Busi5014Assessment2

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Evaluating a capital Project 1 Financial Analysis Professor Watson Marcia Clarke MBA-FPX5014 Capella University January 3, 2024

Evaluating a capital Project 2 Introduction Capital budgeting is the process of selecting projects that contribute value to a company, encompassing various activities such as acquiring land or acquiring fixed assets like machinery or vehicles (Pinkasovitch, A 2021). It is an integral part of organizational decision-making, especially for evaluating significant investments like new facilities or equipment. The evaluation involves analyzing cash inflows and outflows to determine if a proposed project aligns with the organization's investment criteria and warrants approval. Key capital budgeting techniques used for such assessments include net present value (NPV), internal rate of return (IRR), Payback Period, and Profitability Index (PI). ABC Healthcare Corporation, a leading entity in the healthcare industry with ownership of hospitals, ambulatory surgical centers, urgent care facilities, and outpatient clinics, is planning three potential capital projects for the upcoming financial year. The objective is to analyze these projects comprehensively and identify the one that will bring the maximum value to the organization and its shareholders. The analysis will involve a thorough examination of current and projected cash flows for each project, utilizing capital budgeting techniques. The computation of future cash flows will consider upfront costs associated with each project. By applying capital budgeting tools, this analysis aims to provide insights into the potential value each project can generate. The recommendations derived from this analysis will be presented to the leadership, considering the findings related to future cash flows, upfront costs, and overall financial feasibility for each project. Ultimately, the goal is to guide ABC Healthcare in making informed decisions that align with the maximization of shareholder value. Evaluating a capital project A capital project is an extensive, capital-intensive investment initiative aimed at building upon, adding to, or enhancing a capital asset. Distinguished by its substantial scale, high cost, and considerable planning requirements relative to other investments, a capital project involves costs that are capitalized or depreciated over time (Barone, A 2020). The three projects scrutinized in this report include the potential purchase of major equipment, expansion into three additional states, and a marketing/advertising campaign. The decision-making process will be guided by capital budgeting techniques to ensure the choice made maximizes shareholder value. Capital budgeting is the systematic evaluation undertaken by a business to assess potential major projects or investments (Kenton, W 2020). This process is crucial for companies considering substantial projects, such as acquiring new plants or equipment. Capital budgeting involves analyzing a project's cash inflows and outflows to ascertain whether the anticipated return aligns with the minimum benchmarks set by ABC Healthcare Corporation. In this analysis, the capital budgeting techniques of net present value (NPV), internal rate of return (IRR), payback period, and profitability index (PI) will be applied to compute the viability of the three potential projects. The results derived from these computations will be used to recommend the most favorable option for consideration. Capital budgeting tools Net present value (NPV) is defined as the difference between the present value of cash inflows and the present value of cash outflows over a specific period (Fernando, J 2021). Regarded as the most accurate method for evaluating a capital project (Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. 2018), NPV is widely used to assess the profitability of a projected investment. The concept behind NPV lies in recognizing that a dollar in the future is

Evaluating a capital Project 3 not equivalent to the same dollar today, considering the time value of money. Money tends to lose value over time, and therefore, a dollar invested today has the potential to earn a return, making its future value possibly higher than a dollar at the same point in the future. The calculation of NPV involves various financial concepts within a single formula, incorporating elements such as cash flows, the time value of money, the discount rate over the project's duration (usually the Weighted Average Cost of Capital or WACC), terminal value, and salvage value (Seth, S 2021). The process begins with calculating the present value of cash inflows and outflows to determine the overall net present value, providing a comprehensive assessment of the investment's economic feasibility. The Net Present Value (NPV) is computed by considering the expected future value (FV), applicable rates (r), and periods (t) for both the initial investment (denoted by the subscript 0) and subsequent years (denoted by the subscript n). The summation of these factors across all periods results in the net present value. A positive NPV indicates that the investment in current dollars exceeds the anticipated cost, and such a project would benefit stockholders, warranting acceptance. Conversely, if the NPV is negative, the project is considered less favorable and may be rejected. The discount rate utilized in NPV calculations is crucial, representing the return expected on a financial asset with comparable risk (Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. 2018). Companies may set the discount rate based on the expected returns of other projects with similar risk. One advantage of NPV is its ability to handle multiple discount rates, enabling the separate discounting of cash flows for each year. Internal Rate of Return (IRR) is another metric employed to assess the potential profitability of project investments. It represents the discount rate at which the present value of future after-tax cash flows equals the initial cost of the capital investment (Margaret, J 2021). The calculations for IRR are akin to those for NPV, using the same data. To determine the IRR, the NPV is set to zero, and the formula is rearranged to solve for the discount rate. The IRR is a crucial component in capital budgeting and corporate finance, aiding businesses in evaluating the profitability of potential investments. If a project is anticipated to have an Internal Rate of Return (IRR) greater than the rate utilized to discount cash flows, it signifies that the project adds value to the business. Conversely, if the IRR falls below the discount rate, it implies that the project might destroy value (Margaret, J 2021). IRR calculations are often combined with Weighted Average Cost of Capital (WACC) and Net Present Value (NPV) calculations. A project with an IRR exceeding the required rate of return (RRR) is considered profitable and worthy of investment.

