MBA FPX 5014 Assessment 2 Evaluation of Capital Projects

MBA FPX 5014 Assessment 2 Evaluation of Capital Projects

Name

Capella university

MBA-FPX5014 Applied Managerial Finance

Prof. Name

Date

Executive Report

This evaluation of capital projects provides an analysis of three potential projects to determine which one Drill Tech, Inc. should pursue. Capital budgeting tools were applied to assess a major equipment purchase, an expansion into Europe, and a marketing/advertising campaign. After reviewing the incremental cash flow changes, the net present values (NPV) for the three projects were calculated: the NPV for the major equipment purchase was 28.77, the NPV for the European expansion was 17.1, and the NPV for the marketing/advertising campaign was 32.4. Based on these findings, the marketing/advertising campaign is the most profitable capital project over time.

Evaluation of Capital Projects: Drill Tech, Inc.

Drill Tech, Inc. is a mid-sized manufacturing company based in Minnesota (Saunders, 2000). For the upcoming fiscal year, the company has identified three capital projects for consideration. A capital project is a long-term endeavor focused on improving, building, maintaining, or developing a company’s capital assets (Marshall, McManus, & Viele, 2017). Such projects often require significant investments, which are made continuously over the duration of the project (Brigham & Houston, 2012). Therefore, it is crucial for Drill Tech, Inc. to select the project that will provide the highest shareholder value upon completion.

Shareholder value refers to the intrinsic worth that a shareholder gains from holding shares in a company. In publicly traded companies, shareholder value is part of the equity, alongside long-term debt, contributing to the company’s overall capitalization (Saunders, 2000). As a company’s earnings increase, its shareholder value grows, making the company more valuable (Gibson & Dunn, 1989). Choosing the project that will best enhance shareholder value is key to determining which project Drill Tech, Inc. should pursue.

Capital Projects Backgrounds

Project A: Major Equipment Purchase

The first potential project involves purchasing major equipment, which includes heavy machinery to improve manufacturing processes. The initial investment is $10 million, and the project is projected to reduce the cost of sales by 5% annually over eight years. At the end of this period, the equipment is expected to have a salvage value of $500,000. The project is considered low-risk, with a required rate of return of 8%, and the equipment will be depreciated using a MACRS 7-year schedule (Brigham & Houston, 2012). The marginal corporate tax rate for this project is 25%.

Project B: Expansion into Europe

The second option is to expand into Western Europe, with a forecasted increase in sales of 10% annually over a five-year period, accompanied by a 10% increase in the cost of sales. The initial investment is $7 million, with an upfront net working capital (NWC) of $1 million, which is expected to be recouped at the end of five years. The project has a higher risk, with a required rate of return of 12%, and a 30% marginal corporate tax rate due to higher European tax rates.

Project C: Marketing/Advertising Campaign

The final proposed project involves a marketing/advertising campaign, with no initial start-up investment but requiring $2 million annually for six years, totaling $12 million. The campaign is expected to increase both sales and the cost of sales by 15% annually over the project’s six-year duration. The project is considered moderately risky, with a required rate of return of 10% and a 25% marginal corporate tax rate.

Capital Budgeting Methods

Capital budgeting methods are used to assess long-term, high-budget investments, which often span multiple years or decades and involve significant financial risks (Saunders, 2000). These methods aid in evaluating projects by reducing risks, aiding decision-making, and avoiding under or overinvestment (Saunders, 2000). Three common capital budgeting methods include the payback period, internal rate of return (IRR), and profitability index (PI).

Payback Period

The payback period calculates the time required to recover the initial investment (Phillips et al., 2012). Project A has a payback period of two years, Project B has a payback period of three years, and Project C does not have an initial investment, so no payback period can be computed.

Internal Rate of Return (IRR)

IRR identifies the rate at which the net present value of an investment becomes zero (Phillips et al., 2012). The IRR for Project A is 0.70, for Project B is 0.81, and Project C’s IRR is not applicable due to the lack of an initial investment.

Profitability Index (PI)

PI is a capital budgeting tool that evaluates the value generated per unit of investment (Brigham & Houston, 2012). While Project A and B’s PI can be computed, Project C lacks an initial investment, making it challenging to assess comparably.

Net Present Value (NPV)

NPV is often used to evaluate capital projects by comparing the present value of expected cash flows to the initial investment (Brigham & Houston, 2012). In this evaluation, Project A has an NPV of 28.77, Project B’s NPV is 17.1, and Project C’s NPV is 32.4, making the marketing/advertising campaign the most profitable.

Conclusion

By analyzing the potential projects through capital budgeting methods, it is clear that Project C, the marketing/advertising campaign, offers the highest potential to increase shareholder value, as indicated by its superior NPV. Therefore, Drill Tech, Inc. should pursue Project C.

References

Anthony Saunders. (2000). Financial institutions management: a modern perspective. McGraw-Hill College.

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.

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

MBA FPX 5014 Assessment 2 Evaluation of Capital Projects

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

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

Class	Typical Assets	Depr. Method
3-year	Small tools, tractors, horses, specialized devices	200% Decl. Bal.
5-year	Computers, autos, small aircraft, construction equipment	200% Decl. Bal.
7-year	Office furniture, fixtures, equipment, most machinery	200% Decl. Bal.
10-year	Specialized heavy machinery, mobile homes	200% Decl. Bal.
15-year	Billboards, service station buildings	150% Decl. Bal.
20-year	Sewer pipes, most utility property	150% Decl. Bal.