Assessment 3: Financial Engineering to enhance shareholder value

Evaluation Of Capital Projects

MBAFPX5014: Applied Managerial Finance

1 April 2022

Executive Summary

Capital budgeting refers to a process a firm undertakes to evaluate potential investments that add

value to the firm. The potential projects should as well enhance shareholders' value. A firm will

be required to assess the cash inflows and the cash outflows of a particular task within its

economic lifetime. The company determines whether the returns from the potential project have

met the target benchmark. A project is approved if it has completed the target benchmark. If a

project doesn't encounter the standard mark, it is rejected. If several assignments are considered,

the project that yields the best returns is preferred over the rest. ABC healthcare company is

considering three projects that have been proposed to increase shareholder value. This report

entails the ABC healthcare background and the capital budgeting used to evaluate and scrutinize

each of the three projects to recommend the project with the highest shareholder value.

Introduction

ABC healthcare is a giant firm in the medical industry. The company was established in 1995.

They initially opened a clinic in the same year at phoenix. By 2005, ABC healthcare had thirteen

surgical centers and eleven additional outpatient clinics. ABC health has acquired several firms

since it was founded. It has expanded into a full hospital operating twenty-four hours. Currently,

it has more than one hundred operational medical facilities.

Evaluating ABC healthcare's fiscal state is necessary to maximize shareholder value as the firm

ensures its expansion and growth. After the previous analysis of ABC healthcare's performance,

it was realized that shareholder value wasn't maximized. Analysts had previously evaluated the

healthcare performance and realized that shareholders' value maximization was not met. Hence,

they had to propose other projects to determine whether the value could be completed. Since its

mission is to be among the top leaders, it has to ensure a robust financial base. On behalf of ABC

company, Maria has requested three potential projects to be evaluated using capital budgeting

techniques and finally presented before the leadership team. The leadership team will develop a

viable decision on which project to choose upon evaluation.

The three anticipated projects A, B, and C. Project A entails significant equipment purchases.

Project B involves expansion into three additional states. The third project that is projected C

encompasses marketing and advertising campaign. Therefore, the manager ought to predict each

project's cash flows by using capital budgeting techniques to consider which offers the best

shareholders value. There are Four capital budgeting appraisal methods that will be used to attain

this goal. The four methods include profitability index, present net worth, payback period, and

internal rate of return. After evaluating these techniques, the manager will give out suitable

recommendations.

Capital Budgeting appraisal tools

The capital appraisal tools or methods aid a firm in the determination of which project to

undertake among several projects. The strategies help decide which project to accept and which

to reject. A project with the best-expected returns is chosen over the others. ABC healthcare will

decide which project will have the best shareholders' value by using the methods. This discussion

will discuss the four primary appraisal methods: NPV, payback period, PI, and internal rate of

return.

Net present value (NPV)

The net present value method is ranked among the topmost capital budgeting techniques. It is

attained by deducting the PV of cash outflows from the cash inflows. Since the calculations of

this method are complex, the ABC company will be compelled to use an excel spreadsheet in

calculating the NPV of each project (Mayes, (n.d.). A project with a positive net present value is

chosen, while a negative NPV is rejected. The highest positive net current worth is selected if

several projects are being appraised. In our case, we will outweigh the three projects and choose

the best among the three since all the projects possess a positive NPV. The net present value

determines whether a project's projected return offsets an average interest rate on the preliminary

venture. As a result, investors would not risk investing in a project that yields no return.

However, this method may not be sufficient in determining which project will deliver the highest

shareholders' value.

the formula of the Net Present value is as follows:

NPV = Cash flow / (1 + i) ^t – initial investment

where: i is the discount rate

t is the period

Internal rate of return

The internal rate of return abbreviated IRR is a well-thought-out one of the most excellent

imperative substitute capital budgeting appraisal techniques for the NPV. The internal rate of

return is a discount rate that returns the net present value of the entire cash flow to null. For

instance, the highest IRR of the three projects is accepted for ABC healthcare. Performing the

computations of the internal rate of return by hand is challenging; the ABC healthcare crew is

compelled to use an excel spreadsheet to carry out these computations. The justification behind

the IRR method is that it ensures a solitary numeral that recapitulates the project's virtues. Once a

discount rate is set, the IRR can be accomplished; whatever is approximately the given discount

rate must be accepted, whatever below the discount rate ought to be vetoed. The allocated

discount rate will be consequent while carrying out the NPV.

