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Evaluation of Capital Projects
Christine Muncy December 21, 2023
1
Executive Summary
Under the leadership of its president, Maria Gomez, ABC Healthcare Corporation owns multiple healthcare facilities, including ambulatory surgical centers, hospitals, urgent care centers, and outpatient clinics. The company is evaluating three capital projects to increase shareholder value.
A thorough financial analysis is critical to making informed investment decisions, and this involves utilizing various capital budgeting tools to evaluate the available options. The analysis will evaluate factors, including the investment cost, net present value, internal rate of return, payback period, and profitability index. We need to determine the investment option that best suits our needs. After careful evaluation, it is expected that Project C will be the most profitable investment choice regarding maximizing shareholder value.
2
Table of Contents
Executive Summary ………………………………………………………………….….….…… 2
Company Background ……………………………………………………………….…….……. 4
Capital Budgeting Tools ..……………………………………………………………..…….….. 4
Project A: Major Equipment Purchase …………………………………..……………………… 5
Project B: Expansion into Three Additional States ………………...…………………………… 6
Project C: Marketing/Advertising Campaign …………….……………………………………... 7
Recommendation ………………………………………………………………………………... 8
References ……………………………………………………………………………………… 10
Appendix A…………………………………………………………………………………...… 11
Appendix B …………………………………………………………………………………….. 12
Appendix C …………………………………………………………………………………….. 13
Appendix D …………………………………………………………………………………….. 14
3
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Company Background
ABC Healthcare Corporation is a well-known healthcare company that operates a chain of hospitals, outpatient clinics, ambulatory surgical centers, and urgent care centers. The company is assessing three capital projects involving a significant equipment purchase, expansion into three new states, and an innovative marketing and advertising initiative. To determine the most profitable project for its shareholders, the company will employ various budgeting tools that account for each project's cost and duration differences.
Capital Budgeting Tools
Capital budgeting is critical in long-term financial planning for significant projects or business ventures, such as new equipment acquisitions or property purchases. These projects are usually funded by external revenue sources such as other departments. The capital budgeting process enables companies to evaluate the risks and expected returns on investment associated with a project. The company continuously reviews the capital budgeting plan throughout the project to anticipate any changes in cash outflows that could delay the project's completion and result in additional expenses. When multiple investment opportunities arise, leadership must compare the risks and returns of each project to determine their profitability before deciding which project to pursue.
Companies use various methods to evaluate the financial implications of a project. ABC Healthcare has three projects and is looking to assess their profitability. To evaluate the feasibility of every initiative, the organization intends to conduct a comprehensive analysis of its Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period (PB), and Profitability Index (PI) (Pinkasovitch, 2022)
NPV compares the present value of expected cash flows with the value of money invested in the project using a discount rate. When a project's net present value (NPV) is positive, it indicates it will generate profit. Conversely, if the NPV is negative, it implies that the project will result in a loss (Fernando, 2023)
IRR measures a project's estimated annual growth rate, while PB calculates the time required to recover the initial investment (Fernando 2023)
The Profitability Index, or PI, is a vital financial metric for evaluating investment opportunities. It is calculated by dividing the present value of future cash flows by the initial capital investment. Using PI, investors can determine whether an investment is worth pursuing. The higher the PI, the more profitable the investment, and vice versa. However, calculating an accurate PI requires accurate forecasting of future cash flows and discount rates. Therefore, having the right expertise and knowledge to make informed and wise financial decisions is essential (Chen, 2023)
4
Project A: Major Equipment Purchase
ABC Healthcare is evaluating the feasibility of purchasing new major equipment, which can result in an annual reduction of 5% in the cost of sales for eight years. The cost of acquiring the equipment is $10 million, and it will be depreciated using the Modified Accelerated Cost Recovery System (MACRS) 7-year schedule. This schedule enables companies to recover the equipment's cost through annual deductions over a specific period. The depreciation rate is faster
in the initial years and then slows down for the remaining useful life of the equipment. The equipment's salvage value at the end of the eighth year is expected to be $500,000 (Kagan, 2023)
The investment is expected to increase the annual sales revenue to $20 million for the eight-year duration, while the cost of sales is anticipated to decrease from 60% to 55%. The investment is safe, and the required rate of return is 8%, with the marginal corporate tax rate at 25%.
