MBA FPX 5014 Assessment 2 Evaluation of Capital Projects

MBA FPX 5014 Assessment 2 Evaluation of Capital Projects

Student Name

Capella University

MBA-FPX5014 Applied Managerial Finance

Prof. Name:

Date

Executive Report

This evaluation of capital projects provides an analysis of the suitability of three potential capital investments to determine which project Drill Tech, Inc. should pursue. The analysis uses capital budgeting tools to evaluate three projects: a major equipment purchase, an expansion into Europe, and a marketing/advertising campaign. By assessing the incremental changes to cash flow, it was determined that the net present value (NPV) for the major equipment purchase was 28.77, the NPV for the expansion into Europe was 17.1, and the NPV for the marketing/advertising campaign was 32.4. Based on this evaluation, the marketing/advertising campaign was identified as the most profitable capital project over time.

Evaluation of Capital Projects

Drill Tech, Inc.

Drill Tech, Inc. is a mid-sized manufacturing company headquartered in Minnesota (Saunders, 2000). For the upcoming fiscal year, three capital projects were identified for Drill Tech, Inc. to consider. A capital project refers to a long-term initiative aimed at improving, building, maintaining, or developing a capital asset for the company (Marshall, McManus, & Viele, 2017). Such projects often require significant investments that occur consistently over the project’s duration (Brigham & Houston, 2012).

Given the ongoing and potentially substantial investment involved, it is essential for Drill Tech, Inc. to determine which project will provide the greatest shareholder value upon completion. Shareholder value (SV) refers to the intrinsic value that a shareholder gains by owning a share of the company. For publicly traded companies, SV forms part of the equity, alongside long-term debt, and contributes to overall capitalization (Saunders, 2000). As a company grows more valuable through increased earnings, SV rises, enhancing the company’s overall worth (Gibson & Dunn, 1989). Therefore, identifying which of the three projects will most effectively increase shareholder value is critical in deciding which project Drill Tech, Inc. should pursue.

Capital Projects Backgrounds

Project A: Major Equipment Purchase

The first potential project involves purchasing major equipment, including heavy machinery that would enhance manufacturing processes. The initial investment for this equipment is $10 million, with an expected benefit of reducing the cost of sales by 5% per year over eight years. Additionally, the equipment is projected to have a salvage value of $500,000 at the end of the eight-year period.

Due to the relatively lower risk of this investment, the required rate of return is set at 8%, and the equipment will be depreciated using the Modified Accelerated Cost Recovery System (MACRS) over a seven-year schedule. Within the MACRS framework, fixed assets are assigned to specific classes, each with corresponding depreciation schedules defined by the Internal Revenue Service (IRS, 2019). For this project, the seven-year depreciation schedule applies because the equipment falls under the “most machinery” category.

Table 1. MACRS Depreciation and Classes

The business is projected to have sales of $20 million in the first year, maintaining this level annually over the eight-year period. Initially, the cost of sales was 60%, which the 5% reduction will lower to 55% annually. The marginal corporate tax rate for this project is assumed to be 25%, which is critical to consider when planning to account for post-tax income (Brigham & Houston, 2012).

Project B: Expansion into Europe

The second potential project involves expanding Drill Tech, Inc.’s operations into Western Europe. This project forecasts a 10% annual increase in sales over five years, alongside a corresponding 10% rise in the cost of sales. The previous year’s annual sales were $20 million. The expansion will require a $7 million initial investment and an upfront net working capital (NWC) of $1 million, which is expected to be recovered at the end of year five.

Due to higher European tax rates, the marginal corporate tax rate is set at 30%, which is 5% higher than that of the equipment purchase project. As this expansion poses higher risks, the required rate of return for the project is set at 12%.

Project C: Marketing/Advertising Campaign

The third proposed capital project involves investing in a marketing/advertising campaign. This project does not require an initial investment but will cost $2 million annually for six years, totaling $12 million. The forecast predicts a 15% annual increase in sales and a 15% rise in the cost of sales during this six-year period. The marginal corporate tax rate for this domestic project is assumed to be 25%. This moderately risky investment has a required rate of return of 10%.

Capital Budgeting Methods

Capital budgeting methods are essential for evaluating long-term, high-budget investments, which often span several years and involve substantial financial risks. These methods help reduce potential costs, assist in making irreversible financial decisions, and prevent over or under-investments (Saunders, 2000). The following methods were used to evaluate the three proposed projects:

Payback Period

The payback period method determines when the initial investment will be recovered. This approach focuses on the initial investment, project lifespan, and cash inflows (Phillips et al., 2012). However, it does not consider the time value of money, which can be a drawback. Using this method, Project B recovers its initial investment in year three, while Project A does so in year two. Project C, which lacks an initial investment, cannot have a payback period calculated.

IRR: Internal Rate of Return

The internal rate of return (IRR) identifies the discount rate at which the NPV of an investment equals zero. This method considers the time value of money but involves a complex calculation process (Phillips et al., 2012). The IRR for Project A is 0.70, and for Project B, it is 0.81. Since Project C lacks an initial investment, the IRR cannot be computed.

PI: Profitability Index

The profitability index (PI) uses the ratio of the present value of future cash benefits at the required rate of return to the initial investment outflow, helping to decide whether to accept (PI > 1) or reject (PI < 1) an investment (Brigham & Houston, 2012). Due to Project C’s absence of an initial investment, comparing it with Projects A and B using this method is challenging.

NPV: Net Present Value

Net present value (NPV) compares the present value of expected cash inflows to the initial investment, accepting projects with a positive difference. NPV is widely used due to its applicability across various scenarios. Project C (marketing/advertising campaign) had the highest NPV, suggesting it would provide the greatest shareholder value increase.

Conclusion

Capital budgeting methods are instrumental in determining which proposed capital projects offer the highest potential for increasing shareholder value. This evaluation of Drill Tech, Inc.’s projects—major equipment purchase, European expansion, and marketing/advertising campaign—revealed that the NPV for the marketing/advertising campaign was highest at 32.4, making it the most favorable project for enhancing shareholder value.

References

Brigham, E. F., & Houston, J. F. (2012). Fundamentals of Financial Management. Cengage Learning.

Gibson, C. H., & Dunn, J. (1989). Financial Statement Analysis, International Edition. Assessment, 45, 49.

Internal Revenue Service (IRS). (2019). MACRS tables. Retrieved from https://www.irs.gov/publications/p946

Marshall, D., McManus, W., & Viele, D. (2017). Accounting: What the Numbers Mean (11th ed.). New York, NY: McGraw-Hill Education.

MBA FPX 5014 Assessment 2 Evaluation of Capital Projects

Phillips, F., Libby, R., Libby, P. A., & Mackintosh, B. (2011). Fundamentals of Financial Accounting. New York, NY: McGraw-Hill Irwin.

Saunders, A. (2000). Financial Institutions Management: A Modern Perspective. McGraw-Hill College.