- Mention two of the most common capital budgeting methods, and list some situations where these methods are used more often.
When it comes to capital budgeting, a lot of businesses follow academic theory, using the well-known methods of Internal Rate of Return (IRR) and net present value (NPV) practices to weigh new projects. As you can see in the article that a survey showed that the ‘respondents cited net present value and internal rate of return as their most regularly used capital budgeting techniques; 74.9% of CFOs always or almost always used NPV and 75.7% always or almost always used IRR’. Those companies that are big in size contrary to small firms mostly use these two methods. Also, companies who are highly levered use these two methods for capital budgeting.
- How often the payback method is used in valuing ventures? And who uses it the most? Why do they use it?
As shown in the article payback method is always or most of the time used by 56.7% of CFO’s. . The article also says that mostly those firms that are small in size uses payback method. Also those small firms that have older CEOs with long employment time period and without the education level of MBAs are most commonly known to use the payback method.
- What is the most common method used in forecasting the cost of equity? Who usually uses it?
Capital Asset Pricing Model (CAPM) is the most common method used for forecasting the cost of equity. As shown in the research ‘73.5% of respondents always or almost always used it’. Large firms mostly use CAPM to find the cost of equity and also public firms are known to be using CAPM.
- What is the name of the new theory of capital structure? Explain the new version of optimal debt equity model?
The new theory of capital structure is known as “pecking-order” theory. This theory says that real company leverage ratios normally do not copy capital structure targets, but somewhat the greatly seen company practice of financing new investments with either the availability of internal funds or rather issuing debt rather than equity in the case when external finances are needed. It considers equity to be a much expensive source of finance and says that should be the last preference in raising capital for a firm.
- According to the trade-off theory, mature companies with limited opportunities for investment should have a higher leverage ratio, why is that?
Large mature firms that have a lesser opportunities available to them have higher leverage ratios due to their high levels of over investment. This also helps them with the benefit of tax deductibility and lowers theirs financial distress cost.
- What is the most important factor that affects CFO’s decisions of making debt? What does this factor mean?
According to the survey the most important factor that effected decisions regarding the debt was Financial Flexibility. The term financial flexibility refers to a firm's ability to respond to unexpected expenses and investment opportunities.
- What is the conflict between the theory and practice in calculating the leverage, and how do practitioners explain this conflict?
The major conflict between the theory and practice of corporate capital structure begins from academics’ teaching on estimating leverage as a percentage of the market value of the firm as opposing to the most companies and rating agencies do, which is calculated as a percentage of the book value of assets.
- Write a paragraph about new topic/information you have learned from this article? Why do you think it’s important?
I have learned the difference between the traditional trade off theory and the pecking order theory. It has explained well how pecking order theory regards the equity as the most expensive option of the financing the company’s investment decisions and should be only considered as a last option. It also tells us the factors that in reality affecting the decision-making of the CFO’s and compares it to the theoretical explanations.
