OOU FIN 204 Assignment 1. What is capital budgeting? 2. mention any three needs for capital budgeting 3. what are the procedures involve in capital budgeting decisions 4. state any four characteristics of capital budgeting. Calculation Abc limited is planning to spend 1.7 million naira on a project that is expected to last for 10yrs. The project is expected to generate annual cash inflow of 380,000. The company cost of capital is 16% and the company requires all project to have achieved payback in discounted cash flow terms by the end of 5years otherwise the project will not be undertaken advice the company of this project as the financial analyst N. B : please note both in a different sheet , to be submitted next week Monday. Thank you.
This accounting problem is solved step by step below, with detailed explanations to help you understand the method and arrive at the correct answer.
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Here are the answers to your assignment:
1. What is capital budgeting?
Capital budgeting is the process of evaluating and selecting long-term investment projects that are consistent with the firm's goal of maximizing owner wealth. It involves deciding whether to invest in projects like new equipment, facilities, or product lines.
2. Mention any three needs for capital budgeting.
Capital budgeting is needed for several reasons, including:
• It involves a large outlay of funds, making careful evaluation essential.
• It has a long-term impact on the firm's profitability and strategic direction.
• Capital investment decisions are often irreversible or very costly to reverse once made.
3. What are the procedures involved in capital budgeting decisions?
The procedures involved in capital budgeting decisions typically include:
1. Generation of investment proposals: Identifying potential projects.
2. Evaluation of proposals: Analyzing the financial viability and risks of each project.
3. Selection of projects: Choosing the projects that align with the company's objectives and financial criteria.
4. Implementation: Executing the chosen projects.
5. Review and post-audit: Monitoring the project's performance and comparing it to initial projections.
4. State any four characteristics of capital budgeting.
Four characteristics of capital budgeting are:
• It involves significant financial outlays.
• The decisions have long-term implications for the business.
• It carries a high degree of risk and uncertainty.
• The decisions are often irreversible or difficult to reverse without substantial loss.
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Calculation:
Let's calculate the discounted payback period for Abc Limited's project.
Given:
Initial Investment = ₦1,700,000
Annual Cash Inflow = ₦380,000
Cost of Capital (Discount Rate) = 16%
The company requires all projects to have a discounted payback period of 5 years or less.
Step 1: Calculate the present value (PV) of each year's cash inflow using the discount factor 1/(1 + r)^n, where r = 0.16.
| Year (n) | Annual Cash Inflow (₦) | Discount Factor (1/(1.16)^n) | Present Value of Cash Inflow (₦) | Cumulative Present Value (₦) |
| :------- | :--------------------- | :------------------------------- | :------------------------------- | :--------------------------- |
| 1 | 380,000 | 0.8621 | 327,598 | 327,598 |
| 2 | 380,000 | 0.7432 | 282,416 | 610,014 |
| 3 | 380,000 | 0.6407 | 243,466 | 853,480 |
| 4 | 380,000 | 0.5523 | 209,874 | 1,063,354 |
| 5 | 380,000 | 0.4761 | 180,918 | 1,244,272 |
| 6 | 380,000 | 0.4104 | 155,952 | 1,400,224 |
| 7 | 380,000 | 0.3538 | 134,444 | 1,534,668 |
| 8 | 380,000 | 0.3050 | 115,900 | 1,650,568 |
| 9 | 380,000 | 0.2630 | 99,940 | 1,750,508 |
Step 2: Determine the year in which the cumulative present value of cash inflows equals or exceeds the initial investment of ₦1,700,000.
From the table, at the end of Year 8, the cumulative PV is ₦1,650,568.
At the end of Year 9, the cumulative PV is ₦1,750,508.
The initial investment of ₦1,700,000 is recovered between Year 8 and Year 9.
Step 3: Calculate the exact discounted payback period.
Amount remaining to be recovered after Year 8 = Initial Investment - Cumulative PV at Year 8
= ₦1,700,000 - ₦1,650,568
= ₦49,432
Discounted Payback Period = 8 years + (Amount remaining / PV of cash inflow in Year 9)
= 8 years + (₦49,432 / ₦99,940)
= 8 years + 0.4946 years
= 8.49 years
Advice to the company:
As a financial analyst, I advise Abc Limited not to undertake this project. The calculated discounted payback period is 8.49 years, which is longer than the company's required maximum payback period of 5 years. Therefore, the project does not meet the company's investment criteria.
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