IRR is calculated using the formula below.

Profitability index (PI)

The profitability index is arrived at by subtracting the initial cost from its present value. The pi

designates an index that epitomizes the association between the expenses and paybacks of an anticipated

project. The profitability index aims at showing the attractiveness of a project. Any investment with

profitability higher than one is considered good; hence undertaking while investment with a negative

profitability index or less than one should be rejected given several proposed projects to be conducted; the

project with the highest profitability index is chosen since it is the most attractive.

The profitability index is calculated using the formula:

Profitability Index = (Net Present Value + Initial Investment) / Initial Investment

Payback period

The payback period is a capital appraisal technique that determines the period taken for a firm or

individual to recuperate the initial cost of an investment. This method is calculated by dividing

the initial cost of investment by the yearly anticipated cash flow. A project with a shorter

payback period is considered to be good. Of the three projects proposed by ABC healthcare, the

one with the shortest payback period will be regarded (Ross et al., 2018). The payback period

technique doesn’t contemplate the time value of money, unlike the NPV and the internal rate of

return techniques. The method is commonly used as it is the simplest to calculate. It supplements

a supplement appraisal technique to other appraisal techniques.

when calculating the payback period, we use the formula:

Payback Period = Investment / Cash Flow Per Unit

Project a: major equipment purchase

The following are the project results on purchasing significant equipment after evaluation using

different capital budgeting techniques.

The first project to be evaluated is the purchase of major equipment. The anticipated cost of

acquiring this new major equipment is equivalent to $10 million with the intent of projecting the

abridged price of sales by five per annum for the subsequent eight years. The salvage value is

estimated to be $500,000. The required rate of return on this project must be greater than 8%.

The depreciation method used in this equipment machine is the modified accelerated cost

recovery system depreciation rate for the recovery period technique (Shelton, 2017, Feb 19). The

Payback period 1.36

Net present value 44,262,269

Profitability index 5.43

Internal rate of return 79.79%

schedule used must be a 7-year schedule. Yearly sales for the first year are expected to be $20

million and should stay constant year over year for the eight years. Preceding this project, ABC

healthcare is presently operating at the cost of sales at 60%, with a marginal corporate tax rate of

25%.

From the above table, the payback period of this project is 1.36. The net present value is

$44,262,269. The profitability index and the internal rate of return are anticipated to be 5.43 and

79.79%, respectively. The project is attractive since its profitability index is above one.

Project b: expansion into three additional states

The second ABC healthcare project to be undertaken is expansion into three different states. The

results after the evaluation are as per the table below.

The initial investment in the expansion project is $7 million—networking capital of one

million dollars to be recouped at the end of five years.

As per the table above, the project has a positive net present value of $22,259,712. It has

an attractive profitability index of 3.78. The IRR has surpassed the required rate of return of

12%. It has the shortest payback period of 1.14.

Project c: marketing/advertising campaign

Payback period 1.14

Net present value 22,259,712

Profitability index 3.78

Internal rate of return 91.48%

Payback period 1.23

Net present value 33,470,903

The marketing and advertising campaign project has a positive net present value of

$33,470,903. It has an attractive profitability index of 4.84. The internal rate of return of this

project is 90.36%. The payback period is 1.23.

Recommendations

After the evaluation of the three proposed projects, it can be construed that the senior

manager should consider choosing the best project to increase shareholders' equity. Of the three

projects, major equipment purchase is the most attractive project compared to the other two

projects. It is the strongest with the highest profitability index and net present value. Therefore,

having high profitability index, investors will be attracted to undertaking a particular project.

Profitability index 4.84

Internal rate of return 90.36%

References

Mayes, T. R. (n.d.). Microsoft Excel as a financial calculator part I. http:// www.tvmcalcs.com/

index.php/calculators/excel_tvm_functions/ excel_tvm_functions_page

Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2018). Corporate finance: Core

principles and applications (5th ed.). New York, NY: McGraw-Hill.

Shelton, C. (2017, Feb 19). MACRS Depreciation Tables & How to Calculate. Retrieved from

Fit Small Business: https://fitsmallbusiness.com/macrs-depreciation-calculator/