Running head: DRILL TECH

Evaluation of Capital Budgeting: Drill Tech

Name:

Institution:
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Drill Tech is a medium-sized manufacturing company, based in Minnesota. The

company’s management wishes to invest in a project but first needs to understand the risks and

returns involved. The objective of this paper is to examine the available options to arrive at the

most optimal decision.

The three investment options

The first investment option is the purchase of major equipment for $10 million. After

purchasing the equipment, Drill Tech will reduce the cost of sales by 5% annually. The

equipment will be used for 8 years, after which it will be disposed for $500,000. This investment

has a required rate of return of 8%, implying that the project is less risky. This project will be

evaluated as per MACRS 7-year schedule and the projected annual sales is $20 million. Cost of

sales account for 60% of total sales. The returns from the investment will be charged at a

marginal corporate rate of 25%.

The second investment option is expansion into Europe. It is common for firms to enter

foreign markets to generate more business and revenue. Entry into the global market also gives a

firm access to a larger customer base and better talent. In this case, Drill Tech will incur $7

million in costs and a net working capital of $1 million. The annual sales remain at $20 million

while the cost of sales is 10%. This project will last for 5 years, after which the working capital

will be recovered. During the project’s life, the income will be charged at a marginal corporate

tax rate of 30%. The required rate of return of this project is 12%.

The last option is starting a marketing campaign, at a cost of $2 million per year. In any

company, marketing is important in generating aggregate demand for product or service.

Marketing also helps the company to establish positive relationship with customers. This project
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will last for 6 years and sales/ cost of sales will increase by 15% annually. The annual sales and

marginal corporate tax rate is $20million and 25% respectively. This project is moderately risky

as the required rate of return is 10%.

Application of capital budgeting

The decision-making process will employ capital budgeting, which useful in choosing the

most profitable investment option. It is also useful in maximizing shareholder value and

determineing which project should be accepted or rejected. Capital budgeting approach was used

because the three investment options require huge financial resources. Choosing the wrong

project could end up negatively affecting Drill Tech in a great way. Besides incurring huge

losses, making wrong investment decision negates the goal of the company, which is to

maximize shareholder value.

Capital projects can be independent, mutually exclusive, or contingent. An Independent

project does not influence the acceptance or rejection of another. In this case, all these three

projects are independent of each other. As such, they will be evaluated separately and the

decision will be made depending on their impact. On the other hand, mutually exclusive projects

cannot be carried out at once. For instance, leasing a building and buying land to establish a

wholly-owned store are mutually exclusive projects. Finally, the implementation of a contingent

project depends on other factors. For instance, the establishment of an organic food store could

be contingent on finding a farm to grow the crops.

Capital budgeting adheres to a number of standards, one of which is that the sunk costs

are ignored. The sunk costs are not considered when evaluating a project’s viability. Second,

there are cash flow considerations whereby cash received earlier is more valuable. Third, tax
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payments are not taken into consideration when assessing a project’s profitability. Finally, the

capital budgeting process does not take into account the financing costs.

Net present value

It is the present value of cash flows minus initial investments. NPV is the goal standard in

financial analysis and investment decision-making. A project with NPV greater than 0, should be

accepted because the costs are less than benefits. Conversely, if the NPV is less than 0, the

project should be rejected. The first driver in NPV calculation is the cash flow resulting from the

investment. The aim of the project is to generate as much cash flow as possible. The second

driver is the timing of the project. The longer the cash flow delays before it is realized, the deer it

gets discounted. The last driver is the discount rate which is the cost of borrowing money. A high

discount rate leads to lower NPV and vice versa.

The obvious advantage of NPV is that it appreciates the time value of money. Second, the

NPV determines the profitability of a project in terms of dollars. Also, it considers the cost of

capital and the risks involved in the implementation of a project. It does this by placing much

value on cash flows that are realized earlier than cash flows that occur in future. On the flipside,

NPV requires guesswork about a firm’s cost of capital. If the estimation is not correct, then it

could lead to suboptimal investment decisions. Also, NPV is not suitable for comparing two

projects of different sizes.

