Abstract
Project appraisal is where the cost benefit analysis of a particular project over the other is conducted to determine the more profitable venture to invest in. the hospital has two projects that are mutually exclusive and they require the financial accountant to come up with an appraisal technique that will enable them o invest wisely. The profitability index method, the evaluation of the rate of return and the net present value are all methods that can be used to give decision criteria that the managers can use to justify the project they chose. The rehabilitation center has been evaluated through the three methods and it has been found out that it is the better project since it has a higher profitability index, appositive net present value and a larger percentage of internal rates of return compared to the neonatal project. The project chosen will be the most profitable and most realistic as the methods of appraisal are derived from discounted cash flows.
Part 1
Capital budgeting is a branch of financial management that involves the pledging of lots of capital for long term fixed assets or projects. The benefits of this investment are not realized at once but accrue over a given series of time. Capital budgeting is based on the principal of forgoing current consumption of cash in the aim of obtaining future gains. The managers faced with capital budgeting decisions are faced with uncertainty and their decisions are of the permanent nature. They are face with the task of prioritizing financial resources. In the case of mutually exclusive projects the financial manager is faced with the task of deciding between two projects that have the same propose and can be viewed to substitute one another. One project can substitute the other in the case where the budget is tight. Capital budgeting procedures are the steps followed in the evaluation of any project before it is selected (Helfert, 2001).
The first step is to generate or come up with an investment proposal. This is mainly aimed at the increase of returns to any organization and various proposals are presented to the financial management team. The second step in the to estimate the future cash flows of the project and this is the forecasted estimates of the cash that is going to be received from this proposal. The reason why cash flows are preferred to accounting profits is because the cash flows are not affected by the accounting standards and hence consistent with the goals of the shareholder of wealth maximization. The third step in the evaluation of the project using the various project appraisal techniques. After this select and implement the project that is most viable to the organization. Continuous evaluation of the project is undertaken over the life span of the project and in case the project is not living up to the set standards a replacement decision has to be made while it is in use or at the end of its economic life. The method used in project appraisal should consider the time value of money by discounting the cash flows generated by the project and it should give a clear decision criterion on whether to accept or reject the project. The net present value, the return on investment and profitability index are the discounted cash flow methods that are utilized by the manager to evaluate the decision to either build a rehab center or build a neonatal wing. The net present value indicates the total present value of all expected cash flows from a projects net initial capital. The formulae used to calculate the net present value is:
N.P.V= {∑t=1nCt/ (1+r) n}-Io
Where Ct is the cash flows for the period, r is the discounting rate and n is the life span of the project. Io is the initial capital for this investment. The decision criteria under Net present value method is that the final product after substitution of the values in the above equation with the real values of each. In the case that the net present value will be a positive value, the project ought to be accepted. Net present value being a positive value means that the total present value is greater than the initial capital and thus the project is worth while. In case the net present value is negative, the project must be discarded because the net present value will be lower than the initial investment. When the net present value is zero the manager is indifferent because the net present value is equal to the initial cost of investment. In this case we have two mutually exclusive projects that are both have the positive net present values the one with the bigger value is chosen over the project with the smaller value. The project of a rehabilitation center is more profitable than the one of the neonatal wing and hence the rehabilitation center will be favored (Klammer, 2000).
Using the profitability index method for project appraisal, also called the cost benefit analysis method, this method show the amount of cash flow in the present value terms generated from every unit of money of the initial capital invested to the project. Profitability index is computed by dividing the total present value by the initial capital (Megginson, 2008).
Profitability index= total present value/initial capital
The decision criterion for this method is that if this value is greater than one the project should be accepted because it is profitable. If the value is less than one the project should be rejected and if the profitability index is zero the managers should be indifferent. The two mutually exclusive projects have positive profitability indexes so the project with the larger index is chosen over the one with the smaller index because the hospital lacks adequate funds to fund both projects (Brigham, 2011).
Rate of return on investment is also known as the internalized rate of return of each project independent of the other project. Internal rate of return is compared with the cost of borrowing capital to finance the project. Internal rate of return is the rate of return at which the net present value is zero. To accept a project under this criteria the internal rate of return must yield a percentage greater than the cost of capital. The formulae employed to compute internal rate of return is:
I.R.R=L +A-0 (H-L)
A+B
Where H is the higher discounting rate is the lower discounting rate producing negative N.P.V, A is the positive N.P.V, B is the negative N.P.V, the decision criteria Under internal rate of return is accept the project if the rate is greater than cost of capital, reject a project whose rate is lower than the cost of capital and indifferent if the rate is equal to the cost of capital the rehabilitation project has a larger rate than the neonatal clinic hence it should be preferred. Overall the rehabilitation project is the better of the two and thus it should be preferred over the other (Brigham, 2009).
References
Brigham, E. F., & Houston, J. F. (2009). Fundamentals of financial management. Mason, OH: South-Western Cengage Learning.
Brigham, E. F., & Ehrhardt, M. C. (2011). Financial management: Theory and practice. Australia: South-Western Cengage Learning.
Helfert, E. A. (2001). Financial analysis: tools and techniques: A guide for managers. Boston [etc.: McGraw-Hill.
Klammer, T. P., Ansari, S. L., & Bell, J. (2000). The capital budgeting process. Burr Ridge, Ill.: Irwin McGraw-Hill.
Megginson, L, & Smart, Scott B. (2008). Introduction to Corporate Finance + SMARTMoves + Thomson ONE. South-Western Pub.
Part 2
The equipment, if capital to acquire it is available, purchasing the machine would cost the company 50000 dollars and taking depreciation into account, after four years the residue value of the equipment will be 40000 dollars. The organization can decide to sell the machine at a profit and get some profit from the sale or sell it at residue value. Consequently, leasing the machine for 11000 dollars for duration of 5years would mean the company would loss 55000 dollars at the end of the period assuming the operating standards are similar. In the case where the firm has adequate has adequate capital to buy the machine buying the machine would be the more likely method to use. The firm will end up having a residue machine to sell and it will also have served the purpose it was meant for (Johnson, 1999).
Capital budgeting verdicts are those decisions that are involved when making significant investment decisions for the long term. It involves considerable amounts of capital and is characterized by the benefits not being realized in the short run but rather the over a period of years. The company foregoes all current money consumption activities for gains in the long term. Capital structure decisions are those decisions that capital structure of the organization (Kühn, 2006).
The capital structure is comprised of the equity and borrowed capital. The choice of capital of capital has an effect on the entity and has the capability of dilution of the ownership of the company. The greater the extent to which an organization is financed by debt capital especially debentures and ordinary shares may sway the controlling power and also the controlling rights (Bierman, 2003).
References
Bierman, H. (2003). The capital structure decision. Boston, Mass. [u.a.: Kluwer Academic Publ.
Johnson, H. J. (1999). Making capital budgeting decisions: Maximizing the value of the firm. London: Financial Times.
Kühn, C. (2006). Capital structure decisions in institutional buyouts. Wiesbaden: Deutscher Universitäts-Verlag.
