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ABC Healthcare Corporation Project Evaluation
Crystal Leslie
Assessment 2 Evaluation of Capital Projects
June 7
th
, 2024
2
Executive Summary
Leadership has asked for an analysis of the three proposed capital projects based on forecasted cash flow. The forecasts of the projected cash flows are in the attached spreadsheets, titled Projected Cash Flows [XLSX]. Our company constraint only allows for one project to be chosen, so it has been asked to discover which would provide the most shareholder value for the company. Capital Budgeting Tools will be used to help determine this.
Company Background
ABC Healthcare Corporation is in the healthcare industry. “The healthcare sector
consists of businesses that provide medical services, manufacture medical equipment
or drugs, provide medical insurance, or otherwise facilitate the provision of healthcare
to patients” (Healthcare sector: Industries defined and key statistics 2021). The
founder and president of the company is Maria Gomez. Our biggest rival is HCA
Healthcare Inc, which is headquartered in Tennessee. ABC Healthcare Corp owns a
large amount of emergency and surgical centers, making sure lives are saved every
day. We are there to make sure people stay healthy during critical times. We make sure to review financial information and market value, so we make sure we are helping as
many people as possible. This review will allow us to know how we can maximize
shareholder value, making things better for everyone involved.
Capital Budgeting Tools
“Capital budgeting is the process by which investors determine the value of a potential investment project” (Pinkasovitch, 2024).
There are many different techniques used in Capital Budgeting. Some of these techniques include net present value, internal rate of return, profitability index, payback period, discounted payback period, modified internal rate of return, and real options analysis. The ones we will be analyzing today are Net Present Value, Payback period, Internal Rate of Return, and Profitability Index. NPV (Net Present Value):
Net Present Value is called NPV for short. It calculates the net value of an investment over time. It uses all cash inflow and outflow. It also uses a discount rate, which accounts for the time value of money. This tool has two limitations, project size and discount rate assumption. Typically, if NPV is greater than zero we accept the project and if NPV is less than zero we reject the project. However, when we are comparing multiple projects than we look for which project has the highest NPV. If NPV is positive, it will add value to the company. The NPV helps us know if we would add more value than we could have with the discount rate elsewhere.
3
Payback period:
The payback period is how long it takes to recover the initial investment, the shorter the better. A project is accepted if the payback period is less than or equal to the amount of years of the project and the desired payback period. The formula is dependent on if the cash flows are even or uneven. With even cash flows the formula is “Payback Period = Initial Investment / Net Cash Flow per period. If the cash flows are uneven you have: Payback Period = Years before full recovery + Unrecovered cost at the start of the year / Cash flow during the year” (
Payback period calculator
2024).
IRR (Internal Rate of Return):
The Internal Rate of Return is a discount rate that ends in a NPV of 0. It estimates the profitability of potential investments. The Internal Rate of Return is called IRR for short. If IRR is greater than the discount rate the project should be accepted. If the IRR is less than the discount rate than reject the project. You calculating the IRR by trying numbers until you find the correct one. With this tool, different size projects can be compared more accurately since it uses percentages. The problem with this tool is that if it is non-
conventional than there may be more than one IRR, making it impossible to find.
PI (Profitability Index):
The Profitability Index is called PI for short. Constraints such as budget and number of engineers make it so all projects cannot be accepted. The formula is NPV divided by the upfront investment. It helps us understand the value of the project, what NPV we are getting per dollar. The highest option gives us the most. For PI to work two things must be true: all resources must be exhausted and there is a single resource constraint. Sometimes to make sure all resources are exhausted, more than one project can be accepted.
Project A: Major Equipment Purchase
The first project out of the three is Project A, a major equipment purchase. This project would be purchasing new equipment at the cost of ten million dollars. It is projected to reduce the cost of sales by 5% per year for eight years. It is predicted to be able to be sold for 500,000 dollars after the eight years. The required rate of return of the project is 8% and the equipment will be depreciated at a MACRS 7-year schedule. The marginal corporate tax rate is presumed to be 25%.The annual sales for all eight years is projected to be 20 million. Previously, the cost of sales has been 60%.
Project B: Expansion into Three Additional States
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The second potential project, Project B, is a project to expand into three more states. The expansion is predicted to increase sales/revenues and cost of sales by 10% per year for 5 years. Start-up costs are projected to be $7 million. The upfront needed investment in net working capital is $1 million, being recouped at the end of year five. The marginal corporate tax rate is presumed to be 25%. Finally, this is a more risky investment than Project A, so the required rate of return of the project is 12%.
Project C: Marketing/Advertising Campaign
The final project, Project C, is a six year long marketing/advertising campaign that will cost 2 million dollars per year. It is a moderate-risk investment so the rate of return for the project is 10%. It is expected that the campaign will increase sales and costs of sales by 15% per year. Finally, the marginal corporate tax rate is presumed to be 25%.