Payback period

The second technique is payback period which is the time taken to recoup the initial

investment (Adelaja, 2015). A firm should accept a project if its payback period is less than a

predetermined cutoff period. This tool is suitable for small companies that are facing liquidity
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problems. Such companies would want to recover the initial investment as soon as possible. The

payback period is easy to understand and it tends to favor projects that return large early cash

flows. The ease of use and interpretation of payback period makes it suitable for making capital

budgeting decisions. However, it ignores the time value of money and does not take into account

cash flows that are generated after the payback period.

Profitability ratio

The third technique is the profitability ratio, which is the number of times a project’s net

cash flows cover the initial investment (Blokdyk, 2019). A project is chosen if its profitability

index is more than 1 but rejected if the index is less than 1. When dealing with more than two

projects, one should choose the one with the highest profitability index. Profitability index is

advantageous since: it is easy to use, accounts for risk, considers the time value of money, and

takes into account all the cash flows. However, profitability index involves estimation of cost of

capital and cash flows. Also, profitability index is not effective when dealing with mutually

exclusive projects of different sizes.

Internal rate of return

The fourth tool is the internal rate of return, which is the discount rate that makes all cash

flows zero (Blokdyk, 2019). Upon obtaining the IRR, it is then compared to the hurdle rate or the

required rate of return. A project is accepted if the IRR is greater than the hurdle rate.

Conversely, a project is rejected if the IRR is less than the hurdle rate. In other words, a firm

should only invest in a project whose IRR is higher than the opportunity cost of capital. One of

the main advantages of IRR is that it takes into account the time value of money and it measures

profitability. However, it is ineffective when handling projects with unconventional cash flows.
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Other techniques

The fifth tool is the accounting rate of return (ARR), which also referred to as the average

rate of return (Baker, 2011). A project is accepted if its ARR is greater than the required rate of

return. Finally, there is discounted payback period, which is used when the life span of a project

is not clear. A project is accepted if the discounted payback period is less than its economic life.

The results of capital budgeting

In Project I (purchase of equipment) the following results were obtained:

Net present value Internal rate of return Profitability index

$29,183,703.2. 67.55% 3.92

Table 1: Project I (purchase of equipment)

Based thee results above, the NPV was greater than 0, hence the project is acceptable.

The internal rate of return of 67.55% was greater than the hurdle, hence the project is viable.

Finally, the profitability index was greater than 1; hence, Drill Tech should accept the project.

Net present value Internal rate of return Profitability index

$14,772,848.26 73% 2.85

Table 2: Project II (expansion into Europe)

Based on table II above, expanding into Europe is an acceptable venture since the NPV is

greater than 0 and IRR is greater than the required rate of return of 12%. Similarly, the

profitability index is greater than 1, making the project even more viable.

Net present value Internal rate of return Profitability index

$22,365,848.26 270% 12.18

Table 3: Project III (marketing campaign)

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The last project had the highest internal rate of return and profitability index. However,

Project II has a lower NPV than Project I.

Conclusion

Project II had the lowest profitability index and NPV; hence, it was eliminated. The

choice between Project I and III was decided using the NPV criterion. NPV was given priority

because it is more reliable when ranking investments. Unlike IRR, NPV takes into account the

total yield of an investment. Given that Project I (purchase of equipment) had the highest NPV,

Drill Tech should settle for this investment option.

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References

Baker, H. & English, P. (2011). Capital Budgeting Valuation: Financial Analysis for Today's

Investment Projects. John Wiley & Sons

Adelaja, T. (2015). Capital Budgeting: Investment Appraisal Techniques under Certainty. Create

Space Independent Publishing Platform

Blokdyk, G. (2019). Financial Discounting Techniques a Complete Guide. Emereo Pty Limited