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CHAPTER 1
ANSWERS

Answer to Q. 1.1

The most widely accepted goal of the firm is ‘to maximise shareholder wealth’ or ‘market value
of the firm’. This goal incorporates both the profitability and risk into one objective. The firm
can maximise shareholder wealth by investing in only those projects that generate positive net
present values (NPV). Net present value refers to the discounted sum of the expected net cash
flows. The discount rate takes into account the timing and risk of the future cash flows that are
available from an investment. The NPV represents the amount of wealth or value added to the
firm from the project. Thus, the selection of projects on the basis of NPV criterion directly
relates to the achievements of the firm’s goal.

Answer to Q. 1.2

The relationship between the firm’s overall goal, financial management and capital budgeting is
depicted in Figure 1.1 of the textbook. It is reproduced below.
GOAL OF THE FIRM

Maximise shareholder wealth or value of the firm

Financing Dividend Investment

decision decision decision

Long-term Short-term
investments investments

CAPITAL BUDGETING

As you can see from Figure 1.1, the goal of the firm is to maximise shareholder wealth or value
of the firm. Financial management is largely concerned with financing, investment and dividend
decisions, which of course stem from the firm’s goal.

Financing decisions deal with the question of how funds should be raised to acquire various
assets. These decisions relate to the optimal capital structure of the firm in terms of debt and
equity. Within each classification of debt and equity, there are many varieties. Debentures, bank
overdrafts, bank loans of different maturities, commercial bills and promissory notes are
examples of different forms of debt. Preference shares, ordinary shares and convertible notes
(hybrids of debt and equity) are examples of different forms of equity.
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Dividend decisions relate to the form in which the cash flows generated by the firm are passed
onto equity holders. The net cash flows can be distributed to the share holders in the form of
dividends or reinvested in the firm to generate more cash flows.

Investment decisions deal with the way the funds raised in the financial markets are employed in
productive activities, that is how much to invest and what assets should be invested in. Funds
may be invested in short-term assets and long-term assets. The amount invested in some assets
may be fairly small while the amount invested in some other assets may be very large. Capital
budgeting is primarily concerned with sizable investments in long-term assets. The investment
decision is not confined to the acquisition of real assets. It also includes the acquisition of assets
through takeovers and mergers. These involve the purchase of shares of another firm. In
evaluating investment decisions, analysts focus on three key factors: cash flows, time and risk.

Refer to the introductory section of Ch 1 for a detailed discussion on the relationship between the
firm’s overall goal, financial management and capital budgeting.

Answer to Q. 1.3

Refer to ‘Classification of Investment Projects’ section in the textbook for a discussion on

different types of investments. Examples of each type of investment are presented below.

a) Independent Projects: The acceptance or rejection of one does not directly eliminate
other projects from consideration or cause the likelihood of their selection. Examples
would include:
(i) The introduction of a new product line (soap) and at the same time the
replacement of a machine, which is currently producing a different product (plastic
bottles).
(ii) The installation of a new air conditioning system and the commissioning of a
new advertising campaign for a product currently sold by the firm.

b) Mutually Exclusive Projects: The acceptance of one prevents the acceptance of an

alternative proposal. That is, two or more projects cannot be pursued simultaneously.
Examples would include:
(ii) A firm may own a block of land, which is large enough to establish a shoe
manufacturing business or a steel fabrication plant. The selection of one will
exclude the acceptance of the other.
(iii) A car manufacturing company considering to establish one of its manufacturing
complexes can locate it in Sydney, Brisbane or Adelaide. If the company chooses
Sydney, the other two locations are ruled out.

c) Contingent Projects: The acceptance or rejection of one is dependent on the decision to

accept or reject one or more other projects. Contingent projects may be complementary or
substitute. Example of each would include:
(i) Complementary: The decision to start a pharmacy may be contingent upon a
decision to establish a doctors’ surgery in an adjacent building. The cash flows of
the pharmacy will be enhanced by the existence of a nearby surgery and vice versa.
(ii) Complementary: The introduction of a water recycling plant may increase the
profitability of several other projects.
(iii) Substitutes: customers visiting a shopping complex may treat Chinese and
Thai food as close substitutes. Consequently if the firm establishes both
restaurants, none of the restaurants may be profitable due to the distribution of a
given number of customers between the two restaurants. However, if only one
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restaurant is established, it may generate net present value. Therefore, the
acceptance of one is contingent upon the non-acceptance of the other project.
(iv) Substitutes: two different brands of butter as two different projects. The
success of one project may depend on the non-acceptance of the other project.

