01 Jul Use capital budgeting tools to determine the quality of three proposed investment projects, and prepare a 4-6 page report that analyzes your computations and recommends the proj
Use capital budgeting tools to determine the quality of three proposed investment projects, and prepare a 4-6 page report that analyzes your computations and recommends the project that will bring the most value to the company.
Introduction
This assessment is about one of the basic functions of the finance manager, which is allocating capital to areas that will increase shareholder value and add the most value to the company. This means forecasting the projected cash flows of the projects and employing capital budgeting metrics to determine which project, given the forecast cash flows, gives the firm the best chance to maximize shareholder value. As a finance professional, you are expected to:
- Use capital budgeting tools to compute future project cash flows and compare them to upfront costs.
- Evaluate capital projects and make appropriate decision recommendations.
- Prepare reports and present the evaluation in a way that finance and non-finance stakeholders can understand.
Scenario
Senior leadership has now called upon you to analyze three capital project requests based on forecasted cash flow as they relate to maximizing shareholder value.
Your Role
You are one of Maria's high-performing financial analyst managers at ABC Healthcare Corporation and she trusts your work and leadership. Senior leadership was impressed with your presentation in Assessment 1 and they are tasking you with the analysis of these three proposed capital projects based on forecasted cash flow. You have completed forecasting the projected cash flows of the projects as reflected in the attached spreadsheets, Projected Cash Flows [XLSX]. You now need to conduct your analysis recommending which will provide the most shareholder value to the organization.
Requirements
- Use capital budgeting tools to compute future project cash flows and compare them to upfront costs. Remember to only evaluate the incremental changes to cash flows.
- Employing capital budgeting metrics, determine which project, given the forecast cash flows, gives the organization the best chance to maximize shareholder value.
- Demonstrate knowledge of a variety of capital budgeting tools including net present value (NPV), internal rate of return (IRR), payback period, and profitability index (PI). The analysis of the capital projects will need to be correctly computed and the resulting decisions rational.
- Evaluate capital projects and make appropriate decision recommendations. Accurately compare the indicated projects with correct computations of capital budgeting tools and then make rational decisions based on the findings.
- Select the best capital project, based on data analysis and evaluation, that will add the most value for the company. Provide a rationale for your recommendations based on your financial analysis.
- Prepare reports and present the evaluation in a way that finance and non-finance stakeholders can understand.
Project A: Major Equipment Purchase
- A new major equipment purchase, which will cost $10 million; however, it is projected to reduce cost of sales by 5% per year for 8 years.
- The equipment is projected to be sold for 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 1 are projected at $20 million and should stay the same per year for 8 years.
- Before this project, cost of sales has been 60%.
- The marginal corporate tax rate is presumed to be 25%.
Project B: Expansion Into Three Additional States
- Expansion into three additional states has a forecast to increase sales/revenues and cost of sales by 10% per year for 5 years.
- Annual sales for the previous year were $20 million.
- Start-up costs are projected to be $7 million and an upfront needed investment in net working capital of $1 million. 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%.
Project C: Marketing/Advertising Campaign
- A major new marketing/advertising campaign, which will cost $2 million per year and last 6 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%.
Deliverable Format
In this assessment, you will prepare an appropriate evaluation report to senior leadership using sound research and data to defend your decision.
Report requirements:
- Your report should follow the corresponding MBA Academic and Professional Document Guidelines, including single-spaced paragraphs.
- Ensure written communication is free of errors that detract from the overall message and quality.
- Format your paper according to APA style and formatting.
- Use at least three scholarly resources.
- Length: Between 4-6 pages of content beyond the title page, references, and any appendices.
- Use 12 point, Times New Roman.
