Accounting Case Concerning Capital Budgeting Decisions (Case Study Sample)

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Project Case
Capital investment decisions made by North Sea Oil are crucial as they have a direct influence on the size, risk, and growth prospect of the company; safeguarding the above at optimal levels would yield maximization of shareholders wealth. Furthermore, it would allow North Sea Oil to offset interest payments accruing from outstanding debt capital in the short run and payment of principal amounts on maturity in the long-term. Moreover, appropriate capital investment decisions offer an opportunity for generating additional finances that the entity can plough back in future to invest in other feasible projects; the above source of financing does not accrue interest expenses unlike debt capital. Additionally, adequate investment appraisal techniques increase the price of stocks in the financial markets; the above enhances the credibility of North Sea Oil, which complements its ability in raising finances. Capital budgeting decisions involve investment of funds in the current period to accrue returns in the long-term; North Sea Oil should appraise available options wisely using adequate traditional and modern capital budgeting methods for appraising investmentsCITATION Rya02 \l 1033 (Ryan & Ryan, 2002).
Net Present Value (NPV) and IRR are two modern methods available for analyzing and ranking project A and project B, which are the two options available for investmentCITATION Ber14 \p 234 \l 1033 (Berk & DeMarzo, 2014, p. 234). Both techniques acknowledge time value of money in appraising and ranking of the available alternatives; the above allows discounting and compounding of cash flows in the entire life of a venture to present and future values respectively by North Sea Oil. The acceptance rules of NPV allow North Sea Oil to accept projects with positive values of NPV; projects with a great value of the above rank higher than investments with a smaller value. As such, the technique qualifies acceptance of project B, which has a positive NPV, and rejection of project A as diminishes shareholders wealth. Furthermore, the NPV of project A is still negative even with the change in proportions of the capital structure of North Sea Oil, which increases the Weighted Average Cost of Capital (WACC) from 16.5% to 17.2%; the above decreases the NPV from -$1,520.26 to -$3,861.44CITATION Ber14 \p 422 \l 1033 (Berk & DeMarzo, 2014, p. 422).
The IRR acceptance rules, on the other hand, accepts projects with an IRR that is higher than the WACC of North Sea Oil, which is also known as the hurdle rate; the above is the average rate of raising finances incurred by the entity based on their capital structure. The IRR of project A and B is 16.06% and 17.55% respectively. Considering the values of the above indicators, North Sea Oil should accept project B and reject project A; the IRR for the former exceeds the WACC of 16.5%, which signals that the rate of return of project B is higher than the cost of accessing finances unlike is the case with project A. The scenario is similar for North Sea Oil irrespective of the changes in their capital structure, which does not influence the IRR.
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