Answer to Q. 1.4

Figure 1.2 in the textbook depicts the capital budgeting process. It shows that there are several
sequential and distinctive stages in the process. Capital budgeting is primarily concerned with
sizable investments in long-term assets. This implies that relatively small capital expenditures
should not be subjected to the entire capital budgeting process. The reason is very simple: the
cost of subjecting small capital expenditures to the entire capital budgeting process certainly
overweighs the benefit of doing so. It is not worth to spend so much money to evaluate a small
expenditure.

Generally, it is the larger capital expenditures that are subjected to the capital budgeting process
as in those cases the benefit (of doing so) will exceed the cost.

Answer to Q. 1.5

The capital budgeting process is depicted in Figure 1.2 of the text and reproduced below.

Figure 1.2 presents the sequence of steps involved in the capital budgeting process, all of which
stem from the corporate goal. The strategic planning stage takes the firm’s goal and converts it
into specific objectives: business development areas are identified, priorities are set and
strategies are identified to guide the planning phase. For example, it may be decided that the
firm wants to diversify into the retail furniture market, and a decision may be made as to the best
way of achieving this task (e.g. by direct acquisition of a firm established in that market or by a
merger).

The next step is identifying the investment opportunities. Investment proposals can originate
from levels ranging from the employee on the shop floor (e.g. a machine may need replacing) to
top-level management (e.g. corporate takeovers). Due to constraints such as time and money,
not all proposals will be thoroughly evaluated. Coarse screening of ideas or some preliminary
thoughts will exclude a number of proposals.

Large investment proposals remained after the preliminary or coarse screening process are
subjected to the quantitative analysis which leads to a recommendation for acceptance or
rejection of the proposal. During the quantitative analysis phase, the project will have to be
clearly identified (for example independent, contingent, etc.), its cash flows have to be forecast,
risk has to be considered, and the economic worth of the project has to be evaluated.

Figure 1.2 The Capital Budgeting Process

Corporate goal

Strategic planning
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Investment opportunities

Preliminary screening

Financial appraisal, Quantitative analysis,

Project evaluation or Project analysis

Qualitative factors, judgements and gut feelings

Accept / reject decisions of the projects

Accept Reject

Implementation

Facilitation, monitoring, control and review

Continue, expand or abandon project

Post-implementation audit

The projects which qualify as acceptable by the quantitative analysis are then reviewed in light
of qualitative factors, such as pollution, community support (or opposition) and staff morel.
Both the quantitative and qualitative analyses allow the management to make an informed
decision as to whether or not to proceed with the project.

If the project is accepted and authorized, its implementation can begin. But this is not the end of
the capital budgeting process. The implemented projects should be monitored with periodic
reviews to ensure that they are performing as expected. Appropriate cost controls should be put
in place to ensure, for example, what was proposed and approved is actually acquired at the
budgeted cost and the discrepancies between budgeted and actual costs are explained.
Monitoring of both cash inflows and outflows is critical because, in a worst case, even a possible
termination of the project may have to be considered.

The final stage of the process, post implementation audit, occurs when the project has been in
operation for a period of time. This stage provides management with the information for
identifying where and why the errors or discrepancies occurred. This information will, in turn,
can be used to improve the quality of future investment decisions. A lot can be learnt from
experience.

Further details can be found in Chapter 1, particularly in the section entitled “The Capital
Budgeting Process”.
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