ProjectA
| Project A | Major Equipment Purchase | |||||||||
| Purchasing cost | $10,000,000 | |||||||||
| Life of project in years | 8 | |||||||||
| Reduction in cost per year | 5% | |||||||||
| Salvage value | $500,000 | |||||||||
| Required rate of return | 8% | |||||||||
| Depreciation | MACRS-7 years | |||||||||
| Annual sales | $20,000,000 | |||||||||
| Earlier Cost of sales (60% of sales) : 60% of Annual Sales i.e of 20 million =C9*0.6 |
$12,000,000 | |||||||||
| Tax rate | 25% | |||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | |
| Purchasing Cost | $10,000,000 | |||||||||
| Annual Sales | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | ||
| Cost of the goods sold : Cost of sales reducing by 5% per year for 8 years |
$11,000,000 | $10,000,000 | $9,000,000 | $8,000,000 | $7,000,000 | $6,000,000 | $5,000,000 | $4,000,000 | ||
| MACRS – 7 years rates | 14.29% | 24.49% | 17.49% | 12.49% | 8.93% | 8.92% | 8.93% | 4.46% | ||
| Annual Depreciation | $1,429,000 | $2,449,000 | $1,749,000 | $1,249,000 | $893,000 | $892,000 | $893,000 | $446,000 | ||
| Earnings before interest and taxes (EBIT) / Gross Income : EBIT = Sales – Cost of Sales – Operating Expenses https://www.investopedia.com/terms/e/ebit.asp |
$7,571,000 | $7,551,000 | $9,251,000 | $10,751,000 | $12,107,000 | $13,108,000 | $14,107,000 | $15,554,000 | ||
| Taxes (25%) / Income Taxes : EBIT * Tax rate of 25% |
$ 1,892,750 | $ 1,887,750 | $ 2,312,750 | $ 2,687,750 | $ 3,026,750 | $ 3,277,000 | $ 3,526,750 | $ 3,888,500 | ||
| Earnings after taxes / Net Income : EBIT – Taxes |
$5,678,250 | $5,663,250 | $6,938,250 | $8,063,250 | $9,080,250 | $9,831,000 | $10,580,250 | $11,665,500 | ||
| Add Depreciation | $1,429,000 | $2,449,000 | $1,749,000 | $1,249,000 | $893,000 | $892,000 | $893,000 | $446,000 | ||
| Add: After tax salvage value : Salvage value on 8th year – (Salvage Value * Tax rate 25%) |
: 60% of Annual Sales i.e of 20 million =C9*0.6 | $375,000 | ||||||||
| Cash Flows | ($10,000,000) | $7,107,250 | $8,112,250 | $8,687,250 | $9,312,250 | $9,973,250 | $10,723,000 | $11,473,250 | $12,486,500 | |
| Cummulative Cash Flows | ($10,000,000) | ($2,892,750) | $5,219,500 | $13,906,750 | $23,219,000 | $33,192,250 | $43,915,250 | $55,388,500 | $67,875,000 | |
| Present Value factor (8%) : PV https://www.accountingtools.com/articles/what-is-the-present-value-factor.html |
1 | 0.93 | 0.86 | 0.79 | 0.74 | 0.68 | 0.63 | 0.58 | 0.54 | |
| Present value of cash flows : Ref: Bradford, R.S.W.R.J.J. J. (2017). Corporate Finance: Core Principles and Applications. [Capella]. Retrieved from https://capella.vitalsource.com/#/books/1260384357/ Page 115 (Ch4), 197 (Ch7) |
: Cost of sales reducing by 5% per year for 8 years | ($10,000,000) | $6,580,787 | $6,954,947 | $6,896,219 | $6,844,782 | $6,787,626 | $6,757,309 | $6,694,531 | $6,746,067 |
| Present value of cash inflows | $54,262,269 | |||||||||
| Present value cash outflows | $10,000,000 | |||||||||
| Net present value = Present value of cash inflows – Present value of cash outflows | $44,262,269 | NPV Formula: | $44,262,269 | |||||||
| Internal rate of return (IRR) | IRR: | 79.79% | ||||||||
| Payback period : https://www.investopedia.com/ask/answers/051315/how-do-you-calculate-payback-period-using-excel.asp https://www.elearnmarkets.com/blog/calculation-of-payback-period/ |
1.36 | |||||||||
| profitability Index (PI) + present value of cash inflows/ present value of cash outflows | 5.43 |
ProjectB
| Project B: Expansion Into Three Additional States | Expansion Into Three Additional States | |||||
| Start up Cost | $7,000,000 | |||||
| Life of a project in years | 5 | |||||
| Annual Depreciation (using straightline) : Using straight line depreciation Annual Depreciation= (Asset Cost – Salvage Value)/Asset Life https://corporatefinanceinstitute.com/resources/knowledge/accounting/straight-line-depreciation/ |
$1,400,000 | |||||
| Net working capital | $1,000,000 | |||||
| Required rate of Return | 12% | |||||
| Earlier annual sales | $20,000,000 | |||||
| Earlier Cost of sales (60% of sales) | $12,000,000 | |||||
| Increase in sales and revenue per year | 10% | |||||
| Tax rate | 25% | |||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Purchasing Cost | $7,000,000 | |||||
| Annual Sales | $22,000,000 | $24,200,000 | $26,620,000 | $29,282,000 | $32,210,200 | |
| Cost of goods sold | $13,200,000 | $14,520,000 | $15,972,000 | $17,569,200 | $19,326,120 | |
| Annual Depreciation | $1,400,000 | $1,400,000 | $1,400,000 | $1,400,000 | $1,400,000 | |
