MBA FPX 5014 Assessment 2 Evaluation of Capital Projects
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Executive Report
This evaluation of capital projects provides an analysis of the suitability of three potential capital investments to determine which project Drill Tech, Inc. should pursue. The analysis uses capital budgeting tools to evaluate three projects: a major equipment purchase, an expansion into Europe, and a marketing/advertising campaign. By assessing the incremental changes to cash flow, it was determined that the net present value (NPV) for the major equipment purchase was 28.77, the NPV for the expansion into Europe was 17.1, and the NPV for the marketing/advertising campaign was 32.4. Based on this evaluation, the marketing/advertising campaign was identified as the most profitable capital project over time.
Evaluation of Capital Projects
Drill Tech, Inc.
Drill Tech, Inc. is a mid-sized manufacturing company headquartered in Minnesota (Saunders, 2000). For the upcoming fiscal year, three capital projects were identified for Drill Tech, Inc. to consider. A capital project refers to a long-term initiative aimed at improving, building, maintaining, or developing a capital asset for the company (Marshall, McManus, & Viele, 2017). Such projects often require significant investments that occur consistently over the project’s duration (Brigham & Houston, 2012).
Given the ongoing and potentially substantial investment involved, it is essential for Drill Tech, Inc. to determine which project will provide the greatest shareholder value upon completion. Shareholder value (SV) refers to the intrinsic value that a shareholder gains by owning a share of the company. For publicly traded companies, SV forms part of the equity, alongside long-term debt, and contributes to overall capitalization (Saunders, 2000). As a company grows more valuable through increased earnings, SV rises, enhancing the company’s overall worth (Gibson & Dunn, 1989). Therefore, identifying which of the three projects will most effectively increase shareholder value is critical in deciding which project Drill Tech, Inc. should pursue.
Capital Projects Backgrounds
Project A: Major Equipment Purchase
The first potential project involves purchasing major equipment, including heavy machinery that would enhance manufacturing processes. The initial investment for this equipment is $10 million, with an expected benefit of reducing the cost of sales by 5% per year over eight years. Additionally, the equipment is projected to have a salvage value of $500,000 at the end of the eight-year period.
Due to the relatively lower risk of this investment, the required rate of return is set at 8%, and the equipment will be depreciated using the Modified Accelerated Cost Recovery System (MACRS) over a seven-year schedule. Within the MACRS framework, fixed assets are assigned to specific classes, each with corresponding depreciation schedules defined by the Internal Revenue Service (IRS, 2019). For this project, the seven-year depreciation schedule applies because the equipment falls under the “most machinery” category.
| Class | Typical Assets | Depr. Method |
|---|---|---|
| 3-year | Small tools, tractors, horses, specialized mfg. devices. | 200% Decl. Bal. |
| 5-year | Computers, autos, light trucks, small aircraft. | 200% Decl. Bal. |
| 7-year | Office furniture, fixtures, commercial aircraft, machinery. | 200% Decl. Bal. |
| 10-year | Specialized heavy mfg. machinery, mobile homes. | 200% Decl. Bal. |
| 15-year | Billboards, service station buildings, telePhone equipment. | 150% Decl. Bal. |
| 20-year | Sewer pipes, utility property, land improvements. | 150% Decl. Bal. |
| 27.5 year | Residential real estate property. | Straight Line |
| 31.5 year | Office/non-residential real estate property. | Straight Line |
Table 1. MACRS Depreciation and Classes
The business is projected to have sales of $20 million in the first year, maintaining this level annually over the eight-year period. Initially, the cost of sales was 60%, which the 5% reduction will lower to 55% annually. The marginal corporate tax rate for this project is assumed to be 25%, which is critical to consider when planning to account for post-tax income (Brigham & Houston, 2012).
Project B: Expansion into Europe
The second potential project involves expanding Drill Tech, In