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Evaluating a capital Project 4 Organizations frequently use IRR to compare overall rates in the financial markets, and an IRR below financial market returns may not be an appealing investment opportunity. One advantage of the IRR method is its ability to normalize returns, expressing them as a percentage, making it easily understandable compared to the hypothetical dollar value represented by NPV. However, there are critical disadvantages to using IRR, such as the potential preference for projects with the highest NPV rather than the highest IRR, as financial performance is measured in dollars. Additionally, IRR analysis assumes the reinvestment of incremental cash flow at the same IRR, which may not always be feasible. The payback period is the time required to recover the investment or reach the break-even point. A shorter payback period is considered more attractive, with the best payback period being the shortest possible. The payback period is calculated by dividing the initial investment by the annual cash flow (Payback Period = Initial investment / Cash Flow per year). While the payback period is a straightforward way to analyze potential investments and is useful for small investments, it has disadvantages. It does not consider the time value of money, inflation, or uneven cash flows over time, making it less suitable for large projects where other analysis methods should be employed. The Profitability Index (PI) is another tool used to evaluate capital projects. It represents the relationship between the present value of future expected cash flows and the initial investment in the project. A higher PI indicates a more attractive project. A PI of 1.0 is considered the lowest acceptable measure, suggesting that the project's present value is equal to the initial investment. As the PI increases, the financial attractiveness of the project improves (Chen, J 2020). The formula to calculate the PI is: Profitability Index (PI) = PV of future cash flows / Initial investment. Financial analysis Project A: Major Equipment Purchase The proposal for a major equipment purchases by ABC Healthcare Corporation involves a comprehensive analysis utilizing the methods previously outlined. The proposed equipment acquisition, costing $10 million, is expected to yield a 5% reduction in the cost of sales annually for eight years. The projected salvage value of the equipment at the end of year 8 is estimated to be $500,000. The required rate of return for the project is set at 8%. The investment will be subject to depreciation using the MACRS 7-year schedule. Annual sales for year one are projected at $20 million, with a consistent expectation for the subsequent eight years. The current cost of sales is 60%, and the marginal corporate tax rate is 25%. Given the substantial initial investment, this proposal for major equipment purchases necessitates a thorough analysis. The equipment is expected to depreciate over seven years using the MACRS method. The analysis, conducted using Microsoft Excel, includes the computation of Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), and the Payback Period. The net cash flow calculations illustrate a steady increase in cumulative cash flow year over year, with only the first year exhibiting a negative value due to the significant initial investment. It is noteworthy that the cumulative cash flow becomes positive in the second year. The table below presents the outcomes of this comprehensive analysis.

Evaluating a capital Project 5 The Net Present Value (NPV) for Project A is calculated to be $44,262,269, indicating a positive value that suggests a potentially lucrative investment. The reduction in sales costs, as proposed by the project, serves as an additional incentive contributing to increased profits. The Internal Rate of Return (IRR) for Project A is determined to be 79.79%, signifying a high level of profitability for the investment. The IRR is a key metric used to estimate the profitability of potential investments, and in this case, the substantial IRR reinforces the attractiveness of Project A. The Profitability Index (PI) for the project is calculated at 5.43. The PI serves as a relative measure of an investment's value, and a higher PI value indicates a more attractive investment. With a positive value of 5.43, Project A is deemed to be a favorable investment based on this analysis. The Payback Period for the project is calculated to be 1.36 years. This short payback period suggests that the cost of the $10 million investment will be recovered in approximately 1.36 years, emphasizing the rapid return on the initial investment. Overall, the combination of these metrics further supports the positive outlook for Project A as a strategic investment for ABC Healthcare Corporation. Project B: Expansion into Three Additional States The second project under consideration by ABC Healthcare Corporation involves a potential expansion into three additional states. This strategic move aims to enhance the company's sales by 10% per year, accompanied by a corresponding increase in the cost of sales by 10% annually for a duration of five years. With annual sales for the previous year recorded at $20 million, the startup cost for this expansion is $7 million, along with an initial investment in net working capital amounting to $1 million. The working capital is anticipated to be recovered at the end of year 5. The marginal corporate tax rate applicable is 25%, and the required rate of return for the project has been set at 12%. The outcomes for Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), and payback period are detailed in the table below. The Net Present Value (NPV) for Project B is determined to be $22,259,712, signaling a positive value and suggesting that the project holds potential as a lucrative investment. Despite the expected increase in revenue, the cost of sales is projected to rise by 10% annually. The Internal Rate of Return (IRR) for Project B is calculated at 91.48%, indicating a high level of potential profitability. The IRR is a critical metric used to assess the attractiveness of investments, and in this case, the substantial IRR underscores the favorable outlook for Project B. The Profitability Index (PI) for the project is computed as 3.78. A higher PI value suggests a more attractive investment, and with a positive value of 3.78, Project B is considered a favorable investment based on this analysis. The Payback Period for the project is calculated to be 1.14

