in producing goods or rendering services. Operating leverage is not identical for all the firm’s investments both (the diversifiable and non-diversifiable) risk of capital budgeting projects ather it is unique for each investment. On the other hand, the financial leverage deals with substituting the fixed payments to debt holders for variable payments to share holders. In contrary to operating leverage, the financial leverage deals with three most important corresponding. First, it enables the firm’s choice of leverage for the most part of the entire firm rather than for each investments of the firm. Second, it affects the risk borne by each class of investor rather than affecting the cost of capital for the investment in the environment perfect capital market.
Third, it enables firms to choose their amount of leverage within a very wide range. 7. What are the important differences in the way operating risk (versus financial risk) enters into the consideration of a capital budgeting project? Firms’ required returns can be affected by two major risks. These are the operating risk and financing risk. Operating risk also known as, business risk is the fundamental risk inherent to the firm and affects the business regardless of how it is financed. Operating risk emanates from operating the business. It is presented on the asset side of the firm’s balance sheet.
On the other hand, the financial risk comes from investigating how the firm is financed. Financing risk is based on the capital structure, liabilities, and owners’ equity of the firm. Problem A1 WACC= (1-L)*re +L(1-T)*rd Debt= 30% Equity= 70% L=D/D+E)0. 3 Given1 L=0. 3 re=0. 14 T=0. 4 rd0. 08 WACC=0. 112411. 24% Problem A2 WACC= (1-L)*re +L(1-T)*rd Debt= 100 Equity= 200 L=D/D+E)0. 3333 Given1 L=0. 3333 re=0. 13 T=0. 38 rd0. 075 WACC=0. 102169510. 22% Problem A5 WACC= (1-L)*re +L(1-T)*rd Given1 L=0. 35 re=0. 14 T=0. 4 rd0. 08 WACC=0. 107810. 78% Problem A6 WACC= (1-L)*re +L(1-T)*rd Given1 L=0. 45 re=0. 18 T=0. 4 rd0. 06 WACC=0. 115211. 52%