| Earnings before interest and taxes (EBIT) | $7,400,000 | $8,280,000 | $9,248,000 | $10,312,800 | $11,484,080 | |
| Tax (30%) | $1,850,000 | $2,070,000 | $2,312,000 | $2,578,200 | $2,871,020 | |
| Earnings after tax | $5,550,000 | $6,210,000 | $6,936,000 | $7,734,600 | $8,613,060 | |
| Plus Depreciation | $1,400,000 | $1,400,000 | $1,400,000 | $1,400,000 | $1,400,000 | |
| Net working capital | ($1,000,000) | $1,000,000 | ||||
| Cash flows | ($8,000,000) | $6,950,000 | $7,610,000 | $8,336,000 | $9,134,600 | $11,013,060 |
| Cummulative Cash flows | ($8,000,000) | ($1,050,000) | $6,560,000 | $14,896,000 | $24,030,600 | $35,043,660 |
| Present value factor (12%) | 1.00 | 0.89 | 0.80 | 0.71 | 0.64 | 0.57 |
| Present value of cash flows | ($8,000,000) | $6,205,357 | $6,066,645 | $5,933,400 | $5,805,203 | $6,249,106 |
| Present value of cash inflows | $30,259,712 | |||||
| Present Value of Cash outflows | $8,000,000 | |||||
| Net Present Value = Present Value of cash inflows – Present Value of cash outflows | $22,259,712 | NPV Formula: | $22,259,712 | |||
| Internal rate of return | IRR: | 91.48% | ||||
| payback period | 1.14 | |||||
| Profitability Index (PI) | 3.78 |
ProjectC
| Project C | Marketuing/ Advertising Campaign | ||||||
| Annual cost | $2,000,000 | ||||||
| Life of project in years | 6 | ||||||
| Required rate of return | 10% | ||||||
| Earlier Annual sales | $20,000,000 | ||||||
| Earlier Cost of Sales (60% of sales) | $12,000,000 | ||||||
| Increase in sales and revenue per year | 15% | ||||||
| Tax rate | 25% | ||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| Marketing / Advertising cost | $2,000,000 | $2,000,000 | $2,000,000 | $2,000,000 | $2,000,000 | $2,000,000 | |
| Present value of Annual marketing cost | $8,710,521 | ||||||
| Annual sales | $23,000,000 | $26,450,000 | $30,417,500 | $34,980,125 | $40,227,144 | $46,261,215 | |
| Cost of the Goods sold | $13,800,000 | $15,870,000 | $18,250,500 | $20,988,075 | $24,136,286 | $27,756,729 | |
| Earnings before interest and taxes (EBIT) | $9,200,000 | $10,580,000 | $12,167,000 | $13,992,050 | $16,090,858 | $18,504,486 | |
| Taxes (25%) | $2,300,000 | $2,645,000 | $3,041,750 | $3,498,013 | $4,022,714 | $4,626,122 | |
| Earnings after taxes | $6,900,000 | $7,935,000 | $9,125,250 | $10,494,038 | $12,068,143 | $13,878,365 | |
| Cash Flows | ($8,710,521) | $6,900,000 | $7,935,000 | $9,125,250 | $10,494,038 | $12,068,143 | $13,878,365 |
| Present value factor (10%) | 1.00 | 0.91 | 0.83 | 0.75 | 0.68 | 0.62 | 0.56 |
| Present value of cash flows | ($8,710,521) | $6,272,727 | $6,557,851 | $6,855,935 | $7,167,569 | $7,493,367 | $7,833,975 |
| Cummulative Cash flows | ($8,710,521) | ($1,810,521) | $6,124,479 | $15,249,729 | $25,743,766 | $37,811,909 | $51,690,274 |
| Present value of cash inflows | $42,181,425 | ||||||
| Present value of cash outflows | $8,710,521 | ||||||
| Net Present Value = Present Value of cash inflows – Present value of cash outflows | $33,470,904 | NPV Formula: | $33,470,904 | ||||
| internal rate of return | IRR: | 90.36% | |||||
| Payback periodd | 1.23 | ||||||
| Profitability Index (PI) = present value of cash inflows/ present value of cash outflows | 4.84 |
Comparison
| Projects | Net Present Value | Payback Period | Profitability Index | Internal Rate of Return |
| Project A: Major Equipment Purchase | $44,262,268.65 | 1.36 | 5.43 | 79.79% |
| Project B: Expansion Three Additional States | $22,259,712.14 | 1.14 | 3.78 | 91.48% |
| Project C: Marketing or Advertising Campaign | $33,470,903.72 | 1.23 | 4.84 | 90.36% |
Combined_EvaluateCapProjects
| Project A | Major Equipment Purchase | ||||||||
| Purchasing cost | $10,000,000 | ||||||||
| Life of project in years | 8 | ||||||||
| Reduction in cost per year | 5% | ||||||||
| Salvage value | $500,000 | ||||||||
| Required rate of return | 8% | ||||||||
| Depreciation | MACRS-7 years | ||||||||
| Annual sales | $20,000,000 | ||||||||
| Earlier Cost of sales (60% of sales) : 60% of Annual Sales i.e of 20 million =C9*0.6 |
$12,000,000 | ||||||||
| Tax rate | 25% | ||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
| Purchasing Cost | $10,000,000 | ||||||||
| Annual Sales | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | $20,000,000 | |
| Cost of the goods sold : Cost of sales reducing by 5% per year for 8 years |
$11,000,000 | $10,000,000 | $9,000,000 | $8,000,000 | $7,000,000 | $6,000,000 | $5,000,000 | $4,000,000 | |
| MACRS – 7 years rates | 14.29% | 24.49% | 17.49% | 12.49% | 8.93% | 8.92% |