Based on data from Capella University (2023) Appendix A shows the Major Equipment Purchase
figures for ABC Healthcare Corporation. The investment's calculated net present value (NPV) is positive at $44,262,269, indicating that this investment is lucrative for ABC Healthcare.
During the eight-year project period, this project's estimated internal rate of return (IRR) is 79.79%, indicating a slow but steady profit growth. The payback period for ABC Healthcare's initial investment in equipment purchase is 1.36 years, which means they can recover their investment in just over 15 months. Furthermore, the profitability index (PI) is 5.43, which supports the idea that this investment would be substantial, since it is greater than one.
5
Project B: Expansion into Three Additional States
ABC Healthcare is evaluating its second project, which involves expanding operations into three additional states. The project is expected to generate a 10% increase in sales revenue and cost of sales annually for the next five years. The initial investment required for the project is $7 million,
with an upfront investment of $1 million in net working capital that will be recovered at the end of year 5. A 12% required rate of return has been set to mitigate the risk associated with this investment, along with a marginal corporate tax rate of 25%. The company generated sales of $20 million in 2022.
Based on data from Capella University (2023) Appendix B shows the Expansion into Three Additional States figures for ABC Healthcare Corporation. The calculated NPV for the project is $22,259,712, which is a positive outcome. However, it is almost 50% lower than the NPV for Project A. Despite this, the positive NPV indicates that the investment is financially sound and a wise decision for the company.
Project B has an IRR of 91.48%, which is higher than the IRR of Project A. However, the shorter
duration of Project B may have influenced this outcome. The payback period for Project B is 1.14 years, or 13.5 months, which is three months faster than Project A. Additionally, Project B has a PI of 3.78, indicating it is a substantial investment.
6
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Project C: Marketing/Advertising Campaign
This project outlines the details of a proposed marketing and advertising campaign that requires an annual investment of $2 million spread evenly over six years. The campaign is projected to generate a 15% increase in sales revenue and costs of sales per year, which is 5% higher than the projected increase for Project B. Considering the moderate risk involved, the required rate of return is 10%. The marginal corporate tax rate is 25%, and the annual sales for 2022 are recorded
at $20 million.
Based on data from Capella University (2023) Appendix C shows the Marketing or Advertising Campaign figures for ABC Healthcare Corporation
The project's net present value has been calculated to be $33,470,904, indicating that it is profitable. The NPV falls between the NPVs of Projects A and B, and the project's positive NPV aligns with the other profitable projects.
Project C's internal rate of return (IRR) is calculated to be 90.36%, indicating a high profitability.
Although lower than Project B, it is 11% higher than Project A due to its shorter duration, allowing for quicker profit generation.
The payback period for Project C is approximately 15 months or 1.23 years, which is between the payback periods for Projects A and B. This value indicates that the investment would be recovered within a reasonable period.
The profitability index (PI) of Project C is evaluated to be 4.84, which is lower than Project A but higher than Project B. Nevertheless, the PI value greater than one demonstrates that this investment is financially feasible and acceptable.
7
Recommendation
Our previous discussions established that any project with a positive Net Present Value (NPV) and a Profitability Index (PI) more significant than one should be pursued as it is deemed profitable. However, ABC Healthcare, a company with limited liquid assets, can only undertake one project at a time. Therefore, it is essential to consider the upfront cash investment required for each project and the payback period to make the right investment decision. Determining the Internal Rate of Return (IRR) when evaluating a project's profitability is crucial. A project with more investment cost and risk may be more profitable than a safer and lower-cost project. Therefore, calculating IRR is crucial to making an informed decision regarding potential investments.
We have created a table below to compare the capital budgeting metrics, project length, and initial investment for Projects A, B, and C. From the comparison, we can see that all three projects have positive NPVs and PIs. They will start generating profit in less than two years, and their IRR confirms their profitability. Project A has the highest NPV and PI, while Project B has the highest IRR and shortest payback period. Project C's four capital budgeting metrics values fall between Projects A and B.
