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Question about Capital Budgeting Process

1. Discuss how an organization would determine the total value to be allocated towards capital projects.
2. Discuss the key factors that would determine if a project should be approved in a capital budgeting process.
3. After a capital project has been approved and completed, discuss how you would assess whether or not the project had the desired financial return.

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1. Discuss how an organization would determine the total value to be allocated towards capital projects.

Companies with excess funds must make decisions on how to best invest these funds in order to maximize their potential. The choices that involve spending these funds on long-term projects requires that the company utilize capital budgeting for projects, equipment, technology upgrades, R&D, etc. When determining the total value to be allocated toward a capital project, the company must use accounting techniques to help them analyze which projects have the best potential to maximize their return on the invested capital. In accounting, there are several methods that can be used by accounting managers to help determine the best projects to invest in. The process will also help them determine the total value to spend that would make good business sense and align with the company's future strategic business model.

Two of the more common methods to help determine the total value to allocate are the payback period method and the net present value method. Both of these methods will require the organization to make assumptions based on the use of estimated cash flow amounts. Therefore, how do these methods help determine total value to allocate?

Let us look at each one in more depth.

First, the payback period method is considered by most managers to be especially simple if future inflows from the project being considered happen to be equal in amount each year. If that happens to be the situation with the project in mind, then a simple formula can be used to determine the payback period of the total value invested. The formula would be:

Cost of Capital Project รท Net Annual Cash Inflow = Payback Period

When using the payback period method, if the project has uneven cash flows, by creating a table with a cumulative net cash flow column, the organization can identify the year and an estimate of the portion of a year in which the project recoups its cost. A weakness of the payback method is that it does not take into consideration the time value of money over the life span of the project. Even so, the shorter the payback period is, the sooner the project's cost is recovered which leads to a more attractive project to consider investing in.

When using the net present value method, one of its strengths is that it uses the same cash flow information as described above in the payback method and it requires that each cash flow be discounted by an appropriate discount rate. This will allow for the time value of the money to equate.

The appropriate discount rate could be the company's weighted average cost of capital or its required rate of return. After each cash inflow has been discounted to the point in time at which ...

Solution Summary

The solution provides a 1788-word discussion on how an organisation can determine what value to assign capital projects and the key factors in making the decision to move a project into the capital budgeting process. It ends with a look at how to evaluate such projects to see if they are making the desired financial return 2 references included.

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