A Report on Capital Projects

A Report on Capital Projects

Keeping tabs with the stiff competition witnessed within the contemporary world’s business environment drives organizations into allocating a significant amount of capital for investment purposes. The investments may include modification, addition or replacement of an organization’s fixed asset, and staring a new product line, among other reasons. These kinds of projects are always known as capital projects. Capital projects are large scale investments that demand a significant and consistent flow of investment for a long-term economic gain (Bhawani et al., 2018). The viability of these projects always depends on efficient and effective coordination of all the elements involved within the project, given their complex nature. The goal of this report is to present an extensive analysis and comparison of three capital projects, including project A, project B, and project C, to determine the most viable alternative that will maximize shareholders’ value. Organizations are expected to utilize the various capital budgeting tools to gauge further the viability of each project they plan to undertake.

The conception of capital projects begins with the identification of an opportunity that can result in profits if well executed. Detail-oriented specialists then analyze every element involved within the project and utilize the capital budgeting tools in gauging the viability of these projects before implementation. Not only businesses engage in capital projects, but government organizations too also engage in capital projects through public funding.

Capital projects involving public funding are investments undertaken by the government aimed at benefitting the community. Examples of projects that may be involved in this include those that involve the development of infrastructure and social amenities. Though capital projects are costly, they are always necessary for businesses and governments as they always help in ensuring these organizations keep tabs with the emerging trends and create value for the stakeholders involved (Bhawani et al., 2018).

For the case of this report, Drill Tech Inc. is considering three alternative capital projects for investment. It the first alternative, project A, it considers purchasing major equipment costing $10million, which would reduce the cost of sales by 5% per year for its eight years lifespan. It is to be sold at a salvage value of $500,000. In the second alternative, project B, it is considering expanding its operations into Western Europe where it expects to spend $7 million is starting up the project and allocate an additional $1 million as upfront working capital. The project is to be evaluated for five years. The last alternative is a six-years marketing campaign, which is to cost $2 million per year. The objective is to establish the most profitable alternative.

Capital Budgeting Process and Tools Utilized

Capital budgeting is essential in ensuring a conceived capital project is successfully implemented. It utilizes different techniques and tools in evaluating the viability of various investment opportunities at hand. Capital budgeting involves multiple stages. These stages include project identification, project screening and evaluation, project selection, project implementation, and project performance review.  Project identification consists of the identification of a viable opportunity.

Project evaluation involves analyzing the cash inflow and outflow to be involved in a specific project, as well as the risks and uncertainties associated with the project (Srithongrung et al., 2019). Project selection involves selecting a particular project that is more aligned to the organization’s goal of maximizing its market value. Project implementation requires timely completion as well as active and effective monitoring and coordination of all elements involved. Additionally, performance review entails a comparison of actual results with the forecasted results and making adjustments where necessary.

Various capital budgeting tools have been used to evaluate and select viable capital projects. The financial metric tools include profitability index (PI), net present value (NPV), internal rate of return (IRR), and payback period. Payback period refers to the duration which a project takes to recover the initial amount of investment. The payback period considers the economic life of a project and the cash inflows that are be included within the project.  Through the payback period, consideration of projects is based on their earning capacity. However, it does not consider the time value of money since it is based on thumb rule. Projects with the shortest payback period are generally more profitable than those with a long payback period. A project whose payback period exceeds the project life is not worth investing in due to high costs.

The net present value technique is one of the widely used capital budgeting techniques. It involves discounting cash flows at a specific rate. In every proposed project, the expected cash flows at regular intervals are always predicted. It utilizes the predicted periodic cashflows. The discounted cash flows are then summed up. The net present value is then obtained by subtracting the value obtained from the summation of discounted cash flow from the initial capital outlay.

Typically, projects with a positive value are preferred over those that result in a negative value. The discounting rate is crucial in ensuring an accurate evaluation of the project at hand. For this reason, selecting the appropriate discounting rate is a major huddle (McCartney, Pierce & Mackie, 2016). Any discounting rate selected must always reflect the risk involved within a project as well as consider the different elements of financing mix involved.

The internal rate of return is the rate at which the net present value of an investment at hand is zero. It is the rate at which the discounted cash inflow equals the discounted cash outflow. It is majorly used in measuring the efficiency of a project. Usually, projects with the highest internal rate of return are always more attractive since they project higher incomes.

The profitability index is the ratio of payoff to the investment of a proposed project. It is a critical capital budgeting tool as it allows for quantification of the amount of value created per investment. It is the ratio of the present value of future cash flows at the required rate of return to the initial capital outlay of the investment (McCartney, Pierce & Mackie, 2016).

Evaluation of the Capital Projects

Four capital budgeting tools, including net present value, internal rate of return, payback period, and profitability index, were used to evaluate the three alternative projects. These four metrics align with the business goals of maximizing profits in various ways. While net present value, internal rate of return, and profitability index are used to estimate the profitability of a potential investment, the payback period is a metric used to determine how long it can take to recover investment costs. Applying the four metrics is critical in affirming the viability of a potential investment.

