MBA-FPX5014__Assessment2-1

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Feb 20, 2024

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1 David Estaphnous Capella University Applied Managerial Finance Evaluation of Capital Projects

2 ABC Healthcare Corporation owns hospitals, ambulatory surgical centers, urgent care centers, and outpatient clinics. The company aims to look for new methods to revolutionize health care by keeping people healthy and making our services more convenient, accessible, and affordable. It is dedicated to providing high-quality, compassionate health care to all people. It assists individuals and communities in gaining access to the finest healthcare model for the future today. According to a review of financial ratios, investors were impressed with the company’s performance. In 2019, they were willing to pay $12.1 for $1 of earnings. There was no change in the firm's market value over the three fiscal years, 2016-2019. When the company's trends were examined, there was obvious evidence of an upward trend. The company is considering three possible investment scenarios that could bring revenue and increase the price per share. The company is set to use budgeting tools to make a wise financial decision that will make financial sense to the company. Capital budgeting is how a company decides which proposed fixed asset purchases to accept and which to reject. This procedure generates a quantitative assessment of each proposed fixed asset investment, providing a rational foundation for making a decision. The money in a fixed asset investment may be so significant that a company may go bankrupt if the project fails. As a result, capital budgeting is a required activity for bigger fixed-asset plans. This is less of an issue for smaller investments; in these cases, it is preferable to significantly streamline the capital budgeting process to focus more on getting the investments made as quickly as possible. By doing so, profit centers' operations are not hampered by the analysis of their fixed asset proposals. The net present value(NPV) determines the net change in cash flows associated with a fixed asset purchase. It discounts them to their present value adjusted for a discount rate equal to the minimum acceptable rate of return. One of the concerns

3 with NPV is the discount rate used to approve the project is adjusted downward to justify the approval of the project. The other disadvantage is that NPV doesn't consider cashflows past a certain point(Bragg, 2023). The second tool used is the payback period. The company will gain the money vested into the project during the payback period. It doesn't consider the discount rate, which is the rate at which the federal government lends to the banks. This method can only supplement other budgeting tools to determine when the company can gain its investment money. The disadvantages of using a payback period are that it only deals with an arbitrary cutoff date and no consideration to cash flow post that cutoff date. The third tool is the internal rate of return (IRR), a financial research indicator used to determine the profitability of possible investments. In a discounted cash flow analysis, IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero. The IRR is used to supplement the NPV in deciding between 2 projects because NPV projects the financial benefit to the company over the first few years, which benefits the company more than the financial benefit over later years and a greater return(Fernando, 2023). The fourth tool is the profitability index, which is the ratio of the present value of future predicted cash flows to the project's initial investment. A PI of more than 1.0 is considered a solid investment, with higher values correlating to more appealing enterprises. The profitability index helps in project ranking by allowing investors to evaluate the value created per investment unit. A profitability index 1.0 is logically the lowest permissible measure on the index because any value less than that indicates that the project's present value (PV) is less than the initial investment. The proposed project's financial attractiveness grows as the profitability index's value rises.

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4 Project A: Major Equipment Purchase The first project ABC Healthcare is considering is A new major equipment purchase, which will cost $10 million; however, it is projected to reduce the cost of sales by 5% per year for eight years. The equipment is projected to be sold for a salvage value estimated to be $500,000 at the end of year 8. Being a relatively safe investment, the required rate of return of the project is 8%. The equipment will be depreciated at a MACRS 7-year schedule. Annual sales for year one are projected at $20 million and should stay the same per year for eight years. Before this project, the cost of sales was 60%. The marginal corporate tax rate is presumed to be 25%, as demonstrated in Figure 1. (Fig. 1) Analysis The NPV is positive at $44,262,269, indicating that the investment is profitable. The project's IRR is 79.79%, but because it is more extended than the other two, this IRR may show a slow, constant profit during the 8-year project term. The payback period for this project is 1.36 years,

5 which means that ABC Healthcare's original expenditure for the equipment acquisition will be reimbursed in just over 15 months. The PI of this project is 5.43, which is higher than 1. Consequently, this project is valid since NPV is positive, IRR is 79.8%, and PI is higher than 1. Project B: Expansion Into Three Additional States Expansion into three additional states is forecast to increase sales/revenues and cost of sales by 10% per year for five years. Annual sales for the previous year were $20 million. Start-up costs are projected to be $7 million, and an upfront investment in net working capital of $1 million is needed. The working capital amount will be recouped at the end of year 5. The marginal corporate tax rate is presumed to be 25%. Being a risky investment, the required rate of return of the project is 12%, as demonstrated in Figure 2. (Fig. 2) Analysis

6 The NPV for this project is positive at $22,259,712. However, it is about 50% lower than the NPV for Project A. With a positive NPV, it would still be a sound investment. The IRR for Project B is 91.48%, more significant than the IRR for Project A. However, this could be attributed to the project's shorter length. The project's payback period is 1.14 years, implying that the initial investment will be repaid three months sooner than with Project A. The project's PI is 3.78, and the fact that it is more significant than one indicates that it is likewise a good investment. Project C: Marketing/Advertising Campaign A significant new marketing/advertising campaign will cost $2 million annually and last six years. It is forecast that the campaign will increase sales/revenues and costs of sales by 15% per year. Annual sales for the previous year were $20 million. The marginal corporate tax rate is presumed to be 25%. Being a moderate-risk investment, the required rate of return of the project is 10%, as demonstrated in Figure 3. (Fig. 3)

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7 Analysis This project's NPV is calculated to be $33,470,904. This NPV is also positive, as with Projects A and B, and it falls between those NPVs. This project would also be sound based just on NPV. The IRR for Project C has been calculated to be 90.36%. It is 1% lower than Project B but 11% higher than Project A. Additionally, the IRR should be more significant because this project is two years shorter than Project A because revenues will be created more quickly. This project has a payback period of 1.23 years. This figure falls between Projects A and B's payback timeframes. Recommendation Before making an investment decision, the company must evaluate the length of the projects, the upfront payment, and the risk level. Project A is the most expensive of the three, with 10 million invested upfront; it is also the safest and lasts eight years. Project B is the riskiest investment, with a lower upfront payment than Project A but higher than Project B. It also only spans five years. Project C requires an investment of 2 million dollars every year for six years, and it has a moderate risk compared to the other two projects. The profitability of Project A is higher than the other three projects. The NPV and PI measure profitability and ensure projects add value to the company. Projects A, B, and C were profitable, with NPV being a positive value. The projects' PI are above one, making them all viable and sound investments. However, the company can only undertake one project. Thus, the project with the highest NPV gets priority as it provides more value to the company than other projects. ABC Healthcare should consider Project A.

8 References Bragg, S. (2023, June 7). Capital budgeting definition . AccountingTools. https://www.accountingtools.com/articles/what-is-capital-budgeting.html Fernando, J. (2023, March). Internal Rate of Return (IRR) rule: Definition and example . Investopedia. https://www.investopedia.com/terms/i/irr.asp#:~:text=The%20internal%20rate%20of%20r eturn,a%20discounted%20cash%20flow%20analysis.