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 $112,000. An additional $4,000 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

5 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 $5,600, with removal costs of $1,300. 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 $4,200 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 $28,000 if the new pumping system is used. 6. FPCs assets are financed by debt and common equity and has a target debt ratio of 25 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 4 percent per year in the coming years. The firms current stock price, P0, is $26.00. 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 firms federal-plus-state tax rate is 30 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. You should show all your work with Excel formulas/equations for all computed numbers for Questions 1, 2 & 3, and concise and direct answers for Question #4 on the attached Cash Flow Estimation Worksheet and answers to te tables at the bottom of your spreadsheet, whenever applicable. NO WORK SHOWN, NO POINTS.) (8 pts) 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) + ,

6 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.) (34 pts) 2. 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 8-year expected life of the new pumping system. (Reference Reading: Cash Flow Analysis Example (RIC Project), one of required Readings for the course.) (8 pts) 3. 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? (10 pts) 4. 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. (Reference Reading: (1) Textbook Chapters 11 & 26 and related parts of Class Notes; and (2) Capital Asset Management Process: the Case of Hose & Fittings Corporation by Bae et al., International Journal of Managerial Finance (IJMF), Vol. 1, No. 3, 2005, pp. 204-220, one of required Readings for the course.)

G H I K L C D E F FALCONVILLE PUMP COMPANY - CASH FLOW ESTIMATION WORKSHEET 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 t=3 t=4 t=5 A B 1 2 3 Input Data (could be more or less than those listed here) 4 Cost of NEW equipment 5 Salvage value new equipment 6 Cost of old equipment 7 Depreciation of old equipment till date 8 Salvage value of old equipment 9 Tax rate 10 WACC 11 12 t=0 t=1 13 I INVESTMENT OUTLAY 14 1 15 2 16 3 17 4 18 5 19 6 20 21 II OPERATING CASH FLOWS OVER THE PROJECT'S LIFE 22 7 23 8 24 9 25 10 26 11 27 12 28 29 III TERMINAL YEAR CASH FLOWS 30 13 31 14 32 15 33 16 34 17 35 t=2 t=6 M t=7 N t=8 O A B D E 29 III TERMINAL YEAR CASH FLOWS 30 13 31 14 32 15 33 16 34 17 35 36 IV NET CASH FLOWS 37 18 38 39 V RESULTS 40 NPV = 41 IRR E 42 MIRR 43 Payback period = 44 45 46 DECISION BASED ON YOUR ANALYSIS: 47 48 49 50 ANSWERS TO QUESTIONS 51 52 Q#1: 53 54 55 IQ#2: 56 57 58 Q#3: 59 60 DU 61 Q#4: 62 63 64 65 F G H I J K L M N O