In project A, the company was considering purchasing major equipment that would cost $10 million and reduce the costs of sales by 5% annually for eight years. Metric analysis after considering earnings from the decrease in costs of sales, depreciation tax shield, and salvage value after-tax, reveal that the project had a total present value of $4,703,869.54 with a net present value of negative $5,296,130.46. The negative NPV shows that the present value of the cost exceeds the present value of incomes, which points to projected loss at the assumed discounting rate.

The IRR of -16% and profitability index of 0.47 confirms that the project’s present value is lower than its projected costs. Throughout the eight-year investment period, the cashflows do not break-even with the cumulative cashflows reading negative $3,525,000 by the end of year eight. As such, its payback period goes beyond the eighth year.

The second proposed project, Project B, focused on expanding the business to Western Europe with a projected startup cost of $7 million and an upfront working capital of $1 million. For the five years of the projected operation, the investment will have a net present value of negative $2,301,269.42, IRR of -11%, and a profitability index of 0.67. The three metrics project that the investment will not maximize shareholders’ profits. Its payback period also exceeds the five years investment period pointing to the fact that the investment will take longer to break-even.

In the third project, project C, the company focused on carrying out an advertising campaign for six years at the cost of $2 million per year. Metric analysis reveals that the project has a net present value of negative $381,085.31, IRR of -1%, profitability index of 0.96, and a payback period of 4.6 years.

Comparison of Projects

The metrics for the three projects are summarized in the table below.

Table 1: Analysis Results

From the analysis, all the projects reported a negative net present value irrespective of the amount invested. Although this might instigate an argument that the three projects are bad for investment since the money earned from them today is less than the costs, the actual discounting rate can always fluctuate in their favor. However, Project C had the highest net present value compared to the other two projects, which indicates that it has the potential of generating the least loss or the maximum profits out of the three projects.

Additionally, it has the highest IRR compared to the other projects, showing that it has the potential of being highly profitable. While projects A and B have a payback period which exceeds their life, project C has the potential of taking 4.6 years or four years seven months of its 6-years lifespan to break-even, showing that it might be profitable in the long run. Its profitability index of 0.96, which is approximately 1, shows that the project will break even. Projects A and B, given their PIs, are to take longer than the anticipated projects’ lives to break-even.

Selection of the Best Capital Project

Holding to the rule that higher NPV, IRR, and PI, and lower payback period are indicators for higher profitability, it can be projected that purchasing the major equipment (Project A) will be the least profitable, followed by expansion into Western Europe (Project B), while advertising campaign (Project C) is the most profitable. Project A has the lowest NPV, IRR, and PI, which also envisage greatest losses.

Therefore, Drill Tech Inc. should opt for the advertising campaign (project C), which will cost $2 million per year for five years. The present value of the initial investment is $8,710,521.40. The company should expect the following cash flows from the investment;

Table 2: Cash Inflows for Project C

Despite having the least negative NPV, Project C still has the potential to generate profits. There might need to double-check the estimated costs and establish ways to economize them. Additionally, the company might achieve profits by revisiting and revising the assumed discounting rate and ensure that it is consistent with the going market rates. Finally, it might also consider finding better opportunities to enhance the marketing campaign in a manner that would generate more profits.

Conclusion

The focus of this report was to analyze three investment projects and pinpoint the one that would maximize the shareholders’ value. Four financial metric tools, including net present value, internal rate of return, payback period, and profitability index, were considered for the analysis. As shown in the excel spreadsheet, the analysis began by determining cash flows for each investment alternative, followed by calculations for each metric. The analysis reveals that Drill Tech Inc. has a greater potential to earn more from project C than any other project. Project A has the lowest NPV, IRR, and PI, proving that it is the most inappropriate alternative to consider. The same values were highest in project C. There is a higher risk that even project C might still land the company into losses despite reporting the least negative NPV. It would need to consider ways to cut the projects’ costs, boost revenues, or adjust the discounting rate to ensure that the project generates profits in the long-term.

References

Bhawani, S., Leicht, R., Taylor, J., & Humphrey, S. (2018). Organizational routine-matching in the delivery of capital projects. Construction Research Congress, 2018. https://doi.org/10.1061/9780784481271.071

McCartney, M. W., Pierce, E. M., & Mackie, W. (2016). The bus decision: A case study employing capital budgeting and creative thinking. Journal of Business Case Studies (JBCS), 12(4), 169-176. https://doi.org/10.19030/jbcs.v12i4.9794

Srithongrung, A., Yusuf, J..,& Kriz, K. A. (2019). A systematic public capital management and budgeting process. Capital Management and Budgeting in the Public Sector, 1-22. https://doi.org/10.4018/978-1-5225-7329-6.ch001