Questions:
- What are the general categories of capital budget scenarios? Please describe the overall decision-making context for each.
As an upcoming business person, your strategic budgeting process is important because it helps allocate resources properly. Therefore, a capital budget allows you to accurately predict the best way of growing your business to meet your long and short term goals. It also helps you evaluate your future projects by determining which ones are most feasible and profitable. Therefore, the general categories of capital budget scenarios are; replacement and repair of existing equipment, regulatory requirements, and expansions and improvements,
However, the overall decision making for the replacement and repair of the existing equipment is that equipment that wears out or breaks down must be replaced because the cost of repairing the equipment must exceed the buying cost, so it is well-advised replace. On the other hand, the decision making in expansion and improvements states that before adding new services or products to your business, expansions, and improvements of existing equipment and facilities must be considered. Lastly, making additions to your buildings, adding new product lines plus the equipment needed to produce it as well as creating additional services are all part of the capital budget for growth.
- Compare the process to create a business plan for a startup company and the process of creating a capital budget proposal. Please explain the three similarities and differences between the two.
A business plan is a roadmap that provides directions to a business so that it can plan for its future and helps it overcome bumps in the road. Contrariwise, capital budgeting is a multi-step process businesses use to determine how worthwhile a project or investment will be.
However, the difference between the two is that a strategic plan plays out the direction and goals of the business and guidelines for actions to archive those goals. At the same time, the budget looks at the needed money to support achieving those goals. The similarity between the two is that they all work towards achieving a common goal.
- Define WACC. In addition, explain how changes in the economy that make investors more risk-averse can affect WACC (think the cost of debt and cost of equity)
An acronym WACC stands for a weighted average cost of capital, of which it is a calculation of a firm’s costs of capital in which each category of capital is proportionately weighted. Besides, all capital sources, including common stock, preferred stock, bonds, and other long-term debt, are included in a WACC calculation. Also, it is ideal to notice that a firm’s WACC increases as the beta and rate of return on equity increases because an increase in WAAC signifies a decrease in valuation and a corresponding increase in risk.
Since the cost of capital is the return which is necessary for a company to invest project like building a plant, a company will only invest or expand operations when the projected returns from a project are greater than the cost of capital, which includes both debt and equity with the aim of optimizing profitability. However, the depth capital is raised by borrowing funds through various channels, such as acquiring loans or credit card financing. Contrariwise, equity financing is the act of selling shares of common or preferred stock. The primary way that market risk affects the cost of capital is by its effect on the cost of equity.