Evaluating a capital Project 6 years, indicating a swift recovery of the investment cost. This very short payback period for the initial investment of $7 million emphasizes the rapid return on investment, further supporting the attractiveness of Project B for ABC Healthcare Corporation. Project C: Marketing/Advertising Campaign The final project under consideration for ABC Healthcare Corporation involves a substantial new marketing/advertising campaign. This campaign is anticipated to incur an annual cost of $2 million and extend over a six-year period. The current value of marketing costs stands at $8,710,521 million. The campaign is projected to drive a 15% annual increase in both sales/revenues and costs of sales. With annual sales for the previous year reported at $20 million, the marginal corporate tax rate is estimated to be 25%, and the required rate of return for the project is set at 10% to account for the moderate risks involved. The outcomes for Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), and payback period are presented in the table below. The Net Present Value (NPV) for the marketing/advertising campaign project is $33,470,904. This positive NPV value signifies that the investment is promising. Alongside the anticipated increase in revenue, the project expects a 15% annual rise in sales costs. The Internal Rate of Return (IRR) for Project C is 90.36%, indicating its high potential profitability. The Profitability Index (PI) for the project is 4.84, emphasizing its attractiveness as an investment. The payback period is 1.23, signifying that the initial investment cost will be recovered in approximately 1.23 years. Conclusion Based on the comprehensive analysis of the three proposed capital projects for ABC Healthcare Corporation, it is recommended to pursue Project A. Project A exhibits the most favorable outcomes in terms of Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), and payback period. These are the key reasons for recommending Project A:  NPV: Project A has the highest NPV, indicating the potential for the greatest value creation for the company. The NPV for Project A is 24% higher than Project C and 50% higher than Project B.  Required Rate of Return: Project A is the safest option with an 8% required rate of return, making it a more secure investment compared to the other projects.  Payback Period: Although Project A has the longest payback period due to its higher upfront cost, the difference in payback periods between Project A and Project C is insignificant.  Profitability Index: Project A has the highest profitability index, further emphasizing its attractiveness as an investment.

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Evaluating a capital Project 7  Overall Value: Considering the combination of NPV, IRR, PI, and payback period, Project A aligns well with the financial goals of ABC Healthcare Corporation and is likely to bring the most value in terms of shareholder returns. It's important to note that the choice between Project A and Project C is influenced by various factors, and the final decision should consider the company's broader strategic objectives, risk tolerance, and available resources. Regular monitoring and reassessment of the chosen project will be crucial for successful implementation and value creation. Recommendations The recommendation is to proceed with Project A, considering the comprehensive analysis of all three projects. Project A stands out as the most favorable option, with an upfront investment of $10 million, the highest NPV ($44,262,268.65), and the highest Profitability Index (PI) of 5.43 among the three projects. While Project C also shows promising results with an NPV of $33,470,903.72 and a PI of 4.84, Project A surpasses in terms of value creation. All three projects exhibit relatively comparable payback periods, each exceeding the required rate of return. However, Project A's combination of a high NPV, minimal risk, and a short payback period makes it the optimal choice for ABC Healthcare Corporation. This recommendation aligns with the company's goal of enhancing stakeholder value. Moving forward with Project A can contribute significantly to the company's financial success and meet its strategic objectives.

Evaluating a capital Project 8

Evaluating a capital Project 9 Bloomenthal, A (2021, March 10). Ratio Analysis. Investopedia.com. Retrieved from https://www.investopedia.com/terms/r/ratioanalysis.asp Boyte-White, Claire (2021, April 21). When Does It Benefit a Company to Buy Back Outstanding Shares? Investopedia.com Retrieved from https://www.investopedia.com/ask/answers/040815/what-situations-does-it-benefit- company-buy- backoutstanding-shares.asp Fernando, J (2021, February 8). Price-to-Earnings Ratio – PE Ratio. Investopedia.com. Retrieved from https://www.investopedia.com/terms/p/price-earningsratio.asp Janssen, C (2021, January 25). Stock Buybacks. A Breakdown. Retrieved from https://www.investopedia.com/articles/02/041702.asp

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