Capital Budgeting Decision Methods 11 CHICAGOVALVE COMPANY Although he was hired as a financial analyst after completing his MBA, Richard Houstons first assignment at Chicago Valve was with the firms 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 direc tor 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 Valve s 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 Valves 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 Valves actual cus tomers From discussions with the firms 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 of5 years would be used, but the system has an economic life of 8 years, and it will be used for that period After 8 years, the system will probably be obsolete, so it will have a zero salvage value at that time Curent depreciation allowances for 5-year class property are 020,032, 0.19, 0.12, 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 net market value is zero. The advantages of the new system are greater reliabil ity and lower human monitoring and maintenance requirements. In total, the new system would save Case 11-CB 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 Valves 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 eriteria To calculate MIRR, all of the cash inflows are compounded to the terminal year, in this case Year 8, at the project's cost of capital, and then these compounded values are summed to produce the projects 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 IRR as 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 Valve s 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 QUESTIONS Table I contains the complete cash flow analysis Examine it carefully and be prepared to answer any questions which might be posed 1. TABLE 1 Project Net Cash Flows Depreciation Tax Savings After-Tax Net Cash Flow $212,500 53,000 63,200 52,150 46,200 45,350 41,100 36,000 36,000 Net Cost $212,500 Cost Savings Year 0 $36,000 36,000 36,000 36,000 36,000 36,000 36,000 36,000 S17,000 27,200 16,150 10,200 9,350 5,100 2 3 4 5 6 0 2. What is the project's NPV? Explain the economic rationale behind the NPV Could the NPV of this particular project be different for Lone Star Petroleum Company than for one of Chicago Valves other potential customers? Explain 3. Calculate the proposed projects IRR Explain the rationale for using the IRR to evaluate capital investment projects Could the IRR for this project differ for Lone Star versus for another customer? 4. Suppose one of Lone Stars executives typically uses the payback as a primary capital bud geting decision tool and wants some payback information. a. What is the project's payback period? b. What is the rationale behind the use of payback as a project evaluation tool? c. What deficiencies does payback have as a capital budgeting decision method? d. Does payback provide any useful information regarding capital budgeting decisions? e. Chicago Valve has a number of different types of products Some that are relatively expensive, some that are inexpensive, some that have very long lives, and some with short lives. Strictly as a sales tool, without regard to the validity of the analysis, would the payback be of more help to the sales staff for some types of equipment than for oth ers? Explain f. People occasionally use the paybacks reciprocal as an estimate of the projects rate of return. Would this procedure be more appropriate for projects with very long or short lives? Explain 5. What is the projects MIRR? What is the difference between the IRR and the MIRR? Which is better? Why? 6. Suppose a potential customer wants to know the projects profitability index (Pl What is the value of the PI for Lone Star, and what is the rationale behind this measure? 7. Under what conditions do NPV, IRR, MIRR, and Pl all lead to the same acceptreject deci sion? When can conflicts occur? Ifa conflict arises, which method should be used, and why? 8. Suppose Congress reinstates the investment tax credit dITC, which is a direct reduction of taxes equal to the prescribed ITC percentage times the cost of the asset What would be the impact of a 10 percent ITC on the acceptability of the control system project? No caleula tions are necessary, just discuss the impact 9. Plot the projects NPV profile and explain how the graph can be used. 10. Now suppose that Chicago Valve sells a low quality, short-life valve system In a typical installation, its cash flows are as follows Net Cash Flow Year $120,000 0 150,000 Assuming an 11 percent cost of capital, what is this project's NPV and its IRR? Draw this pro- jects NPV profile on the same graph with the earlier project and then discuss the complete graph Be sure to talk about db mutually exclusive versus independent projects, 2) conflicts between projects, and 3) the effect of the cost of capital on the existence of conflicts What conditions must exist with respect to timing of cash flows and project size for conflicts to arise? 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 stafm Can you anticipate any problems that might arise? Explain 12. Now suppose that Chicago Valve sells another product that is used to speed the flow through pipelines However, after a year of use, the pipeline must undergo expensive repairs. In a typical installation, the cash flows of this product might be as follows Net Cash Flow Year 30,000 150,000 $120,000 Assuming an 11 percent cost of capital, what is this projects NPV, IRR, and MIRR? Draw this new projects NPV profile on a new graph Explain what is happening with the cash flows on this project