Financial Engineering to Enhance Shareholder Value

Running head: Evaluation of capital projects 1

Evaluation of capital projects 7

Evaluation of capital projects

Capella University

Taccarra Manuel

Professor: John Halstead

May 3, 2023

In ensuring there is consistency in the computations of capital budgeting, a standard capital budgeting tool is used in computing the value of the projects in relation to profitability. There are three main tools used in the analysis of the three projects: Net Present Value (NPV), Internal Rate of Return (IRR) and Payback Period

Project A	Project B	Project C
Cash outlay/upfront cost =$10,000,000 Benefit =Reduce cost of sales by 5 percent. Initial cost of sales =0.6*20,000,000=12,000,000 Amount saved for the company =0.05*12,000,000 =$600,000	Benefit = Increase sales revenue by 10%. New sales =1.1*20,000,000= $22,000,000 Increased sales =$2,000,000 Cost of sales =12,000,000 New cost of sales =1.1*12,000,000 =$13,200,000 Increased cost of sales =$1,200,000 Increased sales margin =$800,000 Upfront cost= (7,000,000+1,000,000) =$8,000,000 Required rate of return =12%	Cost =$2,000,000 per year for 6 years. Total cost (Present value of 6-year cost payment) =$12,000,000 Benefit of the project= Increase sales by 15% New sales =1.15*20,000,000 =$23,000,000 Increased sales =$3,000,000 Increase in cost of sales =1.15*12,000,000 =$13,800,000 Increase =$1,800,000 Net benefit /increased profit margin as a result of the project =3,000,000-1,800,000 =$1,200,000
Determining NPV of the three projects
NPV =($7,437,983.37	NPV =($5,116,179.04	NPV= ($6,773,687.16)
Internal Rate of Return of the three projects
IRR= -13.94%	IRR=-19.4%	IRR=-12.9%
Payment period
PP=10,000,000/600,000= 16.6 years	PP=8000,000/800000 =10 years	PP=12,000,000/1200000 =10 years

In the computations, a key assumption is made that the depreciation expense is provided for by the organization. This is because the MACRS-7 year schedule assumes that an asset depreciated does not have a residual value of $500,000. Based on the computations made, there are conclusions that are made in relation to the viability of the projects. Based on the net present value (NPV), none of the projects realize a profit based on the expected duration at which the projects are expected. This is evident as the net present value of each of the projects is a negative, an indication of a loss (Al Breiki & Nobanee, 2019).

Based on the Internal Rate of Return (IRR), project C is better compared to Project A and B as it has a lower negative rate of return compared to the other projects. However, a negative internal rate of return means the project is not viable for the organization in the given period. This is because the company will not have realized the initially cash invested in establishing the project.

Relevance of capital budgeting tools

Net present value (NPV) is used in computing the value of each of the three projects in determining the most viable project that the company should focus at. NPC is preferred in the three projects in ensuring the conclusions made can easily be compared to provide meaningful decision conclusions. Since factors like inflation and lost compound interest cause future cash flow to differ significantly from current cash flow, NPV must be adjusted accordingly. The ability to calculate net present value helps project managers determine whether or not it makes sense to carry forward with a given venture by providing an accurate estimate of the return on their original expenditure. The program translates the expected return into current currency, giving decision makers more assurance with which to proceed with business choices right away. In light of the company's present financial state, NPV can shed light on the potential benefits of the projects. In determining the value of each of the three projects, the expected cash inflow is analyzed individually per project to determine the cash inflow that the project brings to the company either as a result of reduced cost of sales or increased sales revenue (Malenko, 2019).

Companies use IRR to choose which capital projects to fund, but investors may also use it to assess the profitability of potential asset purchases. Managers can compare the potential returns of various assets using an IRR, which is a method of financial analysis. In order to determine which initiatives offer the best return on investment, company executives employ internal rate of return calculations. The Internal Rate of Return (IRR) starts with a discounted rate that has a zero net present value. Predicted returns are based on the cost of capital, or the total amount needed to fund the project (Prestmo, 2020). Projects whose returns surpass their capital expenses are prioritized by business executives, and those with the greatest IRR are selected.

Payback period is the third tool employed. The amount of time an investment takes to turn a profit is called its payback period. Since people and businesses invest money primarily to make a profit, the payback period is critical. The rate at which an investment pays off is of paramount importance. Divide the original investment by the typical cash flows to get the payback time, which is useful information for investors.

Recommendations

From the capital budgeting activity of the three projects, there is an need to incorporate best practices in determining the value of each of the three projects. The following best practices are proposed which would help in project planning in the future and avoid poor timing that does not yield to profitability.

Timing of the cash flow: The time value of money dictates that monetary flows accrue greater value the sooner they are received. This is so due to their immediate use in a variety of investment vehicles and potential uses in other initiatives. In other words, the horizon for financial flows that occur earlier in time is wider. This makes them more valuable than future cash flows (Malenko, 2019). Capital budgeting should take cash flow into account.

Actual cash flows based decisions: The capital planning process should only take into account future cash flows. Sunk expenses should be disregarded. This is because the effects of sunk costs on the company's financial statements have already been felt. Therefore, they should not bea factor into the profitability of future endeavors.

Interest, taxes, and amortization and depreciation are non-project expenditures, thus they should not be factored into a project's profitability. Project A was planned contrary to this practice as it factored depreciation of the asset using the MACRS 7-schedule and which assumes the asset has no residual value. This affects the reliability of the computation output. Assuming the same capital source will be used to fund all of the projects and all cash flows would be reported in the same tax regimes, these factors are relatively consistent. Management may compare the NPV, IRR, and payback periods of the projects in question to arrive at a conclusion. This is helpful from a capital budgeting standpoint when assessing projects with intangible strategic value. Considering the outlined best practices, the management should have adjusted the expected payback periods of each of the projects in determining the viability of the projects before making proposals on the projects (Prestmo, 2020).

Reference

Al Breiki, M., & Nobanee, H. (2019). The role of financial management in promoting sustainable business practices and development.  Available at SSRN 3472404.

Malenko, A. (2019). Optimal dynamic capital budgeting.  The Review of Economic Studies,  86(4), 1747-1778.

Prestmo, J. B. (2020). Investments and capital budgeting practice: Is there a difference between small and large firms.