MBA FPX 5014 Assessment 2 Evaluation of Capital Projects

Evaluation of Capital Projects

Healthcare companies emphasize how investment decisions impact their future ability to perform and compete. Managers want to use capital budgeting theories to ensure investment in opportunities that yield more efficient returns and grow the organization. This, in turn, maximally enhances the wealth of shareholders. Azlika et al. (2023) describe the complexity and importance of the capital budgeting process, which supports this claim. Currently, ABC Healthcare Corporation is considering several new capital budget proposals. The proposals include the purchase of new equipment, the expansion of business activities, and the new marketing plan. While preparing the evaluation report, the different capital budgeting techniques will be employed to analyze the proposals in terms of expected profits, level of risk, efficiency, and the potential value addition to the company.

Capital Budgeting Tools and Decision Criteria

• Net Present Value (NPV)

The net present value (NPV) determines the difference between the present value of cash inflows and the present value of cash outflows for the duration of the project. For NPV calculations, the future cash flows will be discounted at the project’s cost of capital, reflecting the time value of the cash and the risk of the investment. NPV is one of the more popular capital budgeting decision techniques since it deals with the value of the investment to the shareholders (Cotter, 2023) and ultimately, the value added to the company’s stock. If a project has a positive NPV, it means that the project’s cash inflows are greater than the company’s required rate of return, and the project, in turn, positively impacts the company’s stock. A negative NPV indicates that the company’s cash inflows are less than the required cash outflows and, in turn, the company’s stock value decreases.

Decision Criteria

• Choose projects with a positive NPV.
• Avoid projects with a negative NPV.
• Among multiple project options, the project with the highest NPV should be chosen to provide the greatest benefit to the shareholders.

For example, an NPV of $10 million indicates that the $10 million will be the net increase in the value of the enterprise, even with the risk and cost of the investment.

• Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is where the Net Present Value of a business is zero. The IRR is the anticipated annual return percent on an investment. The IRR is used by financial managers as it is easier to compare the available investments differing in sizes and time periods (Ganti, 2024). If the IRR of an investment is greater than the cost of capital (the hurdle rate), the investment is viable. Conversely, if the IRR of an investment is less than the cost of capital, the investment is non-viable.

Decision Criteria

• Investments with IRR above the required rate of return should be considered.
• Investments with IRR below the required rate of return should be ignored.
• An increase in IRR is usually associated with an increase in profitability.

An example of an attractive investment option would be a project with an IRR of 25% and a required rate of return of 10%.

• Payback Period

The payback period refers to the time needed for an investment to recover its initial outlay, based on cash inflow. In this particular case, this will deal more with the liquidity aspect and recovery period. Firms utilize the payback period method in their assessment of investment risk; since the recovery period is shorter, the risk is less (Oyelakun et al., 2025). However, while the payback method and payback calculations are relatively easy, the payback period method disregards the time value of money and cash flows.

Decision Criteria

• Select projects with shorter payback periods in consideration of the longest acceptable payback period within which the organization wishes to recover its investments.
• It is not advisable to take up projects with higher payback periods.
• An investment with a shorter payback period is always favorable as it reduces the risk. In contrast, the longer the payback period, the greater is the risk.

In this context, a project with a payback period of 1.5 years is always preferred compared to a project with a payback period of 5 years.

• Profitability Index (PI)

Profitability index is the net present value of returns to the initial investment. It shows the value added per unit of investment on a given project. Alrikabi (2022) has noted that the profitability index is effective for analysis of projects that have varying investment levels or of projects that have capital constraints. A profitability index of greater than one indicates value addition; or a profitability index of less than one indicates value loss.

Decision Criteria

• Accept projects with PI > 1.
• Reject projects with PI < 1.
• An Investment with high PI indicates high efficiency.

For example, a PI of 4 indicates that an investment of 1 dollar produces benefits of 4 dollars.

Comparative Analysis

Project Comparison

Considering the analyses of the three project options, all three investments are considered worthwhile, as all three options have values of positive NPV, IRR above the threshold, a payback period of less than two years, and a PI greater than one. However, some value and efficiency creation differences are evident. The second project is able to generate monetary returns quickly with the highest IRR of 91.48 percent and a payback period of 1.14 years. Additionally, the third project shows a high potential for return with an IRR of 33 percent and an NPV of $33 million.

Value creation through Project A is the most evident with an NPV of $44.26 million and a PI of 5.43. Considering the value creation perspective, if the NPV is the measure of the positive contribution of the business to the wealth of the shareholders, then Project A positively influences the company results in a remarkable way. As Sureka et al. (2022) stated, compared to the other capital budgeting tools, the NPV method is the most appropriate one for evaluating the effectiveness of an investment from a wealth creation perspective. Ultimately, Project A shows effective capital creation, as a one-dollar investment in the project will generate a return of $5.43. Even with Project B’s competitive payback period and percentage return, the $22 million wealth creation value of Project A far outweighs it.

