Capital budgeting is a complicated process that is essential to good investment decisions by a company. Please give an example of a capital budgeting decision a company might need to make.

Companies use capital budgeting in order to “determine which of an organization’s long term [sic] investments… are worth pursuing” (Boundless, 2014, p. 600). One example that I came up with to help me remember the purpose of capital budgeting is a clothing retail store. Let’s say that this store is a regional store with average priced clothing. The store recently noticed that their sales are going down since more and more retail stores are opening with similar prices, so there is a lot more competition than when it first opened. The store must use capital budgeting in order to see whether they should continue along the same path, begin selling cheaper clothes, or make the move to a more high-end store. Each path has pros and cons (for example, selling cheaper clothes means the CoGS will go down, but they will also need to sell many more items in order to make the same profit as they currently make or could make selling high-end items), so the store will need to do the proper calculations in order to decide if they will keep the same product at the same price or if they should pivot into a new sales strategy.

Are there examples in using the cost of capital in personal life? When or how have you compared the cost of getting money to the potential benefit of that money?

I am not quite sure if this applies but I think one example of me using Cost of Capital in my personal life has been paying to go back to school. I really only had two options (as far as I know, I can’t sell stock in my educational endeavors) which were paying cash or taking out a loan. The big difference between the two is the amount of time it would take me to finish school since with a loan I could afford to take more classes at once while paying cash would only be one or two classes a semester. However, when making the decision I had to factor in that although taking out a loan would let me finish school faster and possibly get a raise sooner, the interest on that loan and the time that it would take to pay off would actually be a hinderance over time. Paying cash would take a few years longer, but because I don’t have to pay interest on a loan over time it is actually worth it. Plus, on a non-financial note, realistically it would be hard for me to take full-time classes while working full-time and wanting to spend time with my family. I had to think about all of these aspects when considering the how much I would “pay” (both literally and metaphorically) for my education. In this case, getting my degree would be the “hurdle” in order to be able to use that degree for future expansion in opportunities and salary.

Once a business computes its cost of capital, discuss how a manager might decide whether to take on a project or not.  How are capital project investments prioritized?

Once a company knows its cost of capital, a manager can then use that information to use capital budgeting in order to find the Internal Rate of Return, Payback Period, Profitability Index, Net Present Value, and Accounting Rate of Return. Capital projects are prioritized in order of which has the most realistic potential benefit to the company. Ideally this investment would have an IRR of over 0, a low Payback Period, a PI over 1, an NPV over 0, and an ARR greater than or equal to the required rate of return for the company (Boundless, 2014). Any investment which fulfills all of those requirements will take precedence over those which do not fulfill one or more. Any which do not fulfill the majority or any at all will likely be discarded as a bad investment opportunity.

References

Boundless (2014). Finance. Boundless.com