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Name: ______________________________________________________ Period:__________________
Chapter 6
Long-Term Financial Activities
Goals
 Describe the five types of capital project used in business
 Explain factors that affect capital spending decisions
 Discuss the steps in the capital budgeting process
 Explain factors that affect the cost of capital
 Describe the tools used to analyze capital projects
 Explain factors that influence capital project decisions
Vocabulary
Capital project
Replacement project
Cost-saving project
New product or new market project
Government-required project
Social benefit project
Intellectual property
Independent projects
Mutually exclusive projects
Complementary projects
Capital budgeting
Depreciation
Non-cash item
Cost of capital
Discount rate
Cost of debt
Cost of equity
Optimal capital structure
Weighted average cost of capital (WACC)
Payback method
Net present value (NPV)
Internal rate of return (IRR)
Opportunity cost
Sunk cost
Centralized organization
Decentralized organization
Horizontal integration
Vertical integration
Diversification
Joint venture
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Section 6.1
I.
Capital Projects
Types of Capital Projects
A. Replacement – failure to replace items in a timely manner can result in higher ___________________,
lost _________________ and reduced _____________________.
B. Cost Saving – often involves the purchase of _____________________________.
C. New Product or Market – projects that are _______________________ to new products/markets.
Today, these projects often involve __________________________________ such as copyrights,
patents, etc. Other _______________________ assets include goodwill and reputation.
D. Government Required – result from new government ___________________________
E. Social Benefit – can benefit the __________________________ or ________________________.
II. Selection Factors
When selecting projects, the financial manager must consider how the projects will affect the overall
company. ___________________________ projects are not affected by other projects.
Acceptance of a ________________________________ project will not allow the acceptance of
another project. At times the acceptance of one project will require the company to accept another
____________________________ project. Regardless of the type of project under consideration,
the financial manager is always limited by the amount of _______________ available.
Section 6.2
Capital Budgeting Process
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• Set capital spending goals
2
• Determine potential projects
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• Forecast cash flows
4
• Identify cost of capital and risks
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• Select and implement project
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III. Cost of Capital
A. Cost of Debt is the rate of return required by ______________________. The benefits of debt
include the use of ______________ money instead of your own, a lower risk to creditors because the
company is __________________ to repay debts, cost to issue debt is ______________ than the
cost of equity and interest payments are tax ______________________
B. Cost of equity is the required return of the ______________. The benefits of equity include no
obligation to pay ____________________, a greater potential return to investors because of the
increased ________ associated with equity.
C. The optimal capital structure is one that combines a low __________ of capital with maximum market
________________. In meeting this balance, managers consider:
1.
how much ___________ the company currently has
2. the company’s ability to borrow _______________ funds or issue more ____________
3. the feelings of _______________________ about the company’s risk due to debt
4. past and expected future _______________________
D. To determine the cost of capital companies calculate the weighted average cost of capital (WACC).
The goal of every company is to ___________________ its WACC. The actual combination of debt
and equity will vary with changes in overall ______________________ and the company’s risk from
increased use of _____________.
WACC =
Section 6.3
(% of Debt x Cost of Debt) + (% of Equity x Cost of Equity)
Capital Project Analysis
I.
Payback Method
II.
Net Present Value (NPV)
III.
Internal Rate of Return (IRR)
IV.
Opportunity Cost
V.
Sunk Cost
VI.
Risks
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Section 6.4
I.
Business Expansion Strategies
Business Growth Actions
A. Organizational Strategies
1.
Centralized Organizations
a) Decision are made by ___________ managers
b) Advantage: better _______________
c) Disadvantage: may not be able to _________________ to changing conditions
2. Decentralized Organizations
a) Decisions are made at ________________ levels of the organization
b) Advantage: more _________________
c) Disadvantage: lacks __________________
B.Expansion Methods
1.
Horizontal Integration – merger between two or more companies in the same ___________ of
business. Horizontal expansion generally leads to higher ______________ levels and allows
businesses to take advantage of ____________________________________________.
2. Vertical Integration – expansion through increased involvement in the different stages of
__________________________ and _______________________________. Vertical
integration is often used in ________________________ economies where outsourcing is not
possible.
C. Product Variations – adding new products, package sizes, flavors and brands
D. Diversity of Markets ( _________________ and to ___________ a business sells)
1.
Different _____________________ of the country/world
2. Different ___________________ of areas (rural, urban, small town, etc)
3. Different ______________________
a) B2C
b) B2B
II. Reducing Global Risks
A. Conduct business in ________________ regions
B. _____________________ product lines
C. Involve _____________ ownership such as _______________________ where two or more
companies share a business project.
D. Employ _____________ management to gain insight into local customs and business practices.
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Section 6.1 Homework
1. Give an example of a business or government capital projects in our area.
2. Give two synonyms for the term capital project.
3. Name and define the five main types of capital projects.
4. What is an intangible asset? How do these assets relate to capital projects?
5. List four examples of intellectual property.
6. How do mutually-exclusive projects differ from complementary projects?
7. What limitation is present in almost every decision-making situation?
Section 6.2 Homework
9. Why is capital spending vital to the current and future success of every organization?
10. According to financial theory, what is the main goal of business?
11. How is the value of a firm most commonly measured?
12. How do the capital spending goals of a non-profit organization differ from those of a for-profit
organization?
13. What two items provide the basis for a quantitative project analysis?
14. What are the two main sources of cash inflows?
15. What two factors must be considered when estimating cash flows?
16. Why is depreciation NOT considered when estimating cash flows?
17. How is the discount rate used to determine cost of capital?
18. Provide a synonym for the term cost of capital.
19. What are the disadvantages to using debt?
20. What are the disadvantages to issuing equity?
21. How can debt be beneficial to a company?
22. What determines the optimal capital structure?
23. Calculate the WACC if a company has 40% debt at a cost of 7% and 60% equity at a cost of 11%.
24. In general, debt costs less than equity. Using the WACC, one could conclude that using all debt would
create a lower WACC. In reality, using all debt would likely result in a higher WACC. How is the possible?
Section 6.3 Homework
25. List the six tools available to guide managers in deciding which capital project to pursue.
26. What are the advantages and disadvantages to using the payback method?
27. What are the advantages and disadvantages to using NPV?
28. What are the advantages and disadvantages to using IRR?
29. Provide an example of an opportunity costs associated with most capital projects.
30. Why are sunk costs NOT considered in a capital spending analysis?
31. List four factors that should be considered in a risk analysis.
32. For the following situation, what is the payback (in years)?
Initial Cost: $1.5 million
Cash Flows:
Year 1:
Year 2:
Year 3:
Year 4:
Year 5:
$300,000
$400,000
$500,000
$400,000
$300,000
33. What is the net present value (NPV) for the following situation? Should this capital project be accepted?
Initial Cost: $78,000
Cost of Capital: 8%
Cash Flows:
Year 1: $28,000
Year 2: $37,000
Year 3: $34,000
34. A company is considering a one-year investment that costs $100,000. The investment would earn $15,000
during that year. What is the internal rate of return on this investment?
Section 6.4 Homework
35. Why should you consider the organizational structure of a company when deciding about an expansion?
36. Provide an example of a local company that used horizontal expansion and one example of a company with
vertical expansion.
37. List three ways a company can diversify its markets.
38. How can businesses reduce the risks of doing business globally?
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