Brandon Joiner, president and chief executive officer of Falconville Pump Company, Inc., has a potentially serious problem on his hands. The earnings of the firm were essentially flat in 2022 in spite of a general upturn in the industry. Now, well into the third quarter of 2023, the picture is even gloomier. FPCs performance has continued to deteriorate and, for the first time since 2005, a loss was incurred in the third quarter. Unless things improve quickly, it is possible that the company will show a loss for 2023 as a whole. This problem is particularly frustrating to Joiner because it comes on the heels of a report in one of the leading trade journals that rated FPCs products as superior to those of all competitors in the industry in terms of durability and customer service.

Joiner decided that the best course of action was first, to find out how well Stewart is versed in capital budgeting techniques, and second, if the training proves to be adequate, to ask her to work on the marketing division project during her internship. When Joiner questioned Stewart, he was delighted to learn that not only had she worked in the economic evaluation department in her former job, she also had taken an entire course dealing with capital expenditure decisions. (Stewart, for her part, was surprised to learn that FPC was still using the payback method.) She readily agreed to the assignment in the marketing department, and she and Avery decided to start by analyzing one of the standard pumping systems. The following facts, which Avery indicated were fairly typical, were to be used in the illustrative material:

1. The equipment has a delivered cost of $115,000. An additional $3,000 is required to install and test the new system.
2. The new pumping system is classified by the IRS as 7-year property with the same 7-year estimated service life. For assets classified by the IRS as 7-year property, the Modified Accelerated Cost Recovery System (MACRS) permits the company to depreciate the asset over 8 years at the following rates: Year 1 = 14%; Year 2 = 25%; Year 3 = 17%; Year 4 = 13%; Year 5 = 9%; Year 6 = 9%; Year 7 = 9%; Year 8 = 4%. At the end of its estimated service life of 7 years, the salvage value is expected to be $8,000, with removal costs of $1,200.
3. The existing pumping system was purchased at $48,000 five years ago and has been depreciated on a straight-line basis over its economic life of 6 years. If the existing system is removed from the well and crated for pickup, it can be sold for $4,200 before tax. It will cost $1,000 to remove the system and crate it.
4. At the time of replacement (t=0), the firm will need to increase its net working capital requirements by $6,500 to support inventories.
5. The new pumping system offers lower maintenance costs and frees personnel who would otherwise have to monitor the system. In addition, it reduces product wastage because of a higher cooling efficiency. In total, it is estimated that the yearly savings will amount to $32,000 if the new pumping system is used.
6. FPCs assets are financed by debt and common equity and has a target debt ratio of 30 percent. Its debt carries an interest rate of 6 percent. The firm has paid $2.00 of dividend per share this year (D₀) and expects a constant dividend growth rate of 5 percent per year in the coming years. The firms current stock price, P₀, is $28.00. The firm uses its overall weighted average cost of capital in evaluating average risk projects, and the replacement project is perceived to be of average risk.
7. The firms federal-plus-state tax rate is 25 percent, and this rate is projected to remain fairly constant into the future.

QUESTIONS

1. Compute the firms weighted average cost of capital given the info/data in the case. What other approaches/methods can be used to measure the firms cost of common equity and thus its WACC? To that end, what additional info/data would you need?

2. Develop a capital budgeting schedule using the attached Cash Flow Estimation Worksheet (Excel spreadsheet) that should list all relevant cash flow items and amounts related to the replacement project over the 7-year expected life of the new pumping system.

3. Based on the capital budgeting schedule, evaluate the replacement project by computing NPV, IRR, MIRR, and Payback Period. Would you recommend to accept or reject the replacement project based solely on your DCF analysis so far?

4. Before you make the final accept/reject decision, what other factors and approaches would you consider further? Discuss also how to PRACTICALLY take into account those factors and approaches in the capital budgeting decision process, whenever applicable.

CASH FLOW ESTIMATION WORKSHEET

Input Data (could be more or less than those listed here)

Cost of NEW equipment

Annual dep. of old equipment

Salvage value new equipment

Old equipment's depreciable life left

Cost of old equipment

Old equipment's depreciated years

Depreciation of old equipment till date

Annal cost savings

Salvage value of old equipment

Removal cost of old equipment

Tax rate

Removal cost of new equipment

WACC

Net working capital requirement

t=0

t=1

t=2

t=3

t=4

t=5

t=6

t=7

I

INVESTMENT OUTLAY

1

2

3

4

5

6

II

OPERATING CASH FLOWS OVER THE PROJECT'S LIFE

7

8

9

10

11

12

III

TERMINAL YEAR CASH FLOWS

13

14

15

16

17

IV

NET CASH FLOWS

18

V

RESULTS

NPV

=

IRR

=

MIRR

=

Payback period =