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1 Evaluation of Capital Projects student institution MBA-FPX5014 Instructor 5/6/23

2 Evaluation of Capital Projects Executive Summary Under President Maria Gomez's leadership, ABC Healthcare Corporation operates a diverse portfolio of medical facilities encompassing ambulatory surgical centers, hospitals, urgent care centers, and outpatient clinics. Presently, the corporation is engaged in the evaluation of three separate capital projects aimed at bolstering shareholder value. Through the strategic application of capital budgeting tools, a comprehensive financial assessment is underway to discern the optimal project for shareholders. Key metrics such as investment costs, net present value, internal rate of return, payback period, and profitability index are scrutinized to identify the most advantageous undertaking. Upon analysis, it is determined that investing in Project C is the most lucrative approach for maximizing shareholder value.

3 Company Background ABC Healthcare Corporation operates various healthcare facilities, including ambulatory surgical centers, hospitals, urgent care centers, and outpatient clinics. The company is considering three distinct investment opportunities: acquiring new major equipment, expanding into three additional states, and launching a significant marketing and advertising campaign. The corporation must identify which projects will benefit its shareholders most. Given that each project has unique costs and durations, various budgeting tools will be utilized to evaluate their profitability comparatively. Capital budgeting entails the development of a financial strategy for long-term initiatives or business ventures, such as acquiring new properties or equipment, which will be funded by external revenue sources such as other departments (Ross et al., 2022). This process aids companies in assessing the risks and expected returns associated with a project. Furthermore, capital budgeting is an ongoing process that involves regular reassessment to accommodate changes in cash outflows, prevent project delays, and manage additional expenses (Booth et al., 2020). In scenarios where multiple investment options exist, leadership must carefully compare the risks and returns of each alternative to determine their profitability before deciding on which project to pursue. Capital Budgeting Capital budgeting is critical for companies aiming to select projects delivering optimal shareholder value. This involves thoroughly analyzing and evaluating potential investment opportunities to discern which projects will yield the highest return on investment and best serve the organization's shareholders (Ross et al., 2022). Companies can make informed decisions

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4 about allocating their financial resources by considering upfront costs, potential returns, risks, and expected cash flows over time. Various metrics, including Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, and Profitability Index (PI), are employed in capital budgeting to compare the expected returns of different projects. These metrics enable companies to identify projects offering the highest value for shareholders while mitigating risks. Choosing the wrong project can have significant financial implications and hinder a company's ability to generate profits and sustain long-term growth, underscoring the importance of capital budgeting in informed investment decision-making (Mayo, 2018). Therefore, it is essential that companies thoroughly assess all possible metrics before making the final decision on which project to invest in. Capital budgeting is crucial for companies when trying to make an investment decision. Companies may utilize multiple capital budgeting techniques to comprehensively understand a project's financial impact (Booth et al., 2020). For instance, ABC Healthcare Corporation is evaluating the profitability of three projects by calculating NPV, IRR, Payback Period, and PI. While these tools provide valuable insights into a project's potential returns, it is essential to acknowledge their limitations, such as heavy reliance on projected future cash flows and failure to account for certain factors like the time value of money. Project A: Major Equipment Choices ABC Healthcare is contemplating the acquisition of new major equipment, anticipating a reduction in annual sales costs by 5% over eight years. The project, estimated at $10 million, will undergo depreciation utilizing the Modified Accelerated Cost Recovery System (MACRS) 7- year schedule, which facilitates the recovery of equipment costs through annual deductions. Over the equipment's lifespan, depreciation accelerates initially before tapering off in subsequent

5 years. At the end of the eighth year, the equipment can be sold for salvage at $500,000. With an 8% required rate of return and projected annual sales of $20 million throughout the project, ABC Healthcare anticipates reducing its cost of sales from 60% to 55%, resulting in a significant financial impact. Considering a marginal corporate tax rate of 25%, the project promises substantial benefits. Analysis reveals a positive Net Present Value (NPV) of $44,262,269, affirming the project's profitability. Despite an impressive Internal Rate of Return (IRR) of 79.79%, indicating solid returns compared to alternative projects, the extended 8-year duration suggests a steadier profit trajectory. The Payback Period for the initial equipment investment spans just over 15 months, signaling rapid repayment within 1.36 years. Furthermore, a Profitability Index (PI) of 5.43 underscores the investment's strength, with a value exceeding one indicating robust potential returns . Project B: 3 State Expansion

6 ABC Healthcare's second potential project entails an expansion into three additional states, anticipating a 10% annual increase in sales revenues and cost of sales over five years. Initial costs for this endeavor are estimated at $7 million, with an additional $1 million investment in net working capital, to be recuperated by the project's fifth year. Reflecting its high-risk nature, the project's required rate of return stands at 12%, aligning with a marginal corporate tax rate of 25%. Notably, the company achieved $20 million in annual sales in 2022. The analysis reveals a positive Net Present Value (NPV) of $22,259,712 for Project B, although nearly 50% lower than that of Project A, it remains a judicious investment choice. Project B boasts an Internal Rate of Return (IRR) of 91.48%, surpassing Project A's, albeit influenced by its shorter duration. With a swift payback period of 1.14 years, equivalent to just over 13 and a half months, Project B outpaces Project A by three months in initial investment recovery. Furthermore, sporting a Profitability Index (PI) of 3.78, Project B emerges as a robust investment prospect, with its PI exceeding the one threshold.

