Falconville Pump Company, INC.

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.

1. 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.

1. 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.

1. At the time of replacement (t=0), the firm will need to increase its net working capital

requirements by $6,500 to support inventories.

1. 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.

1. 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.

1. The firms federal-plus-state tax rate is 25 percent, and this rate is projected to remain

fairly constant into the future.

QUESTIONS

(Please provide answers to the following four questions on the attached Cash Flow

Estimation Worksheet and show all your work with Excel formulas/equations for

all computed numbers for Questions 1, 2, 3, & 4.

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?

(Hint: A firms weighted average cost of capital is equal to = ()(1 - t) + ,

where and are the weights of debt and equity in the capital structure; and

are the respective costs of debt and equity; and t is the corporate tax rate; Do no round

up your WACC figure.)

1. 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. (Reference Reading: Cash Flow Analysis Example (RIC Project),

one of required Readings for the course.)

1. 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?

1. 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.

A1 A B B B C fx FALCONVILLE PUMP COMPANY - CASH FLOW ESTIMATION WORKSHEET FALCONVILLE PUMP COMPANY - CASH FLOW ESTIMATION WORKSHEET M N 1 2 3 4 5 6 7 8 9 10 11 12 13 \begin{tabular}{l|l} \hline INVESTMENT OUTLAY \\ \hline \end{tabular} Input Data (could be more or less than those listed here) Cost of NEW equipment Salvage value new equipment Cost of old equipment Depreciation of old equipment till date Salvage value of old equipment Tax rate WACC I 4 21 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 \begin{tabular}{|r|} \hline 3 \\ \hline 4 \\ \hline 5 \\ \hline 6 \\ \hline \end{tabular} II OPERATING CASH FLOWS OVER THE PROJECT'S LIFE III TERMINAL YEAR CASH FLOWS 13 14 15 16 17 35 36 37 38 39 \begin{tabular}{l|l} \hline IV & NET CASH FLOWS \end{tabular} 18 \begin{tabular}{|l|l|} \hlineV & RESULTS \\ \hline \end{tabular} \begin{tabular}{l|l} \hline NPV & = \end{tabular} \begin{tabular}{l|l} \hline IRR & = \end{tabular} MIRR Payback period = 44 45 46 DECISION BASED ON YOUR ANALYSIS: Annual dep. of old equipment Old equipment's depreciable life left Old equipment's depreciated years Annal cost savings Removal cost of old equipment Removal cost of new equipment Net working capital requirement