Capital Budgeting in Allcure, Inc.

The acceptance of any project by a business organization is primarily determined by the ascertainment of the management or the project implementation team that the said investment will be financially beneficial to the entity. As such, it is critical that the relevant considerations are made, including an evaluation of the cash flows to be generated as well as profits to be earned. It is, therefore, critical for Allcure Inc. to obtain a comprehensive cost benefit analysis before making the final decision on which project to undertake. Capital budgeting offers various tools for the evaluation of a project’s viability in terms of profitability and cash flow generation. The paper seeks to examine and determine, quantitatively and qualitatively, the viability of the two projects, P-Rec and T-rec, to act as firm basis for the company’s CFO to decide whether or not to invest the company’s resources into the products.

Among the primary capital budgeting techniques used to evaluate the two projects in order to offer justifiable recommendations to the CFO are the NPV and IRR techniques. The Net Present value is a capital budgeting technique used as a reliable metric for the profitability of an entity or project before implementation. As such, it examines the future cash outflows of an investment against the present cash inflows of the same to arrive at the possible benefit or loss of the project. It is also critical to highlight the fact that high and NPV values imply high profitability and, therefore, projects with high NPV values are highly recommended (Lohmann And Baksh, 1993, p.26). Projects or investments with low or negative NPV values, on the other hand, are considered less profitable or unprofitable, thus not recommended for implementation.

Internal Rate of return, on the other hand, is a project appraisal technique used for the evaluation of the potential profitability of projects or investments. The IRR represents a discount rate that makes the NPV of the project being examined zero. Therefore, higher IRR values imply that a project or investment is profitable while low values are red flags for investment in such projects(Lohmann And Baksh, 1993, p.30). IRR indicates a project’s break even rate (Gallo, 2016). The combination of the two appraisal techniques in this paper will form the basis for the response to be offered to the CFO.

Findings

Quantitative

To compare the viability of the two projects, the overall potential for P-Rec and T-Rec to generate profits for Allcure Inc. was evaluated using the IRR and NPV. From the calculations, it is evident that the implementation of P-Rec at a discount rate of 18% is the most viable option for the company. Despite the fact that the implementation of both projects at the same discount rate results in positive NPV’s and IRR’s, the implementation of P-Rec has values ($7,485,549.26 in NPV and 79% in IRR) than T-Rec which guarantees only $460,941.32 in NPV and 24% in IRR. It is, therefore, advisable that the CFO commissions the implementation of the P-Rec following the outlined specifications of the project. When examining the net present value of the P-Rec project, the annual depreciation of $230,000 is deducted from the projected annual sales since it affects the company’s income for the period. It is, therefore, prudent for the CFO to commission the implementation of the project at the expense of T-Rec.

T-REC NPV

required rate of return

18%

Year

Cash flow

0

              (3,320,000)

1

1235000

2

1186000

3

964000

4

752000

5

695000

6

670000

7

634000

8

590000

NPV

$460,941.32

IRR

24%

P-REC

Yr

18%

          (3,320,000)

1

      2,650,000.00

2

      2,650,000.00

3

      2,650,000.00

4

      2,650,000.00

5

      2,650,000.00

6

      2,650,000.00

7

      2,650,000.00

8

      2,650,000.00

NPV

$7,485,549.26

IRR

79%

The implementation of P-Rec over T-Rec is also justified by the high IRR which implies that the project presents the company with a greater opportunity to repay its cost of capital for the investment. Ordinarily, companies would invest in projects whereby they are assured of recovering their original costs of the investment and generate substantial profits going forward. The implementation of P-Rec, therefore, offers a lucrative IRR, 79%, compared to the negligible 24% to be generated by the other project.

It is also imperative to evaluate the overall profitability of the two projects over the period of eight years over which they are expected to operate. The net profit to be generated after taxation at 30% is $2,384,200 for the T-Rec project while the P-Rec project is a guarantee for $5,661,600 net profits at the end of the eight years. It is, therefore, evident that the profitability of implementing P-Rec exceeds that to be generated from the implementation of T-Rec. It is, therefore, further justifiable for the CFO to implement the implementation of the P-Rec project since it would generate more profits for the business compared to T-Rec whose profitability is less than half of that generated by the former. More important for the CFO is the fact that they should concentrate on the 18% rate of return when evaluating the projects for certainty and convenience.  

