Information Provided:

In this example a company is trying discounted cash flow techniques for the first time to figure out if they should replace their product and switch to something new. Below is attached a picture of the DCF chart that needs to be figured out in order to decide to replace the machine. The following facts were to be used in the illustrative material:

1. The equipment has a delivered cost of $105,000. An additional $3,000 is required to install and test the new system.
2. The new pumping system is classified by the IRS as 5-year property, although it has an 8-year estimated service life. For assets classified by the IRS as 5-year property, the Modified Accelerated Cost Recovery System (MACRS) permits the company to depreciate the asset over 6 years at the following rates: Year 1 = 20 percent, Year 2 = 32 percent, Year 3 = 19 percent, Year 4 = 12 percent, Year 5 = 11 percent, Year 6 = 6 percent. At the end of 8 years, the salvage value is expected to be around 5 percent of the original purchase price, so the best estimate of salvage value at the end of the equipment's service life is $5,300, with removal costs of $1,200.
3. The existing pumping system was purchased at $45,000 eight years ago and has been depreciated on a straight-line basis over its economic life of 10 years. If the existing system is removed from the well and crated for pickup, it can be sold for $3,500 before tax. It will cost $1,000 to remove the system and crate it.
4. At the time of replacement, the firm will need to increase its net working capital requirements by $4,500 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 $25,000, if the new pumping system is used.
6. The firm has its target debt ratio of 30 percent, and its cost of new debt is 10 percent. Its expected dividend per share next year, D1, is $2.00 with a future growth rate of 6 percent per year. The firm's current stock price, P0, is $40.00. 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 firm's federal-plus-state tax rate is 30 percent, and this rate is projected to remain fairly constant into the future.

Questions:

(Provide answers in EXCEL attached below is a picture of the correct answer document that needs to be filled out)

1. Compute the firm's weighted average cost of capital given the info/data in the case. What other approaches/methods can be used to measure the firm's cost of equity and thus its WACC? To that end, what additional info/data would you need? (Hint: A firm's 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.)

2. Develop a capital budgeting schedule using the attached Cash Flow Estimation Worksheet (Excel spreadsheet provided below) that should list all relevant cash flow items and amounts related to the replacement project over the 8-year expected life of the new pumping system.

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

FALCONVILLE PUMP COMPANY - CASH FLOW ESTIMATION WORK WORKSHEET Input Data Cost of NEW equipment Annual dep. of old equipment Salvage value new equipment OLD equipment's depreciable life left Coat of old equipment Olid equipment's depreciated years Depreciation of old equipment till dete Annal cost savings Salvage value of old equipment Removal cost of old equipment Tax rate Removal cost of new equipment WACC Networking capital requirement =0 =1 3 t=5 t=6 t=8 INVESTMENT OUTLAY 1 2 3 t=2 3 I 5 6 II OPERATING CASH FLOWS OVER THE PROJECT'S LIFE 7 8 9 10 11 12 III TERMINAL FEAR CASH FLOWS 13 14 15 16 17 IV NET CASH FLOWS 18 V RESULTS NPV IRR MIRR Payback period = DECISION BASED ON YOUR ANALYSIS: ANSWERS TO QUESTIONS: Q#1: Q#2: Q#3: Q#4 FALCONVILLE PUMP COMPANY - CASH FLOW ESTIMATION WORK WORKSHEET Input Data Cost of NEW equipment Annual dep. of old equipment Salvage value new equipment OLD equipment's depreciable life left Coat of old equipment Olid equipment's depreciated years Depreciation of old equipment till dete Annal cost savings Salvage value of old equipment Removal cost of old equipment Tax rate Removal cost of new equipment WACC Networking capital requirement =0 =1 3 t=5 t=6 t=8 INVESTMENT OUTLAY 1 2 3 t=2 3 I 5 6 II OPERATING CASH FLOWS OVER THE PROJECT'S LIFE 7 8 9 10 11 12 III TERMINAL FEAR CASH FLOWS 13 14 15 16 17 IV NET CASH FLOWS 18 V RESULTS NPV IRR MIRR Payback period = DECISION BASED ON YOUR ANALYSIS: ANSWERS TO QUESTIONS: Q#1: Q#2: Q#3: Q#4