Results from Project A:
Due to the fact this is the only project out of the ones being considered that would have a physical item bought, this is the only project that we have a concern about depreciation for. To get the NPV the formula was used which is =NPV(required rate of return, cash flows years 1-8) + (Cash Flow for year 0). In this situation the rate of return was 8%. When the formula was entered, all of the information on the excel sheet applied. It gave us the result of a NPV of $44,262,269. With excel, the work is done for us so we do not need to keep guessing until the math matches our guess. The formula was inputted which is =IRR(Year 0-8 cash flows). The result was an IRR of 79.79%. The type of payback period that was used for this project was the discounted payback period. The formula fr this is: discounted payback period= years until break-even+ unrecovered amount/recovery year cash flow. In this case, we want a positive number so we used absolute value. The numbers used to calculate this was 1+absolute value of (-$2,892,750/$8,112,250). The result we got was 1.36. This means it would take between a year and a year and a half to payback. Finally, profitability index was calculated by the present value cash inflows by present value cash outflows. The result was 5.43.
5
Results from Project B:
The required rate of return for project B is 12%. Using the rate of return and the cash flows, the NPV was calculated to be $22,259,712. The NPV is greater than zero, so if we were trying to determine if we were going to accept just this project, than we would accept it. However, we are comparing the results from all of the Capital Budgeting Tools to the two other projects. The Internal Rate of Return for this project came out to 91.48%. This project has a life of five years instead of eight years like Project 8, so there were less cash flows to include. The payback period came to 1.14, so it would take slightly more than a year to payback. Finally, the profitability index came to 3.78. This is promising since a “profitability index greater than 1.0 is often considered to be a good investment, as it means that the expected return is higher than the initial investment” (Chen, 2024).
Results from Project C:
This project also has different project lengths and a required rate of return. The life of the project in years is 6. The required rate of return is 10%. The NPV calculated for this project was $33,470,904. The internal rate of return calculated to be 90.63%. This tells us the “the annual rate of growth that an investment is expected to generate” (Fernando, 2024) .The payback period is 1.23, so this would also be between a year and 1.5 years. Finally the profitability index for Project C is 4.84, which would appear to show this as an attractive investment.
6
Recommendation
We closely considered the information from all capital budgeting tools used. Looking solely at Net Present Value, Project A has the highest. This shows some advantage to invest in the major equipment purchase. When looking at Payback Period, the most beneficial to invest in would be Project B. The expansion would be paid back faster than the other two projects. This would allow us to start seeing profit faster. Project A has the highest profitability index, this shows that the benefits of this project defiantly outweigh the costs. Finally, looking at the internal rate of return, Project B would be best. “The higher the IRR, the better the return of an investment” (Fernando, 2024).
Other aspects were considered. For example, it is important to consider how much money would need to be initially invested in each project. Project C would have the lowest starting cost, at $2,000. However, that is an annual cost, not a one-time fee. The most expensive start-up cost is for Project A, at $10,000. We also considered the life of the project in years, and how much time commitment we would need to put into each project. The longest project would be Project A, at eight years. The shortest project is Project B, which is 5 years. Next, it was considered which projects gave us an increase in sales and which projects gave up a reduction in cost. It is important to consider which we value more as a company. Project A gave a 5% reduction in cost per year. Project B gave a 10% increase in sales annually. Finally, Project C increased sales by 15% per year. All three projects also vary in risk, which has been emphasized by the required rate of returns. Project has the smallest risk, while Project B has the highest risk. Considering all aspects, the project I would recommend investing in is Project A. This project would raise shareholder value the most out of all three projects. This project has a better Net Present Value and Profitability Index than the other projects. It has a longer payback period than the other two investments, however that makes sense when consider it also has the largest start-up cost. This project does not have the highest internal rate of return. However, since it is an initial investment of $10,000 with an internal rate of return of 79.79% this is a very attractive project. On top of everything else, the risk of this project is also lower than the other projects. Conclusion
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To conclude, all three projects would be of great value. All three projects would be accepted based on the capital budgeting tools if they were not compared to the other projects. However, we can only accept one project. At the time Project A will be the best for shareholder value, which is our focus now. If later we can accept other projects, the others should be put into consideration again.
