Week Five Questions
Chapter 11 (#1, 11, 12)
1. Why do we use the overall cost of capital for investment decisions even when only one source of capital will be used (e.g., debt)?
One may think that an investment financed with a low-cost debt facility is adequate on paper but in the long run that very use of that debt can be the cause of an increase the general risk of the firm and in turn will make any future financing more costly. Every project should be scrutinized to see how it can benefit and even hurt the firm in the short run and long run.
11. It has often been said that if the company can't earn a rate of return greater than the cost of capital it should not make investments. Explain.
When a company is not able to recoup or earn back the total cost of financing on any project this will have a negative effect on the company’s overall operations and they will also lower the capital owned by the shareholders and the value of the company and even perhaps its risk rating.
12. What effect would inflation have on a company's cost of capital? (Hint: Think about how inflation influences interest rates, stock prices, corporate profits, and growth.)
Inflation has a great negative impact on a company because it causes the cost-of-capital to rise. Inflation in the past has shown us that it raises interest rates and lowers the values of stock which in turn, raises the cost of debt and equity directly and the cost of preferred stock indirectly. For instance if a project cost a company 10 percent but only yields a return of 7 percent this can almost put some companies out of business, especially in real estate.
Chapter 12 (#2, 3, 6)
2. Why does capital budgeting rely on analysis of cash flows rather than on net income?
Cash flow is utilized in capital budgeting analysis due to the fact that the principal concern is to deal with the amount of tangible monies that are produced.
What are the...
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