Question

Create an Excel spreadsheet in which you use capital budgeting tools including net present value (NPV), internal rate of return (IRR), payback period, and profitability index (PI) to determine the quality of 3 proposed investment projects, as well as an analysis of your computations and recommends the project that will bring the most value to the company. The analysis of the capital projects will need to be correctly computed and the resulting decisions rational.

Scenario

You work as a finance manager for Drill Tech, Inc., a mid-sized manufacturing company located in Minnesota. Three capital project requests were identified as potential projects for the company to pursue in the upcoming fiscal year. In the meeting to discuss capital projects, the director of finance (and your boss), Jennifer Davidson, gives you a synopsis of the projects along with this question: Which one of these projects will provide the most shareholder value to the company?

She also tells you that other than what is noted in each project scenario, all other costs will remain constant, and you should remember to only evaluate the incremental changes to cash flows.

The proposed projects for you to review are as follows.

Project A: Major Equipment Purchase

• A new major equipment purchase, which will cost $10 million; however, it is projected to reduce cost of sales by 5% per year for 8 years.
• The equipment is projected to be sold for salvage value estimated to be $500,000 at the end of year 8.
• Being a relatively safe investment, the required rate of return of the project is 8%.
• The equipment will be depreciated at a MACRS 7-year schedule.
• Annual sales for year 1 are projected at $20 million and should stay the same per year for 8 years.
• Before this project, cost of sales has been 60%.
• The marginal corporate tax rate is presumed to be 25%.

Project B: Expansion into Europe

• Expansion into Western Europe has a forecast to increase sales/revenues and cost of sales by 10% per year for 5 years.
• Annual sales for the previous year were $20 million.
• Start-up costs are projected to be $7 million and an upfront needed investment in net working capital of $1 million. The working capital amount will be recouped at the end of year 5.
• Because of the higher European tax rate, the marginal corporate tax rate is presumed to be 30%.
• Being a risky investment, the required rate of return of the project is 12%.

Project C: Marketing/Advertising Campaign

• A major new marketing/advertising campaign, which will cost $2 million per year and last 6 years.
• It is forecast that the campaign will increase sales/revenues and costs of sales by 15% per year.
• Annual sales for the previous year were $20 million.
• The marginal corporate tax rate is presumed to be 25%.
• Being a moderate risk investment, the required rate of return of the project is 10%.

Answer 1

Project C will provide the most shareholder value to the company

Project A
	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8
Reduction in cost of sales	600000	600000	600000	600000	600000	600000	600000	600000
Depreciation @8.93%	893000	813255.1	740631.4	674493	614260.8	559407.3	509452.2	463958.2
	-293000	-213255	-140631	-74493	-14260.8	40592.68	90547.76	136041.8
Cash Flow	0							500000
tax	0	0	0	0	0	10148.17	22636.94	34010.46
Incremental Cash Flow	600000	600000	600000	600000	600000	589851.8	577363.1	1065990
Dis Factor	0.9259259	0.857339	0.793832	0.73503	0.680583	0.63017	0.58349	0.540269
	555555.56	514403.3	476299.3	441017.9	408349.9	371706.7	336885.8	575921
PV of Inflow	3680139.5
PV of Outflow	-10000000
NPV	-6319860
Project B
	Year 1	Year 2	Year 3	Year 4	Year 5
Total Profit	13200000	14520000	15972000	17569200	19326120
Increase in Profit	1200000	2520000	3972000	5569200	7326120
Increase in Profit after tax	840000	1764000	2780400	3898440	5128284
Working capital release					1000000
Cash inflow	840000	1764000	2780400	3898440	6128284
Dis Factor	0.8928571	0.797194	0.71178	0.635518	0.567427
PV of Inflow	750000	1406250	1979034	2477529	3477353
PV of Inflow	10090166
PV of Outflow	-8000000
NPV	2090166
Project C
	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Total Profit	13800000	15870000	18250500	20988075	24136286	27756729
Increase in Marketing cost	2000000	2000000	2000000	2000000	2000000	2000000
Increase in Profit	-200000	1870000	4250500	6988075	10136286	13756729
Increase in Profit after tax	-200000	1402500	3187875	5241056	7602215	10317547
Cash inflow	-200000	1402500	3187875	5241056	7602215	10317547
Dis Factor	0.9090909	0.826446	0.751315	0.683013	0.620921	0.564474
PV of Inflow	-181818.2	1159091	2395098	3579712	4720377	5823986
NPV	11672460