CHICAGO VALVE COMPANY Capital Budgeting Decision Methods Directed 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 Valve's sales effort was on demonstrating the reliability and technological superiority 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 Valve's marketing director asked Houston's boss, the financial VP, to lend Houston to marketing to help them develop some analytical procedures that the sales force 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 Valve's sales people 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 concluded that the best way to begin was with an analysis for one of Chicago Valve's actual customers From discussions with the firm's sales people. 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 Valve's 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 five years would be used, but the system has an economic life of eight years, and it will be used for that period. After eight 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 0.20 0.32 0.19 0.12.0.11 and 0.06 in Years 1-6 respectively This system would replace a valve system which has been thed for about twenty years and which has been fully depreciated. The costs for removing the current yem are about equal to its scrap value, so its current net market value is zero. The advantages of the new system are greater reliability and lower buman monitoring and maintenance reyes lo local, the system would save Love Sor Somally in preoperating cos Forcapital budgeting Lone Staran 11 percent of capital and feel plaate tax rates Course MacBook Air Natasha Spurrier, Chicago Valve's marketing manager, gave Houston a free hand in structuring 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 project's 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 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. Table I contains the complete cash flow analysis. Examine it carefully, and be prepared to answer any questions which might be posed. TABLE 1 Project Net Cash Flows Net Cost Depreciation Tax Saving Aller.Tax Cost Saving Year 0 1 (5212,500) 2 3 6 5 6 $17,000 27,200 16,150 10,200 9,350 5,100 0 0 $36,000 36,000 36,000 36,000 36,000 36,000 36.000 36,000 Net Cash Flow (5212,500) 53,000 63,200 52,150 46.200 45,350 41,100 36.000 36.000 7 8 QUESTIONS 1. Explain the inputs into 1) the net initial investment outlay at year 1, 21 the depreciation tax savings in each year of the projects economic life, and 3) the projects incremental cash nows? 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 Valve's other potential customers? Explain 3. Calculate the proposed project's IRR. Explain the rationale for using the IRR to evaluate capital investment projects. Could the IRR for this project differ for Lone Star verses for another customer 4. Suppose one of .one Star's executives typically uses the stuck as a primary capital budgeting decision tool and wants some puytuck information What is the project's payback period . What is the finale behind the use of puytuck as a projections too! 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 others? Explain. 1. People occasionally use the payback's reciprocal as an estimate of the project's rate of return. Would this procedure be more appropriate for projects with very long or short lives! Explain. 5. What is the project's MIRR? What is the difference between the IRR and the MIRR? Which is better? Why? 6. Suppose a potential customer wants to know the project's profitability index (PI). 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 PI all lead to the same accept/reject decision? When can conflicts occur? If a conflict arises, which method should be used, and why? 8. Suppose Congress reinstates the investment tax credit (ITC), 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 calculations are necessary; just discuss the impact. 9. Plot the project's 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: Year 0 Net Cash Flow ($120,000) 150.000 Assuming an Il percent cost of capital, what is this project's NPV and its IRR? Draw this project's NPV profile on the same graph with the earlier project and then discuss the complete graph. Be sure to talk about (1) 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 inforned Houston that all les reps have laptop computers, so they can perform the capital budgeting analyses. For example, they could insert data for their client companies into the models and do both the huste analysis and also sensitivity analyses in which they examine the effects of changes in such things as the savings, the cost of capital, and the tax rate. Therefore, Houstort and Spurer de ople following sensitivity questions which they plan to discussies a. Suppose the annual cost savings offered to be once levels bow would this affect the various decision criteria Wasibe which the stem would be cost justified Discussis happening the spreadsheet model quantify your site of the b. Repeat the type of analysis doni Panoranti your answers if you are using the preshed c. Repeat the type of analysis done in Part 2, but now, vary the tax rate. Again, quantify your answers if you are using the spreadsheet model. d. Would the capability to do sensitivity analysis on a laptop computer be of much assistance to the sales staff? 