Drill Tech, Inc., is a manufacturing company located in Minnesota. The company has three project requests for the upcoming fiscal year. Capital projects require large capital flows to be completed and require huge sums of money because they are large scale (O’Conner et al., 2016). When analyzing capital projects, one of the critical factors to consider is the Net Present Value (NPV). Other factors that can be considered include the internal rate of return (IRR), the payback period, and the probability index. This report analyzes the different capital projects for Drill Tech Inc. It shows that Project C, which involves a marketing/advertising campaign, is the best choice as it has the best NPV, IRR, payback period, and profitability index.
Definition of Capital Budgeting Tools
The purpose of capital budgeting is to compare different proposed projects that may not be similar. An accurate comparison will involve capital budgeting calculations on various factors such as the net present value, the internal rate of return, profitability index, and payback period (Gul, 2018). The net present value provides an overview of the difference between the current value of cash inflow and cash outflows over a given period. An NPV greater than zero should be accepted, and one that is less than zero should be rejected. A positive NPV is highly desirable as it will benefit stakeholders.
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The internal rate of return (IRR) is a metric that analyzes how profitable an investment is going to be. It provides an overview of the growth rate expected in an investment (Patrick & French, 2016). A higher IRR is desirable and shows that a specific investment option is better. The IRR is usually calculated using a net present value of zero and using the expected cash flows.
The profitability index (PI) is a ratio that determines the best returns on investment. The index provides a ranking of projects based on the value created per unit. It provides an overview of the current value of future cash flows per every dollar invested. The higher the PI, the better the value of a project. A profitability index that is higher than 1.0 is the lowest acceptable value since one that is lower than 1.0 indicates that the present value is than the initial investment. The profitability index was calculated using the following formula.
Profitability index = (Net Present Value + Initial Investment)/Initial investment
The payback period is a method that calculates the amount of time it will take for an investment to recover its initial capital. The method is based on the fact that capital budgeting highly relies on the time value of money by considering the profitability and the additional cash flows after the initial capital has been paid back. The lower the payback period, the better the value of the project. The payback period was calculated using the following equation.
Payback period = cost of the investment/ annual cash flow
Each of the given tools cannot be singlehandedly relied upon to determine a project's acceptance or rejection. Depending on the NPV alone can result in poor judgment about where to invest as different projects may have different return rates (Siziba & Hall, 2019). Using the various capital budgeting tools will provide a complete overview of a project's profitability and cost.
Analysis of the Projects
Project A – Major Equipment Purchase
The project involves purchasing equipment worth $10 million that should be used for about eight years. The equipment will be sold for $500,000 at the end of the eighth year. The analysis of the project showed that it requires the most upfront investment. The project also presents the least risk by replacing equipment. The project also lowers the cost of sales by 5% but does not offer a substantial increase in revenue compared to the previous years.
Project B – Expansion into Europe
The project involves expanding into Europe with a startup cost of about $7 million and an upfront investment of $1 million. The cost of sales and revenues are expected to increase by 10% every year for the next five years. The project is risky with a required rate of return is 12%. The given project will increase sales/revenue. However, it is also expected that there will be a higher tax and an increase in the cost of sales. The increased costs could be caused by corporate regulations, compensations, employment, and new transport costs. The advantage of the project is that it has a low initial investment compared to project A.
Project C – Marketing/Advertising Campaign
The project has the least initial costs and will only cost $2 million per year for the next six years. It is expected that the cost of sales and the sales/revenues will go up by 15% every year. It is a moderately risky project with a rate of return of 10%. Project C appears the best option since it does not require a considerable upfront investment, but the investment is spread throughout the six years. The project also offers the largest increase in sales for the three projects. However, the project is risky as the company will not recover any capital in an unsuccessful marketing campaign.
Capital Budgeting Analysis
The different projects were analyzed for the specific periods they were expected to run. The values of the NPV, IRR, PI, and payback period were shown in table 1.
Table 1. Comparison of NPV, IRR, PI, and payback period
| Project A | Project B | Project C | |
| Net Present Value | $29,251,236.81 | $14,772,848.26 | $18,470,248.55 |
| Internal Rate of Return | 67.56% | 72.56% | 269.89% |
| Profitability Index | $3.93 | $2.85 | $10.24 |
| Payback period | 1.47 years | 1.30 years | 0.37 years |
A positive NPV is usually a key consideration in a project, and the project with the highest NPV is considered the best. Project A has the highest NPV of $29,251,236.81, followed by project C of $18,470,248.55 and project B of $14,772,848.26. However, the NPV is not the only factor to be considered. The IRR of project C is the highest at 269.89%, followed by project B at 72.56%, and project A at 67.56%. Project C's profitability index is also the highest at $10.24, followed by project B at $2.85, and project A at $3.93. The payback period of project C is also the least as it is 0.37 years. Project B follows with 1.30 years and project A with 1.47 years. From the analysis, project C has the highest IRR, PI, and payback period and the second-highest NPV. Project A has the highest NPV but the least IRR, profitability index, and payback period.
Recommendation
The finance department aims to undertake a project that will provide the most shareholder value to the company. Project C appears to be the project that outperforms other projects in the capital budgeting analysis. The project's internal rate is higher than all the other three projects by about 200%, suggesting that it will produce the highest growth rate for the investment. Project C was also chosen over Project B because it offers a higher NPV. However, one of the concerns with the choice is that Project C has a smaller NPV compared to Project A. The difference in the NPV is approximately $11 million. The amount may diminish when one considers that the use of additional machinery may require maintenance, extra space, and employee training. Additionally, the payback period of project C does not provide a clear overview of the payback time. The project requires an investment of $2 million every year, resulting in a higher overall payback time.
Project A also has a significant upfront investment of $10 million that significantly affects the profitability from the first year. Project C provides a steady inflow of cash and outflow throughout the years that eh project will be in operation. Project C also predicts an increase in revenues by 15% but project A does not provide any improvement in revenues or sales. An increase in revenue could result in an increase in the value of the company which increases shareholder value. The added advantage of Project C is that it is a readily available option that can be implemented in a very short amount of time. Project A and B may require a significant amount of preparation and can be difficult to implement. The projects also require huge initial investments which can be freed up in case project C is selected.
Conclusion
Comparing the different projects by using capital budgeting tools showed that Project C would be the best option to increase shareholder value. The marketing/advertising campaign is expected to acquire new clients that could be long-term business partners. The increase in annual sales is likely to increase shareholder value. The project also has additional advantages of having the highest internal rate of return, profit index, and payback period. However, Project C appeared less superior to Project A as it had a low NPV. The advantages of other factors outweigh the only benefit of Project A. The use of a marketing/advertising campaign is the best choice for the company's growth and to increase shareholder value.
References
Gul, S. (2018). The review and use of capital budgeting investment techniques in evaluating investment projects: Evidence from manufacturing companies listed on Pakistan stock exchange (PSE). City University Research Journal , 8 (2).
O’Connor, J. T., Choi, J. O., & Winkler, M. (2016). Critical success factors for commissioning and start-up of capital projects. Journal of Construction Engineering and Management , 142 (11), 04016060. https://doi.org/10.1061/(ASCE)CO.1943-7862.0001179
Patrick, M., & French, N. (2016). The internal rate of return (IRR): projections, benchmarks and pitfalls. Journal of Property Investment & Finance .
Siziba, S., & Hall, J. H. (2019). The evolution of the application of capital budgeting techniques in enterprises. Global Finance Journal , 100504.