Based on data from Capella University (2023) Appendix D shows the Capital Project Comparison Analysis for ABC Healthcare Corporation
ABC Healthcare is evaluating three potential projects: Project A, Project B, and Project C. While
each project requires an initial investment, they are all expected to generate financial returns for the company's shareholders.
Project B has the lowest total investment requirement of $7,000,000, while Project A demands an upfront lump sum investment of $10,000,000. Alternatively, Project C requires a significant investment of $12,000,000, but this cost is spread evenly over the six-year project term, costing $2,000,000 annually.
8
Project B aims to expand the healthcare system, resulting in a 10% annual sales increase for five years, equating to $10,000,000. On the other hand, Project C's marketing campaign is anticipated
to generate a 15% sales increase per year for six years, totaling $18,000,000. Lastly, purchasing major equipment will decrease production costs by 5% per year for eight years, amounting to $8,000,000 in savings.
After comprehensively analyzing all capital budgeting metrics, Project C is the most profitable option for ABC Healthcare's shareholders. Despite requiring the highest investment of $12,000,000, the six-year project duration and evenly distributed cost make it more feasible than Project A's significant upfront payment. Additionally, it is expected to deliver the most substantial sales increase, with a 15% annual increase over six years, amounting to $18,000,000.
All three projects have a positive Net Present Value (NPV) and Profitability Index (PI) and will begin generating profits in less than two years. Project A has the highest NPV and PI, while Project B has the highest Internal Rate of Return (IRR) and shortest Payback Period (PBP). Project C's capital budgeting metrics fall between Projects A and B, with a positive NPV and PI, an IRR of 90.36%, and a PBP of 1.23 years.
It is important to note that any project with a positive NPV and PI greater than one is a lucrative investment opportunity. However, it is crucial to consider the upfront cash investment required for each project and the payback period. Furthermore, calculating the IRR can help determine project profitability, and a highly profitable project may justify the additional risk and initial investment cost compared to a safer, lower-cost project.
After conducting a comprehensive analysis of the capital budgeting metrics, it has been concluded that Project C is the most feasible option for the shareholders of ABC Healthcare. All three projects are projected to generate profits within two years. Project A has the highest NPV and PI, Project B has the highest IRR and the shortest PBP, while Project C's metrics are between Projects A and B.
9
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References
Capella (2023). ABC Healthcare Projected Cash Flows
. Assessment 2 Instructions: MBA-FPX5014 - Fall 2023 - Section 06 (capella.edu)
Chen, J. (2023). Profitability index (PI): definition, components, and formula. Investopedia
. https://www.investopedia.com/terms/p/profitability.asp
Fernando, J. (2023). Internal rate of return (IRR) rule: definition and example. Investopedia. https://www.investopedia.com/terms/i/irr.asp
Fernando, J. (2023). Net present value (NPV): What it means and steps to calculate it. Investopedia
. https://www.investopedia.com/terms/n/npv.asp
Kagan, J. (2023). Modified accelerated cost recovery system (MACRS) definition. Investopedia
. https://www.investopedia.com/terms/m/macrs.asp
Pinkasovitch, A. (2022). Capital budgeting: What it is and how it works. Investopedia. https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-
methods.asp#:~:text=Capital%20budgeting%20is%20important%20because,by%20its
%20owners%20or%20shareholders
10
Appendix A Based on data from Capella University (2023) Appendix A shows the Major Equipment Purchase
figures for ABC Healthcare Corporation. 11
Appendix B
Based on data from Capella University (2023) Appendix B shows the Expansion into Three Additional States figures for ABC Healthcare Corporation. 12
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Appendix C
Based on data from Capella University (2023) Appendix C shows the Marketing or Advertising Campaign figures for ABC Healthcare Corporation
13
Appendix D
Based on data from Capella University (2023) Appendix D shows the Capital Project Comparison Analysis for ABC Healthcare Corporation
14
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