• Recommendation

Of all the options evaluated, Project A – Major Equipment Purchase is the best choice, as it is likely to create significant shareholder interest, as well as resultant organizational financial benefit. Project A has the highest NPV ($44,262,269); the creation of shareholder interest and enhanced organizational financial benefit will be made easier by this positive NPV (Sureka et al. 2022). Project A has a profitability index of 5.43. This means, compared to Projects B and C, Project A is likely to be a better use of the company’s resources. Project A has the lowest (79.79%) of the internal rates of return compared to Projects B and C; however, Project A still has a significantly improved return of 8% when compared to the expected rate of return and an extremely high rate of return compared to the required rate of return. Consequently, for the next eight years, ABC Healthcare Corporation will be able to lower the cost of sales by increasing operational effectiveness.

Project Evaluations

• Project A: Major Equipment Purchase

An investment of $10 million will be done for equipment for Project A. Sales cost savings of 5 percent can be achieved each year over 8 years. The project will also benefit from MACRS depreciation over 7 years and will have a salvage value of $500,000. Because the project has low risk, the required return will be set at 8%. The outcome of the project will be considered great from capital budgeting since the NPV will be $44.26 million. Since the IRR will be 79.79% and the required return is 8%, the project will be considered very profitable. A project with a profitability index of 5.43 shows that for every dollar invested, the project will yield a return of great benefit. The purchase of the equipment for the project will lower the expenses over the years.

Financial Performance

• Net Present Value:$44,262,269
• Internal Rate of Return:79%
• Payback Period:36 years
• Profitability Index:43

• Project B: Expansion Into Three Additional States

Project B will open three new locations. It will cost $7 million for the firm to establish each site and an additional $1 million for working capital. With an increase in estimated sales and cost of sales, there will be an annual growth of 10% over the next five years. Due to the project risks, the expected project return will be 12%. After evaluating profitability and liquidity, Project B is most advantageous because of the high value of the IRR at 91.48%. Project B will be the most lucrative of the three projects because of the lowest estimated payback period of 1.14 years. Project B also has substantial disadvantages, the most apparent being that, with a net present value of $22.26 million, it is the lowest of the three projects. With the benefits of Project B, it has become clear that the other projects hold more value.

Financial Performance

• Net Present Value:$22,259,712
• Internal Rate of Return:48%
• Payback Period:14 years
• Profitability Index:78

• Project C: Marketing/Advertising Campaign

Project C includes a marketing and advertising program with a budget of $2 million a year for six years. This program is expected to increase annual sales and revenues by 15%. Project C has a medium risk classification and is expected to yield a 10% return on investment. The risk of the project is justified with a satisfactory net present value of 33.47 million dollars and an internal rate of return of 90.36%. The short payback period of 1.23 years and a profitability index of 4.84 demonstrate recovery of the cost of this project in a short period of time; therefore, the project is financially justifiable. Non-financial factors that will be considered include the building of brand equity and the development of a competitive edge in the market. This project, however, will not be as favorable in increasing shareholder wealth as Project A.

Financial Performance

• Net Present Value:$33,470,904
• Internal Rate of Return:36%
• Payback Period:23 years
• Profitability Index:84

A Guide for All Stakeholders

Capital budgeting criteria enable both financial and non-financial personnel to compare and contrast investments. The net present value for the ABC Healthcare Corporation accounts for the value of the benefits of the investment projects, considering the company’s resources, the associated risks, and the time value of money. Thus, Project A’s net present value of $44.26 million will improve the company’s financial position, as the value will increase by $44 million. The internal rate of return assesses the return on investment (ROI) as a percentage. For Project B, the internal rate of return is 91.48 percent. This indicates that Project B will be productive, as the return will exceed 12 percent on a yearly basis. The payback period determines how many periods will elapse before the initial investment is returned. For Project B, this is 1.14 years. The payback period assesses how well the investment has been utilized. For Project A, this is 5.43, indicating that the project is highly productive, as a one-dollar investment yields five dollars of present value benefits. A comparison of the three projects will indicate that Project A is the most productive and efficient project. Although Projects B and C are more productive, with higher returns and shorter payback periods, Project A is the most valuable project.

Conclusion

The examination of all three capital budgeting decisions concludes that each provides cash inflows sufficient to make a profit. It is also clear that the three capital projects each have positive NPVs, high IRRs within the acceptable range, short paybacks, and profitability indexes above 1.0. However, it is the purchase of Major Equipment (Project A) that is expected to have the most benefit to the company. Project A’s NPV of $44,262,269 is the highest, as is the profitability index of 5.43, which also indicates that the project will be profitable since the IRR is far above the required rate. Additionally, Project A will, from cost savings in the sales function, have a positive impact on the efficiency of the operation. Based on the above, Project A will be selected for ABC Healthcare Corporation.