8
References
Chen, J. (2024, June 9). Profitability index (PI): Definition, components, and formula
. Investopedia. https://www.investopedia.com/terms/p/profitability.asp#:~:text=A%20profitability%2
0index%20greater%20than,may%20be%20the%20best%20option
. Fernando, J. (2024, May 30). Internal Rate of Return (IRR): Formula and examples
. Investopedia. https://www.investopedia.com/terms/i/irr.asp#:~:text=The%20internal%20rate%20
of%20return%20(IRR)%20is%20the%20annual%20rate,the%20NPV%20equal%2
0to%20zero
. Investopedia. (2021, October 31). Healthcare sector: Industries defined and key statistics
. Investopedia. https://www.investopedia.com/terms/h/health_care_sector.asp Payback period calculator
. cleartax. (2024). https://cleartax.in/s/payback-period-
calculator Pinkasovitch, A. (2024, June 13). Capital budgeting: What it is and how it works
. Investopedia. https://www.investopedia.com/articles/financial-theory/11/corporate-
project-valuation-methods.asp
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A company is considering three alternative investment projects with different net cash flows. The present value of net cash flows is
calculated using Excel and the results follow.
Potential Projects.
Present value of net cash flows (excluding initial investment)
Initial investment.
Complete this question by entering your answers in the tabs below.
Required A
a. Compute the net present value of each project.
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FI
Compute the net present value of each project.
Potential Projects
Project A
Present value of net cash flows
Initial investment
Net present value
2
Required B
W
F2
#
Required C
3
APR
11
80
F3
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4
m tv
6
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c
F6
#
&
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Project B
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Y U
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FB
DD
(
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Shaylee Corporation has $2.00 million to invest in new projects. The company's managers have presented a number of possible
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Initial investment.
Present value of future cash flows
Project A
$ 420,000
770,000
Required:
1. Is Shaylee able to invest in all of these projects simultaneously?
2-a. Calculate the profitability index for each project.
2-b. What is Shaylee's order of preference based on the profitability index?
Complete this question by entering your answers in the tabs below.
Project B
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420,000
Req 1
Req 2A and 28
Is Shaylee able to invest in all of these projects simultaneously?
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Project C
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11: Assignment - The Basics of Capital Budgeting
Blue Llama Mining Company is evaluating a proposed capital budgeting project (project Sigma) that will require an initial investment of
$800,000.
Blue Llama Mining Company has been basing capital budgeting decisions on a project's NPV; however, its new CFO wants to start using
the IRR method for capital budgeting decisions. The CFO says that the IRR is a better method because returns in percentage form are
easier to understand and compare to required returns. Blue Llama Mining Company's WACC is 8%, and project Sigma has the same risk
as the firm's average project.
The project is expected to generate the following net cash flows:
Year
Year 1
Year 2
Year 3
Year 4
Cash Flow
$350,000
$475,000
$425,000
$500,000
Which of the following is the correct calculation of project Sigma's IRR?
34.38%
38.20%
42.02%
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Use the WACC to calculate NPV and evaluate IRR for proposed capital budgeting projects. Assume the projects are mutually exclusive and the firm has the money available to fund the project.
12/31/2018
12/31/2017
12/31/2016
12/31/2015
Current Assets
Cash And Cash Equivalents
8,719,000
10,607,000
9,157,000
9,095,000
Short Term Investments
270,000
8,897,000
6,966,000
2,912,000
Net Receivables
7,140,000
7,021,000
6,693,000
6,436,000
Inventory
3,126,000
2,944,000
2,722,000
2,719,000
Other Current Assets
2,042,000
43,000
31,000
730,000
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21,297,000
29,512,000
25,569,000
21,892,000
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2,407,000
2,039,000
1,949,000
2,310,000
Property Plant and Equipment
17,587,000
17,237,000
16,590,000
16,316,000
Goodwill
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2-a. Calculate the profitability index for each project.
2-b. What is Shaylee's order of preference based on the profitability index?
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Req 2A and 2B
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Profit Streams for Projects A and B
period
?? ($)
?? ($)
1
100,000
350,000
2
200,000
300,000
3
250,000
200,000
4
300,000
100,000
5
325,000
100,000
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Understanding the optimal capital structure
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70%
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50%
40%
30%
30%
40%
50%
60%
70%
Id
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7.00%
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Following is information on two alternative investment projects being conside
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Note: Use appropriate factor(s) from the tables provided.
y Tiger Company. The company requires a 4%
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Project X1
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Project X2
$ (220,000)
Net cash flows in:
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Year 2
Year 3
50,000
97,500
60,500
87,500
85,500
77,500
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b. Compute each project's profitability index.
c. If the company can choose only one project, which should it choose on the basis of profitability index?
Answer is complete but not entirely correct.
Complete this question by entering your answers in the tabs below.
Required A
Required B Required C
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at 4%
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70%
7.00%
10.50%
8.61%
40%
60%
7.20%
10.80%
8.21%
50%
50%
7.70%
11.40%
8.01%
60%
40%
8.90%
12.20%
8.08%
70%
30%
10.30%
13.50%
8.38%
Which capital structure shown in the preceding table is Transworld Consortium Corp.’s optimal capital structure?
Debt ratio = 70%; equity ratio = 30%
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Debt ratio = 50%; equity ratio = 50%
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