Water Products Company Case THE COMPANY Water Products Company (WPC) was formed in the United States seven years ago by Elian Gonzalez, Nora Lum, and Bubba Watson, who together purchased a commercial machine shop that had been in business for more than 40 years but, at the time of the acquisition, was feeling pressure from a variety of new entrants into the markets in which the machine shop competed. Gonzalez had a distinguished military career and felt he could use the skills he acquired in the military to help this business return to its previously highly profitable state. Gonzalez currently serves as the president and CEO of the company. WPC produces three primary product lines, all of which are made of brass and are water-related: flow controllers, valves, and pumps. Nora Lum, a long-time friend of Gonzalez and his family, and a practicing accountant, joined the company as its CFO shortly before the formation of WPC. Bubba Watson, a high school friend of Gonzalez, had worked as the manufacturing supervisor at the company for the past 10 years and, at the request of Gonzalez, decided to stay onboard after the formation of WPC. Over the past several years, Watson had toyed with the idea of introducing more technologically up-to-date equipment that, he thought, could help ameliorate the competitive position of the company. Recently, Lum instituted an activity-based costing (ABC) system and a bare-bones Enterprise Resource Planning (ERP) system that, among other things, helped the company assess customer profitability and price its products more competitively. A new marketing manager, Maria Sanchez, was hired last year to develop and implement an aggressive product-promotion plan. These combined changes helped turn the company around. Two years ago, to raise capital needed for an expansion of the plant and the modernization of certain equipment key to the manufacturing process, the company went public. The company was enjoying a renewed reputation as a producer of high-quality brass products, sold principally in the southeast region of the U.S. WPC was, in fact, profitable in each of the past four years. At the end of the most recent year, total assets were approximately $10 million. Over the past two years, sales for the company amounted to approximately $25 million per year. The company's fiscal year corresponds to the calendar year. THE PROPOSED INVESTMENT: AN ASSET-REPLACEMENT DECISION Assume that it is sometime in the fourth quarter of 2021. Watson has presented to Gonzalez and Lum a proposal to purchase a replacement to a machine used to manufacture one of the three products. The existing machine was purchased on January 1, 2020. Assume that the asset replacement, if it occurs, will take place on January 1, 2022. Thus, the issue before Gonzalez, Lum, and Watson is whether to keep the existing machine or to replace it with a new, more technologically advanced machine. ADDITIONAL ASSUMPTIONS REGARDING THE CAPITAL BUDGETING DECISION WPC uses two discounted cash flow (DCF) models-net present value (NPV) and internal rate of return (IRR) to assess capital investment proposals, including the current asset-replacement decision. Because WPC has been a listed company for only a short period of time and is thinly traded, Lum has recommended that, for discounting purposes, the company should use 10% (an estimate of WPC's after-tax weighted average cost of capital [WACC]). In conjunction with your evaluation of the investment proposal at hand, you can assume the following additional facts: The tax law that governs this decision is the U.S. income tax law that is (or was) in effect for 2021. Water Products Company Case The proposed acquisition date is January 1, 2022, which can therefore be considered "time period 0" for purposes of your DCF analysis. Depreciation on the proposed investment for tax purposes will be calculated using the appropriate rates under MACRS half-year convention. This means that a half-year's worth of depreciation is taken in the year of asset disposal, regardless of the date of sale within the year. For financial reporting purposes, the straight-line (S/L) method is used to record depreciation charges. Over the past two years, the marginal income tax rates paid by WPC are 40%. For analysis purposes, assume that marginal tax rates for WPC will, during the years covered by this case, remain constant and equal to the preceding amount. Unless otherwise noted, assume that the company does NOT elect to take advantage of write-offs (if any) allowed by Internal Revenue Code (IRC) $179, Election to expense certain depreciable business assets," but DOES decline to take "bonus depreciation" (if applicable, and as outlined in IRC 179). Prior to considering the capital budgeting decision at hand, the company has already committed to $2 million of other capital expenditures for 2022. For simplicity, the timing convention for discounting estimated after-tax cash flows to present value is: All pre-tax operating cash flows, taxes on pre-tax cash flows, and income tax effects from depreciation deductions occur at the end of each year. For example, time-period-1 operating cash flows are assumed to be received by WPC on December 31, 2022. Likewise, taxes on these cash flows as well as time-period-1 tax savings due to MACRS-based depreciation deductions are assumed to occur on December 31, 2022. Opportunity costs (if any) associated with the decision to replace the existing asset are assumed to occur at the end of year 1 (that is, on December 31, 2022). If the old asset is sold, the pre-tax cash inflow from this sale is assumed to occur at the point of sale (at time period zero, January 1, 2022). By contrast, tax savings associated with the half-year depreciation deduction on the old asset under MACRS are assumed to occur at the end of the year, December 31, 2022. BASE-CASE ANALYSIS: KEEP OR REPLACE THE EXISTING MACHINE? The current machine, which is being considered for replacement, was purchased on January 1, 2020, for $120,000 with an estimated useful life of 12 years and zero salvage value for financial reporting purposes. The estimated disposal value of this machine on January 1, 2022, is $36,000. If not disposed of (i.e., if not sold outright), it is estimated that the current machine could be used for another 10 years (i.e., the same total number of years as its original estimated useful life). The base purchase price for the replacement machine is $170,000. Delivery cost for the machine, to be born separately by WPC, is estimated as $5,000. Installation and testing costs for the new machine are estimated to be $25,000. In the past, WPC has "charged each major investment project with an administrative fee equal to 10% of the purchase price of the asset (investment). This imputed fee represents an allocation of corporate headquarters' (i.e., "overhead") expense. 