Capital Budgeting Decision Methods 11 CHICAGOVALVE COMPANY Although he was hired as a financial analyst after completing his MBA, Richard Houston's first assignment at Chicago Valve was with the firm's marketing department. Historically, the major focus of Chicago Valves sales effort was on demonstrating the reliability and technological supe. riority of the firm's product line. However, many of Chicago Valve's traditional customers have embarked on cost cutting programs in recent years. As a result, Chicago Valves marketing director asked Houston's boss, the financial VP, to lend Houston to marketing to help them develop some analytical procedures that the salesforce can use to demonstrate the financial benefits of buying Chicago Valve's products Chicago Valve manufactures valve systems that are used in a wide variety of applications including sewage treatment systems, petroleum refining, and pipeline transmission. The complete systems include sophisticated pumps, sensors, valves, and control units that continuously monitor the flow rate and the pressure along a line and automatically adjust the pump to meet pre-set pressure specifications. Most of Chicago Valves systems are made up of standard components, and most complete systems are priced from $100,000 to $250,000 Because of the somewhat technical nature of the products, the majority of Chicago Valve's salespeople have a background in engineering As he began to think about his assignment, Houston quickly came to the conclusion that the best way to sell a system to a cost-conscious customer would be to conduct a capital budgeting analysis which would demonstrate the cost effectiveness of the system. Further, Houston con cluded that the best way to begin was with an analysis for one of Chicago Valve's actual cus tomers From discussions with the firm's salespeople, Houston concluded that a proposed sale to Lone Star Petroleum, Inc. was perfect to use as an illustration Lone Star is considering the purchase of one of Chicago Valves standard petroleum valve systems which costs $200,000, including taxes and delivery. It would cost Lone Star another $12,500 to install the equipment, and this expense would be added to the invoice price of the equipment to determine the depreciable basis of the system. A MACRS class life of 5 years would be used, but the system has an economic life of 8 years, and it will be used for that period Aller 8 years, the system will probably be obsolete, so it will have a zero salvage value at that time Current depreciation allowances for 5 year class property are 020,032, 019.012, 011, and 006 in Years 1-6, respectively This system would replace a valve system which has been used for about 20 years and which has been fully depreciated. The costs for removing the current system are about equal to its scrap Value, so its current et market value is zero. The advantages of the new system are greater reliability and lower human monitoring and maintenance requirements Intotal, the new system would save Case 11 Capital Budgeting Decision Methods Lone Star $60,000 annually in pre tax operating costs. For capital budgeting. Lone Star uses an 11 percent cost of capital, and its federal plus-state tax rate is 40 percent Natasha Spurrier, Chicago Valve's marketing manager, gave Houston a free hand in structur ing the analysis, but with one exception she told Houston to be sure to include the modified IRR MIRR) as one of the decision criteria To calculate MIRR, all of the cash inflows are compounded to the terminal year, in this case Year 8, at the projects cost of capital, and then these compounded values are summed to produce the project's terminal value. Then, MIRR is found as the discount rate which causes the present value of the terminal value to equal the net cost of the equipment. Spurrier had recently attended a seminar on capital budgeting and, according to the seminar leader, the MIRR method has significant advantages over the regular IRR. For that reason, it is rapidly replacing TRR a primary capital budgeting method Now put yourself in Houston's position, and develop a capital budgeting analysis for the valve system. As you go through the analysis, keep in mind that the purpose of the analysis is to help Chicago Valves sales representatives sell equipment to other nonfinancial people, so the analysis must be as clear as possible, yet technically correct. In other words, the analysis must not only be right, it must also be understandable to decision makers, and the presenter Harrison, in this case must be able to answer any and all questions, ranging from the performance characteristics of the equipment to the assumptions underlying the capital budgeting decision criteria. 11. Natasha Spurrier informed Houston that all sales reps have laptop computers, so they can perform capital budgeting analyses for their clients For example, they could insert data for their client companies into the models and do both the basic analysis and also sensitivity analyses, in which they examine the effects of changes in such things as the annual cost sav. Case: 11 Capital Budgeting Decision Methods ings, the cost of capital, and the tax rate. Therefore, Houston and Spurrier developed the fol lowing sensitivity questions which they plan to discuss with the sales reps a. Suppose the annual cost savings differed from the projected level; how would this affect the various decision criteria? What is the minimum annual cost savings at which the sys tem would be cost justified? Discuss what is happening and, if you are using the Lotus model, quantify your answers, otherwise, just discuss the nature of the effects b. Repeat the type of analysis done in Part a, but now, vary the cost of capital Again, quan tify your answers if you are using the Lotus model c. Repeat the type of analysis done in Part a, but now, vary the tax rate Again, quantify your answers if you are using the Lotus model d. Would the capability to do sensitivity analysis on a laptop computer be of much assis tance to the sales staff? Can you anticipate any problems that might arise? Explain