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ABC Healthcare Corporation Project Evaluation

Crystal Leslie

Assessment 2 Evaluation of Capital Projects

June 7th, 2024

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Executive Summary

Leadership has asked for an analysis of the three proposed capital projects based on
forecasted cash flow. The forecasts of the projected cash flows are in the attached
spreadsheets, titled Projected Cash Flows [XLSX]. Our company constraint only allows
for one project to be chosen, so it has been asked to discover which would provide the
most shareholder value for the company. Capital Budgeting Tools will be used to help
determine this.

Company Background

ABC Healthcare Corporation is in the healthcare industry. “The healthcare sector

consists of businesses that provide medical services, manufacture medical equipment
or drugs, provide medical insurance, or otherwise facilitate the provision of healthcare
to patients” (Healthcare sector: Industries defined and key statistics 2021). The
founder and president of the company is Maria Gomez. Our biggest rival is HCA
Healthcare Inc, which is headquartered in Tennessee. ABC Healthcare Corp owns a
large amount of emergency and surgical centers, making sure lives are saved every
day. We are there to make sure people stay healthy during critical times. We make sure
to review financial information and market value, so we make sure we are helping as
many people as possible. This review will allow us to know how we can maximize
shareholder value, making things better for everyone involved.

Capital Budgeting Tools

“Capital budgeting is the process by which investors determine the value of a potential
investment project” (Pinkasovitch, 2024). There are many different techniques used in Capital
Budgeting. Some of these techniques include net present value, internal rate of return,
profitability index, payback period, discounted payback period, modified internal rate of
return, and real options analysis. The ones we will be analyzing today are Net Present
Value, Payback period, Internal Rate of Return, and Profitability Index.

NPV (Net Present Value):

Net Present Value is called NPV for short. It calculates the net value of an investment
over time. It uses all cash inflow and outflow. It also uses a discount rate, which
accounts for the time value of money. This tool has two limitations, project size and
discount rate assumption. Typically, if NPV is greater than zero we accept the project
and if NPV is less than zero we reject the project. However, when we are comparing
multiple projects than we look for which project has the highest NPV. If NPV is positive,
it will add value to the company. The NPV helps us know if we would add more value
than we could have with the discount rate elsewhere.
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Payback period:

The payback period is how long it takes to recover the initial investment, the shorter the
better. A project is accepted if the payback period is less than or equal to the amount of
years of the project and the desired payback period. The formula is dependent on if the
cash flows are even or uneven. With even cash flows the formula is “Payback Period =
Initial Investment / Net Cash Flow per period. If the cash flows are uneven you have:
Payback Period = Years before full recovery + Unrecovered cost at the start of the year
/ Cash flow during the year” (Payback period calculator 2024).

IRR (Internal Rate of Return):

The Internal Rate of Return is a discount rate that ends in a NPV of 0. It estimates the
profitability of potential investments. The Internal Rate of Return is called IRR for short.
If IRR is greater than the discount rate the project should be accepted. If the IRR is less
than the discount rate than reject the project. You calculating the IRR by trying numbers
until you find the correct one. With this tool, different size projects can be compared
more accurately since it uses percentages. The problem with this tool is that if it is non-
conventional than there may be more than one IRR, making it impossible to find.

PI (Profitability Index):

The Profitability Index is called PI for short. Constraints such as budget and number of
engineers make it so all projects cannot be accepted. The formula is NPV divided by the
upfront investment. It helps us understand the value of the project, what NPV we are
getting per dollar. The highest option gives us the most. For PI to work two things must
be true: all resources must be exhausted and there is a single resource constraint.
Sometimes to make sure all resources are exhausted, more than one project can be
accepted.

Project A: Major Equipment Purchase

The first project out of the three is Project A, a major equipment purchase. This project
would be purchasing new equipment at the cost of ten million dollars. It is projected to
reduce the cost of sales by 5% per year for eight years. It is predicted to be able to be
sold for 500,000 dollars after the eight years. The required rate of return of the project is
8% and the equipment will be depreciated at a MACRS 7-year schedule. The marginal
corporate tax rate is presumed to be 25%.The annual sales for all eight years is
projected to be 20 million. Previously, the cost of sales has been 60%.

Project B: Expansion into Three Additional States

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The second potential project, Project B, is a project to expand into three more states.
The expansion is predicted to increase sales/revenues and cost of sales by 10% per
year for 5 years. Start-up costs are projected to be $7 million. The upfront needed
investment in net working capital is $1 million, being recouped at the end of year five.
The marginal corporate tax rate is presumed to be 25%. Finally, this is a more risky
investment than Project A, so the required rate of return of the project is 12%.

Project C: Marketing/Advertising Campaign

The final project, Project C, is a six year long marketing/advertising campaign that will
cost 2 million dollars per year. It is a moderate-risk investment so the rate of return for
the project is 10%. It is expected that the campaign will increase sales and costs of
sales by 15% per year. Finally, the marginal corporate tax rate is presumed to be 25%.

Results from Project A:

Due to the fact this is the only project out of the ones being considered that would have
a physical item bought, this is the only project that we have a concern about
depreciation for. To get the NPV the formula was used which is =NPV(required rate of
return, cash flows years 1-8) + (Cash Flow for year 0). In this situation the rate of return
was 8%. When the formula was entered, all of the information on the excel sheet
applied. It gave us the result of a NPV of $44,262,269.

