Think about Unit VII and the importance of understanding the cost of capital to a business. Comment on why it is important and explain why as debt increases (in capital structure), eventually the WACC will increase (despite the fact debt is usually the lower cost component cost of capital).

200 word discussion board answer only. Thanks.

UNIT VII STUDY GUIDE Capital Budgeting Course Learning Outcomes for Unit VII Upon completion of this unit, students should be able to: 7. Perform a capital budgeting analysis. 7.1 Contrast mutually exclusive project decisions and stand-alone project decisions. 7.2 Calculate project feasibility using various capital budgeting methods. Reading Assignment Chapter 11: Investment Decision Criteria, pp. 328-361 Unit Lesson Capital budgeting is a decision process used to decide when to accept independent projects or select among alternatives in the case of competing or mutually exclusive projects. In both cases, capital budgeting must add value to an organization. Different capital budgeting methods can result in conflicting results. Take the case of United Drone Company as an example. United Drone Company manufactures commercial drones and wants to find a centrally located distribution center to supply its dealers. Jerry Hampton, the controller, has three potential locations he wants to evaluate. Hampton has identified Chicago, Denver, and St. Louis as potential sites for a distribution center. United will lower costs by building a distribution center. Increased cash flow results from these lower costs. These cost savings improves cash flow as follows: Projected cash flows for each year exclude depreciation because it does not affect cash, but it does reduce taxable income, lowering income tax payments included in these cash flows. To get an idea of how long it will take for United to recover its investment, Hampton performs a quick payback analysis. Results of this analysis show the following: BBA 3301, Financial Management 1 UNIT x STUDY GUIDE Title By making this calculation, Hampton has an idea about how long each location will take to cover the initial investment. Hampton notices that after these payback periods it appears each investment will have positive cash flows, but he cannot tell which investment has superior cash flows. Keeping payback in mind, Hampton decides to calculate net present value (NPV) to look at the discounted cash flows over the life of each facility. Discounting brings each alternative's cash flows back to what they are worth in today's dollars allowing Hampton to compare "apples to apples." Assuming a cost of capital for United of 9.5%, a NPV analysis reveals the following: Although Denver has the shortest payback, Chicago has the highest NPV followed by Denver. St. Louis has a much lower NPV than Chicago or Denver. Payback fails to take the cash flows after the payback period into consideration. Failure to consider these cash flows results in conflicting outcomes. Hampton still wants to know the returns on an investment in each location, which neither payback period nor NPV calculations show. Because Hampton desires some measure of return on investment, he decides to calculate internal rate of return (IRR). IRR calculates a return on capital by solving for a rate where the present value of the cash flows equates to zero. This calculation done by hand is an iterative process, which means an assumption is first made about what rate will produce the desired result. Once tried, someone making this calculation can try a higher or lower rate to move toward a rate where the present value of the cash flows equates with zero. Using a spreadsheet like Excel makes such a calculation easy. For example, Hampton calculated IRR for each location as follows: BBA 3301, Financial Management 2 UNIT x STUDY GUIDE Title As an example, Excel uses the IRR financial function as follows: Notice in the values box, the cell references correspond with the spreadsheet for both the initial and subsequent cash flows. Excel does all the work by performing the iterations needed to achieve a workable solution. Hampton has an idea of return on investment by making these calculations and compares the result with United's 9.5% cost of capital. Because all three scenarios result in much higher IRRs than 9.5%, they all will have positive results. Hampton can make a case for Chicago because it has the highest NPV, but Denver is close behind and has a faster payback and higher IRR. Again conflicting results hamper Hampton's decision. Another method Hampton can try is to calculate profitability index for each location. Profitability index simply divides present value (PV) of the cash flows by the initial investment. If a location's profitability index is greater than one, it means it has cash flows with a PV greater than the initial investment. United should accept the project with the highest profitability index and NPV because it results in adding the greatest value to the firm. Hampton calculated profitability index for each location as follows: BBA 3301, Financial Management 3 UNIT x STUDY GUIDE Title Upon Hampton's review of these numbers, he finds Denver has a higher profitability index despite Chicago having a higher NPV. Again, conflicting results confront Hampton. Hampton decides to select Chicago because despite a lower profitability index and IRR it still adds the most value to the firm. Because these projects are mutually exclusive, Hampton has to decide which project to invest in. United may have other independent projects where a choice between projects is not necessary. Mutually exclusive projects are those where a firm considers alternatives. Decision makers like Hampton have to select the best alternative. Independent projects do not compete with other projects, but a firm still needs to decide if the project adds value to the firm or not. Although Hampton has made a decision by selecting Chicago, he can verify his decision using other capital budgeting methods. For example, using the discounted payback method can improve results from use of the conventional payback method. Modified internal rate of return (MIRR) improves the results from IRR by eliminating any change in direction of cash flows under conventional IRR. Another factor influencing capital budgeting decisions is the discount rate used in discounting cash flows. Recall that the discount rate is a firm's cost of capital. If cost of capital is not accurate, discounting may not produce accurate results or current conditions may warrant a higher discount rate because of increased risk. Calculation of cost of capital is a topic reserved for later. In summary, United tasked Hampton to decide among competing alternatives. Hampton used various capital budgeting techniques to make an informed decision. Capital budgeting entails deciding on an alternative or project that adds the most value to the firm. NPV is the preferred capital budgeting method because it offers the best result in deciding among alternatives and projects that add the most value to the firm. In the case of independent projects, all that a firm needs to accept a project is a positive NPV. IRR, and PI can result in conflicting results that do not provide accurate outcomes. Learning Activities (Non-Graded) The following video tutorials will help you with the concepts covered in the textbook chapters. It is strongly encouraged to watch these videos prior to starting the unit assessment. Click here for Capital Budgeting Click here for Checkpoint 11.1: Calculating NPV Click here for Checkpoint 11.2: Calculating NPV Click here for Checkpoint 11.3: Calculating PI Click here for Checkpoint 11.4: Calculating IRR Non-graded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. BBA 3301, Financial Management 4