Capital Budgeting Decision Methods 11 CHICAGOVALVE COMPANY Although he was hired as a financial analyst after completing his MBA, Richard Houston's first assignment at Chicago Valve was with the firm's marketing department. Historically, the major focus of Chicago Valves sales effort was on demonstrating the reliability and technological supe. riority of the firm's product line. However, many of Chicago Valve's traditional customers have embarked on cost cutting programs in recent years. As a result, Chicago Valves marketing director asked Houston's boss, the financial VP, to lend Houston to marketing to help them develop some analytical procedures that the salesforce can use to demonstrate the financial benefits of buying Chicago Valve's products Chicago Valve manufactures valve systems that are used in a wide variety of applications including sewage treatment systems, petroleum refining, and pipeline transmission. The complete systems include sophisticated pumps, sensors, valves, and control units that continuously monitor the flow rate and the pressure along a line and automatically adjust the pump to meet pre-set pressure specifications. Most of Chicago Valves systems are made up of standard components, and most complete systems are priced from $100,000 to $250,000 Because of the somewhat technical nature of the products, the majority of Chicago Valve's salespeople have a background in engineering As he began to think about his assignment, Houston quickly came to the conclusion that the best way to sell a system to a cost-conscious customer would be to conduct a capital budgeting analysis which would demonstrate the cost effectiveness of the system. Further, Houston con cluded that the best way to begin was with an analysis for one of Chicago Valve's actual cus tomers From discussions with the firm's salespeople, Houston concluded that a proposed sale to Lone Star Petroleum, Inc. was perfect to use as an illustration Lone Star is considering the purchase of one of Chicago Valves standard petroleum valve systems which costs $200,000, including taxes and delivery. It would cost Lone Star another $12,500 to install the equipment, and this expense would be added to the invoice price of the equipment to determine the depreciable basis of the system. A MACRS class life of 5 years would be used, but the system has an economic life of 8 years, and it will be used for that period Aller 8 years, the system will probably be obsolete, so it will have a zero salvage value at that time Current depreciation allowances for 5 year class property are 020,032, 019.012, 011, and 006 in Years 1-6, respectively This system would replace a valve system which has been used for about 20 years and which has been fully depreciated. The costs for removing the current system are about equal to its scrap Value, so its current et market value is zero. The advantages of the new system are greater reliability and lower human monitoring and maintenance requirements Intotal, the new system would save Case 11 Capital Budgeting Decision Methods Lone Star $60,000 annually in pre tax operating costs. For capital budgeting. Lone Star uses an 11 percent cost of capital, and its federal plus-state tax rate is 40 percent Natasha Spurrier, Chicago Valve's marketing manager, gave Houston a free hand in structur ing the analysis, but with one exception she told Houston to be sure to include the modified IRR MIRR) as one of the decision criteria To calculate MIRR, all of the cash inflows are compounded to the terminal year, in this case Year 8, at the projects cost of capital, and then these compounded values are summed to produce the project's terminal value. Then, MIRR is found as the discount rate which causes the present value of the terminal value to equal the net cost of the equipment. Spurrier had recently attended a seminar on capital budgeting and, according to the seminar leader, the MIRR method has significant advantages over the regular IRR. For that reason, it is rapidly replacing TRR a primary capital budgeting method Now put yourself in Houston's position, and develop a capital budgeting analysis for the valve system. As you go through the analysis, keep in mind that the purpose of the analysis is to help Chicago Valves sales representatives sell equipment to other nonfinancial people, so the analysis must be as clear as possible, yet technically correct. In other words, the analysis must not only be right, it must also be understandable to decision makers, and the presenter Harrison, in this case must be able to answer any and all questions, ranging from the performance characteristics of the equipment to the assumptions underlying the capital budgeting decision criteria. 11. Natasha Spurrier informed Houston that all sales reps have laptop computers, so they can perform capital budgeting analyses for their clients For example, they could insert data for their client companies into the models and do both the basic analysis and also sensitivity analyses, in which they examine the effects of changes in such things as the annual cost sav. Case: 11 Capital Budgeting Decision Methods ings, the cost of capital, and the tax rate. Therefore, Houston and Spurrier developed the fol lowing sensitivity questions which they plan to discuss with the sales reps a. Suppose the annual cost savings differed from the projected level; how would this affect the various decision criteria? What is the minimum annual cost savings at which the sys tem would be cost justified? Discuss what is happening and, if you are using the Lotus model, quantify your answers, otherwise, just discuss the nature of the effects b. Repeat the type of analysis done in Part a, but now, vary the cost of capital Again, quan tify your answers if you are using the Lotus model c. Repeat the type of analysis done in Part a, but now, vary the tax rate Again, quantify your answers if you are using the Lotus model d. Would the capability to do sensitivity analysis on a laptop computer be of much assis tance to the sales staff? Can you anticipate any problems that might arise? Explain