With excel, the work is done for us so we do not need to keep guessing until the math
matches our guess. The formula was inputted which is =IRR(Year 0-8 cash flows). The
result was an IRR of 79.79%. The type of payback period that was used for this project
was the discounted payback period. The formula fr this is: discounted payback period=
years until break-even+ unrecovered amount/recovery year cash flow. In this case, we
want a positive number so we used absolute value. The numbers used to calculate this
was 1+absolute value of (-$2,892,750/$8,112,250). The result we got was 1.36. This
means it would take between a year and a year and a half to payback. Finally,
profitability index was calculated by the present value cash inflows by present value
cash outflows. The result was 5.43.
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Results from Project B:

The required rate of return for project B is 12%. Using the rate of return and the cash
flows, the NPV was calculated to be $22,259,712. The NPV is greater than zero, so if
we were trying to determine if we were going to accept just this project, than we would
accept it. However, we are comparing the results from all of the Capital Budgeting Tools
to the two other projects. The Internal Rate of Return for this project came out to
91.48%. This project has a life of five years instead of eight years like Project 8, so
there were less cash flows to include. The payback period came to 1.14, so it would
take slightly more than a year to payback. Finally, the profitability index came to 3.78.
This is promising since a “profitability index greater than 1.0 is often considered to be a
good investment, as it means that the expected return is higher than the initial
investment” (Chen, 2024).

Results from Project C:

This project also has different project lengths and a required rate of return. The life of
the project in years is 6. The required rate of return is 10%. The NPV calculated for this
project was $33,470,904. The internal rate of return calculated to be 90.63%. This tells
us the “the annual rate of growth that an investment is expected to generate”
(Fernando, 2024) .The payback period is 1.23, so this would also be between a year
and 1.5 years. Finally the profitability index for Project C is 4.84, which would appear to
show this as an attractive investment.
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Recommendation

We closely considered the information from all capital budgeting tools used. Looking
solely at Net Present Value, Project A has the highest. This shows some advantage to
invest in the major equipment purchase. When looking at Payback Period, the most
beneficial to invest in would be Project B. The expansion would be paid back faster than
the other two projects. This would allow us to start seeing profit faster. Project A has the
highest profitability index, this shows that the benefits of this project defiantly outweigh
the costs. Finally, looking at the internal rate of return, Project B would be best. “The
higher the IRR, the better the return of an investment” (Fernando, 2024).

Other aspects were considered. For example, it is important to consider how much
money would need to be initially invested in each project. Project C would have the
lowest starting cost, at $2,000. However, that is an annual cost, not a one-time fee. The
most expensive start-up cost is for Project A, at $10,000. We also considered the life of
the project in years, and how much time commitment we would need to put into each
project. The longest project would be Project A, at eight years. The shortest project is
Project B, which is 5 years.

Next, it was considered which projects gave us an increase in sales and which projects
gave up a reduction in cost. It is important to consider which we value more as a
company. Project A gave a 5% reduction in cost per year. Project B gave a 10%
increase in sales annually. Finally, Project C increased sales by 15% per year. All three
projects also vary in risk, which has been emphasized by the required rate of returns.
Project has the smallest risk, while Project B has the highest risk.

Considering all aspects, the project I would recommend investing in is Project A. This
project would raise shareholder value the most out of all three projects. This project has
a better Net Present Value and Profitability Index than the other projects. It has a longer
payback period than the other two investments, however that makes sense when
consider it also has the largest start-up cost. This project does not have the highest
internal rate of return. However, since it is an initial investment of $10,000 with an
internal rate of return of 79.79% this is a very attractive project. On top of everything
else, the risk of this project is also lower than the other projects.

Conclusion
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To conclude, all three projects would be of great value. All three projects would be
accepted based on the capital budgeting tools if they were not compared to the other
projects. However, we can only accept one project. At the time Project A will be the best
for shareholder value, which is our focus now. If later we can accept other projects, the
others should be put into consideration again.
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References

Chen, J. (2024, June 9). Profitability index (PI): Definition, components, and formula.

Investopedia.

https://www.investopedia.com/terms/p/profitability.asp#:~:text=A%20profitability%2

0index%20greater%20than,may%20be%20the%20best%20option.

Fernando, J. (2024, May 30). Internal Rate of Return (IRR): Formula and examples.

Investopedia.

https://www.investopedia.com/terms/i/irr.asp#:~:text=The%20internal%20rate%20

of%20return%20(IRR)%20is%20the%20annual%20rate,the%20NPV%20equal%2

0to%20zero.

Investopedia. (2021, October 31). Healthcare sector: Industries defined and key

statistics. Investopedia.

https://www.investopedia.com/terms/h/health_care_sector.asp

Payback period calculator. cleartax. (2024). https://cleartax.in/s/payback-period-

calculator

Pinkasovitch, A. (2024, June 13). Capital budgeting: What it is and how it works.

Investopedia. https://www.investopedia.com/articles/financial-theory/11/corporate-

project-valuation-methods.asp
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