Qualitative findings

When examining different investment options for viability, different quantitative measures such as cost benefit analyses, NPV, IRR, ROI, and risk assessments are often used to evaluate the possible profitability of the underlying options against the prevalent costs (Feeney, Haines and Riding, 1999, p.132). However, research has proved that such quantitative techniques suffer several shortcomings in highlighting the real picture of the investment or project due to the possibility of leaving out the actual benefits or dangers unexamined due to their unquantifiable nature (Bradbury, Gallagher and Suckling, 2017, p.51). Such unquantifiable aspects include environmental and human life effects of the projects. It is, therefore, critical to assess such factors before implementing any economic decision (Jaiyeoba and Haron, 2016, p.250). For instance, from the case, it is evident that the launch of the revolutionary pre-version of P-Rec might result in long-term health hazards for some patients due to unknown reasons. On the other hand, the launch of T-Rec would result in a safe but relatively less effective traditional treatment plan for all its clients. As such, it is important for the management of Allcure Inc. to consider an option that would be quantitatively and qualitatively justifiable before the final implementation of either project.

Recommendations and Justifications

From the quantitative analysis conducted on the two projects, P-Rec and T-rec, it is most beneficial for Allcure Inc. to implement the P-Rec whose NPV and IRR are far much higher than those guaranteed by T-Rec over the same period. This is backed by the fact that the company is a profit making entity; thus profitability is a paramount aspect to be considered. All factors held constant, the company should opt to invest in the first option, which is more profitable than the second. It is, however, important to examine the qualitative findings on the projects. Despite that the P-Rec project would result in various adverse effects on the patients in the long-run, the same would be eliminated after eight years once the project is complete and the final version of the drug released. On the other hand, the launch of T-Rec would result in a safer but lesser-effective traditional treatment method for the patients. As such, the quantitative and qualitative findings are conflicting in this case. This is because the most profitable project posits substantial adverse effects compared to the least profitable.  

Detail Comparison and Further Recommendations

With the contradicting findings of the qualitative and quantitative evaluations of the projects, it is critical for the management to examine other aspects such as ROI to make a sound decision. Moreover, the company’s management should explore other options such as finalizing the development of the most profitable product, P-Rec, before its launch to avert the possible adverse effects on the patients. Also, they may opt to improve the efficiency of T-Rec before implementation and discard P-Rec on the grounds of the threat posed on the patients in the long-term. The consideration of these recommendations would significantly assist the organization in safely and successfully launching the most beneficial product out of the two.

Conclusion

From the examination of the two options, the launch of P-rec remains the most viable option for the company due to its guarantee for huge profits over the years. His is backed by the high NPV and IRR values compared to the launch of T-Rec. The safety of P-Rec can be improved with time as the business generates sufficient profits to invest in further R&D.

References

Bradbury, F., Gallagher, W. and Suckling, C. (2017). Qualitative aspects of the evaluation and control of research and development projects. R&D Management, 3(2), pp.49-57.

Feeney, L., Haines, G. and Riding, A. (1999). Private investors’ investment criteria: Insights from qualitative data. Venture Capital, 1(2), pp.121-145.

Gallo, A. (2016). A Refresher on Internal Rate of Return. [online] Harvard Business Review. Available at: https://hbr.org/2016/03/a-refresher-on-internal-rate-of-return [Accessed 10 Oct. 2018].

Jaiyeoba, H. and Haron, R. (2016). A qualitative inquiry into the investment decision behaviour of the Malaysian stock market investors. Qualitative Research in Financial Markets, 8(3), pp.246-267.

Lohmann, J. And Baksh, S. (1993). The Irr,Npv And Payback Period And Their Relative Performance In Common Capitial Budgeting Decision Procedures For Dealing With Risk. The Engineering Economist, 39(1), pp.17-47.

Appendix

P-REC

Yr

18%

          (3,320,000)

1

      2,650,000.00

2

      2,650,000.00

3

      2,650,000.00

4

      2,650,000.00

5

      2,650,000.00

6

      2,650,000.00

7

      2,650,000.00

8

      2,650,000.00

NPV

$7,485,549.26

IRR

79%

T-REC NPV

required rate of return

18%

24%

Year

Cash flow

0

              (3,320,000)

            (3,320,000)

1

1235000

1235000

2

1186000

1186000

3

964000

964000

4

752000

752000

5

695000

695000

6

670000

670000

7

634000

634000

8

590000

590000

NPV

$460,941.32

($61,436.16)

IRR

24%

23%