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7 Project C: Marketing/Advertising The third potential project under consideration involves implementing a new major marketing and advertising campaign, incurring an annual cost of $2 million over six years. Unlike the preceding projects, this initiative spreads its expenses evenly across its duration rather than requiring a substantial upfront investment. Projections anticipate a 15% annual increase in both sales revenues and cost of sales, surpassing the expected growth rate for Project B by 5%. With a moderate level of risk, the project necessitates a required rate of return of 10%, aligning with the company's marginal corporate tax rate of 25%. Notably, annual sales for 2022 stood at $20 million. Analysis reveals a positive Net Present Value (NPV) of $33,470,904 for the new major marketing and advertising campaign, positioning it between the NPVs of Projects A and B and affirming its profitability. Despite a slightly lower Internal Rate of Return (IRR) of 90.36% compared to Project B, it surpasses Project A's by 11%, reflecting the project's shorter duration and potential for more rapid profit generation. The projected payback period for this initiative is 1.23 years, falling between the payback periods of Projects A and B. Additionally, boasting a Profitability Index (PI) of 4.84, higher than Project B but lower than Project A, the project emerges as a favorable investment opportunity

8 with a PI exceeding 4.84. Recommendation As highlighted earlier, profitable projects are characterized by a positive Net Present Value (NPV) and a Profitability Index (PI) exceeding one. Selecting a single project becomes imperative for companies like ABC Healthcare with limited liquid assets. Therefore, besides profitability metrics, factors such as upfront cash investment and payback period demand

9 consideration. Additionally, the Internal Rate of Return (IRR) calculation holds significance as it gauges a project's expected profitability (Mayo, 2018). While a high-profit venture may warrant the associated risks and initial investment, compared to a lower-cost, safer alternative, a comprehensive assessment of all factors is essential before reaching a final decision (Mayo, 2018). The table below compares capital budgeting metrics, initial investment, and project duration for Projects A, B, and C. Upon comparing the three projects, it is apparent that all are financially viable, boasting positive NPVs and profitability indexes, with anticipated profitability within two years. Each project's IRR further confirms its profitability. Project A stands out with the highest NPV and profitability index, suggesting the most substantial return on investment. Conversely, Project B exhibits the highest IRR and the shortest payback period, making it an attractive option for those seeking a quicker ROI. Project C's metrics fall between A and B, representing a moderate-risk investment with a reasonable return.

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10 Regarding initial investment, Project B requires the lowest upfront cost at $7,000,000, followed by Project A at $10,000,000. However, both necessitate this investment as a lump sum upfront. In contrast, Project C entails the highest total investment, spread evenly across its six- year term, costing $2,000,000 annually. All projects are expected to benefit ABC Healthcare's shareholders financially, with Project A and B reducing production costs by 5% annually, resulting in total savings of $8,000,000 over eight years, and Project B is forecasted to increase sales by 10% annually, amounting to a total increase of $10,000,000 over five years. Project C, a marketing campaign, is projected to boost sales by 15% annually, resulting in a total increase of $18,000,000 over six years. Considering the analysis, Project C is the most advantageous option for ABC Healthcare's shareholders. The project exhibits positive values across all four capital budgeting metrics, including NPV, IRR, Payback Period, and Profitability Index. With a projected payback period of 1.23 years and profitability within 15 months, Project C offers promising returns. While its IRR is marginally lower than Project B, its shorter six years and spread-out investment of $12,000,000 make it an appealing choice. Moreover, its forecasted sales increase of 15% annually, totaling $18,000,000, positions ABC Healthcare for swift reinvestment in subsequent projects. Conclusion Capital budgeting is essential in helping companies assess projects before deciding which provides the best returns and profitability. Capital budgeting techniques such as IRR, NPV, PI, and PBP are critical for a firm to apply in evaluating its investments. In most cases, NPV is the primary tool as it factors in the time value of money. Its cash flows are also discounted at the future present value, hence providing the company with an opportunity to have a clear

11 perspective of the project’s future cash flows in the present (Booth et al., 2020). Other techniques such as PBP, PI, and IRR can also be considered and, at times, be higher for a particular project. Despite this, the project exhibiting the utmost value will be chosen, provided the variations in its value from the other techniques remain rational.

12 References Booth, L., Cleary, W. S., & Rakita, I. (2020). Introduction to corporate finance . John Wiley & Sons. https://books.google.co.ke/books? hl=en&lr=&id=EXLLDwAAQBAJ&oi=fnd&pg=PA1&dq=introduction+to+finance+&o ts=iLxpkCLOcl&sig=9u9zgIzQXgVyTyWGpgCuXjBKyY0&redir_esc=y#v=onepage&q =introduction%20to%20finance&f=false Mayo, H. B. (2018). Basic finance: an introduction to financial institutions, investments, and management . Cengage Learning. https://books.google.co.ke/books? hl=en&lr=&id=h9VUEAAAQBAJ&oi=fnd&pg=PP1&dq=introduction+to+finance+&ot s=XLkhfzUzts&sig=LqBzf_AqjIH2k2ss-Gg- 7QnWN_M&redir_esc=y#v=onepage&q=introduction%20to%20finance&f=false Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2022). Fundamentals of corporate finance. https://thuvienso.hoasen.edu.vn/bitstream/handle/123456789/12640/Contents.pdf? sequence=1

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