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: Year 0 1 2 Net Cash Flow (530,000) 150.000 120,000) Assuming an 11 percent cost of capital, what is this project's NPV, IRR. and MIRR? Draw this new project's NPV profile on a new graph. Explain what is happening with this project. CHICAGO VALVE COMPANY Capital Budgeting Decision Methods Directed 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 Valve's sales effort was on demonstrating the reliability and technological superiority 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 Valve's marketing director asked Houston's boss, the financial VP, to lend Houston to marketing to help them develop some analytical procedures that the sales force 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 Valve's sales people 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 concluded that the best way to begin was with an analysis for one of Chicago Valve's actual customers From discussions with the firm's sales people. 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 Valve's 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 five years would be used, but the system has an economic life of eight years, and it will be used for that period. After eight 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 0.20 0.32 0.19 0.12.0.11 and 0.06 in Years 1-6 respectively This system would replace a valve system which has been thed for about twenty years and which has been fully depreciated. The costs for removing the current yem are about equal to its scrap value, so its current net market value is zero. The advantages of the new system are greater reliability and lower buman monitoring and maintenance reyes lo local, the system would save Love Sor Somally in preoperating cos Forcapital budgeting Lone Staran 11 percent of capital and feel plaate tax rates Course MacBook Air Natasha Spurrier, Chicago Valve's marketing manager, gave Houston a free hand in structuring 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 project's 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 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. Table I contains the complete cash flow analysis. Examine it carefully, and be prepared to answer any questions which might be posed. TABLE 1 Project Net Cash Flows Net Cost Depreciation Tax Saving Aller.Tax Cost Saving Year 0 1 (5212,500) 2 3 6 5 6 $17,000 27,200 16,150 10,200 9,350 5,100 0 0 $36,000 36,000 36,000 36,000 36,000 36,000 36.000 36,000 Net Cash Flow (5212,500) 53,000 63,200 52,150 46.200 45,350 41,100 36.000 36.000 7 8 QUESTIONS 1. Explain the inputs into 1) the net initial investment outlay at year 1, 21 the depreciation tax savings in each year of the projects economic life, and 3) the projects incremental cash nows? 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 Valve's other potential customers? Explain 3. Calculate the proposed project's IRR. Explain the rationale for using the IRR to evaluate capital investment projects. Could the IRR for this project differ for Lone Star verses for another customer 4. Suppose one of .one Star's executives typically uses the stuck as a primary capital budgeting decision tool and wants some puytuck information What is the project's payback period . What is the finale behind the use of puytuck as a projections too! 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 others? Explain. 1. People occasionally use the payback's reciprocal as an estimate of the project's rate of return. Would this procedure be more appropriate for projects with very long or short lives! Explain. 5. What is the project's MIRR? What is the difference between the IRR and the MIRR? Which is better? Why? 6. Suppose a potential customer wants to know the project's profitability index (PI). 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 PI all lead to the same accept/reject decision? When can conflicts occur? If a conflict arises, which method should be used, and why? 8. Suppose Congress reinstates the investment tax credit (ITC), 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 calculations are necessary; just discuss the impact. 9. Plot the project's 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: Year 0 Net Cash Flow ($120,000) 150.000 Assuming an Il percent cost of capital, what is this project's NPV and its IRR? Draw this project's NPV profile on the same graph with the earlier project and then discuss the complete graph. Be sure to talk about (1) 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 inforned Houston that all les reps have laptop computers, so they can perform the capital budgeting analyses. For example, they could insert data for their client companies into the models and do both the huste analysis and also sensitivity analyses in which they examine the effects of changes in such things as the savings, the cost of capital, and the tax rate. Therefore, Houstort and Spurer de ople following sensitivity questions which they plan to discussies a. Suppose the annual cost savings offered to be once levels bow would this affect the various decision criteria Wasibe which the stem would be cost justified Discussis happening the spreadsheet model quantify your site of the b. Repeat the type of analysis doni Panoranti your answers if you are using the preshed c. Repeat the type of analysis done in Part 2, but now, vary the tax rate. Again, quantify your answers if you are using the spreadsheet model. d. Would the capability to do sensitivity analysis on a laptop computer be of much assistance to the sales staff? 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: Year 0 1 2 Net Cash Flow (530,000) 150.000 120,000) Assuming an 11 percent cost of capital, what is this project's NPV, IRR. and MIRR? Draw this new project's NPV profile on a new graph. Explain what is happening with this project