Question

When could a firm’s required rate of return be used to evaluate investment projects? If it was used in all projects, what would be the likely result?

The cost of capital depends upon the use to which the funds are put” Explain this statement?

discuss the relative advantages and disadvantages of pursuing (1) flexible and (2) restrictive current asset management strategies

Answer 1

Required rate of return

A firm’s required rate of return is used to evaluate investment projects, when discounted capital budgeting techniques are used. Discounted capital budgeting techniques help the firms to find the profitability after considering the present value of all future cash inflows. When the discounting is used in capital budgeting, the decision making will be accurate. A firm’s required rate of return is compared while decision making, in the case of Internal Rate of Return (IRR) method. IRR and firm’s required rate of return are compared to decide whether to accept or reject a project.

If the firm’s required rate of return is used in all projects, the appraisal of the investment proposals will be efficient. Results will be reliable. It is good to consider firm’s required rate of return in capital budgeting techniques.

Cost of Capital

The cost of capital depends upon the use to which the funds are put. This means that the cost of capital depends upon the type of finance the company uses. Usually the capital structure of the company is a blend of both equity and debt. If the company is financed fully by equity, the cost of capital will be cost of equity. If there are only debt capital, it is cost of debt. Cost of debt is considered to be cheaper than cost of equity. This is because the cost of debt has tax advantage. If a company fully depends on equity financing, the cost of capital will be more, since there is no tax advantage for equity.

Current Asset management

Current Asset management involves the management of Cash, accounts receivables, cash equivalents and all other current currents of a company. It is a part of working capital management. The strategies for managing current assets are Restrictive strategy and Flexible strategy.

• In Restrictive strategy, the level of current assets to be kept is low. But Flexible strategy insists on maintaining high level of liquid assets in the company
• Restrictive strategy involves high return as well as risk. But Flexible strategy involves low risk and low return
• Disadvantages of Flexible strategy are low return on current assets, high inventory carrying costs, and high cost for liberal credit policy. Disadvantages of Restrictive strategy are high potential financial costs and high operating shortage costs