A task force of capital budgeting analysts at Morrison Limited collected the following data concerning the drilling and production of known petroleum reserves at an offshore location: Table 6-4. Note: Use appropriate factor(s) from the table provided. Investment in rigging equipment and related personnel costs required to pump the oil Net increase in inventory and receivables associated with the drilling and production of the reserves. Assume this investment will be recovered at the end of the project Net cash inflow from operations for the expected life of the reserves, by year: 2022 2023 2024 Salvage value of machinery and equipment at the end of the well's productive life Cost of capital $4,900,000 960,000 1,600,000 2,880,000 1,360,000 800,000 12% Required: a. Calculate the net present value of the proposed investment in the drilling and production operation. Assume that the investment will be made at the beginning of 2022, and the net cash inflows from operations will be received in a lump sum at the end of each year (Ignore income taxes). b. What will the internal rate of return on this investment be relative to the cost of capital? c. Differences between estimates made by the task force and actual results would have an effect on the actual rate of return on the project. For each estimate, state the effect on the actual ROI if the estimate turns out to be less than the actual amount finally achieved.
Net Present Value
Net present value is the most important concept of finance. It is used to evaluate the investment and financing decisions that involve cash flows occurring over multiple periods. The difference between the present value of cash inflow and cash outflow is termed as net present value (NPV). It is used for capital budgeting and investment planning. It is also used to compare similar investment alternatives.
Investment Decision
The term investment refers to allocating money with the intention of getting positive returns in the future period. For example, an asset would be acquired with the motive of generating income by selling the asset when there is a price increase.
Factors That Complicate Capital Investment Analysis
Capital investment analysis is a way of the budgeting process that companies and the government use to evaluate the profitability of the investment that has been done for the long term. This can include the evaluation of fixed assets such as machinery, equipment, etc.
Capital Budgeting
Capital budgeting is a decision-making process whereby long-term investments is evaluated and selected based on whether such investment is worth pursuing in future or not. It plays an important role in financial decision-making as it impacts the profitability of the business in the long term. The benefits of capital budgeting may be in the form of increased revenue or reduction in cost. The capital budgeting decisions include replacing or rebuilding of the fixed assets, addition of an asset. These long-term investment decisions involve a large number of funds and are irreversible because the market for the second-hand asset may be difficult to find and will have an effect over long-time spam. A right decision can yield favorable returns on the other hand a wrong decision may have an effect on the sustainability of the firm. Capital budgeting helps businesses to understand risks that are involved in undertaking capital investment. It also enables them to choose the option which generates the best return by applying the various capital budgeting techniques.
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