1 By the time of the investment decision (January 1, 2022), the machine in question would have recorded two years' worth of depreciation for financial reporting purposes and two and a half years' worth of MACRS-based depreciation for tax purposes. Under current MACRS rules, a half-year of depreciation is taken in the year of asset disposal. Since the proposed transaction is assumed to occur on the first day of the fiscal year, under MACRS (Modified Accelerated Cost Recovery System) WPC would record a half-year of depreciation expense for the existing asset for tax purposes for 2022. Annual depreciation expense for financial reporting purposes = (Purchase price - Salvage Value) / Useful Life. In the present case, depreciation charges = ($120,000 - $0) / 12 years = $10,000 per year. You can find tax depreciation rates at the end of the case document. Water Products Company Case During the discussion of the proposed investment, Watson pointed out that if the company purchases the replacement machine, it is likely to lose some business during the time the old machine is being removed and the replacement machine is installed (and tested). His best guess-and it is only a guess-is that the contribution margin lost during this time would be $5,000 (pre-tax). If the replacement asset is purchased, pre-tax operating cash flows are expected to increase by $35,000 per year. The new machine is technologically advanced, which is expected to provide two benefits: (1) a reduction in annual cash operating expenses and (2) an increase in sales volume. The latter is attributable to the greater output capacity of the replacement machine. The new machine has an expected useful life of 10 years. DEALING WITH UNCERTAINTY: SENSITIVITY ANALYSIS The decision team is aware that many assumptions will be going into the DCF analysis of the present asset-replacement decision.4 Team members are therefore curious as to how sensitive the replacement decision is with respect to each of the following issues or considerations: The discount rate (WACC) used to estimate the present value of after-tax cash flows; The amount of annual after-tax operating cash inflow associated with each investment alternative (keep vs. replace); The estimated useful life of each of the two assets (i.e., these lives may be different); and The possible need to account for an additional investment in (net) working capital should the company purchase the replacement machine. In terms of the assumed discount rate, Watson offered the following observations at a recent business meeting with Gonzalez and Lum: "OK, we see that on the basis of our DCF analysis one decision option is preferable (in a present-value sense). This analysis assumed an after-tax discount rate (i.e., a WACC) of 10%. Is this the correct amount? Does the rate we use matter in terms of our assessment of the present investment proposal? Over the weekend, I came across a Harvard Business Review article that suggested we might have to give more thought to this issue." What do you folks think?" At the next planning meeting, Watson raised another sensitivity-analysis issue: "Well, we addressed the issue of how sensitive our recommended course of action would be in terms of the assumption regarding the discount rate used in our DCF decision models. It seems to me, however, that there are other areas of concern regarding the numbers we used in our base-case analysis. Key concerns among these might be the 'guestimates' we are making-and up to 10 years out!-regarding the annual pre-tax operating cash inflows associated with each decision alternative. I think we have a pretty good handle on the operating cash flows associated with the existing asset. After all, we've been using that machine now for two years. The operating cash flow estimate associated with the replacement asset, on the other hand, was determined in conjunction with the discussions we had with the sales agent for the new machine, which suggests to me the possibility that those estimates could be, well, overly optimistic. I know we are dealing with a lot of assumptions here. To keep the analysis manageable, let's go with the discount rate we used 2 Pre-tax operating cash inflows from using the new machine are estimated as $55,000 per year. Pre-tax operating cash inflows from using the existing machine are assumed to be $20,000 per year. 3 This life can and often does differ from the tax recovery period. 4 In structuring the DCF analysis of the present asset-replacement decision, you may want to consult the following article: Su-Jane Chen and Timothy R. Mayes, "A Note on Capital Budgeting: Treating a Replacement Project as Two Mutually Exclusive Projects," Journal of Financial Education, Spring/Summer 2012, pp. 56-66. Posted in Canvas. This is NOT how I prepared the DCF in the example video. 5 See article posted in Canvas that I am not allowed to post. Water Products Company Case in our base-case analysis, 10% (after-tax), and let's assume the use of NPV as our decision model. I'm curious as to how sensitive our recommendation is with respect to the assumption we are making regarding the amount of annual pre-tax operating cash inflows associated with the replacement asset. Perhaps we can rely on Excel to help us explore this issue." At that point, Watson said: "Two-plus years ago I was involved in the decision to purchase the existing asset. At the time, I remember we factored into the decision the amount of 'net working capital' we thought necessary to support the increased sales volume associated with our investment. I also remember that the amount was something like $20,000. I'm not really sure what this is all about, but I'm thinking that we should at least address this issue. At a minimum, I think we should answer some questions: (1) Conceptually, do we need to amend our base-case analysis to incorporate this information? Why or why not? (2) Assuming we replace the existing asset with the new machine, we would have to commit another $20,000 of (net) working capital to support the anticipated increase in sales. Would this affect our recommended course of action?" Before the meeting concluded, Gonzalez commented: "Since we're on the subject, does anyone here think it's strange that we're assuming, in our base-case analysis, that the useful life of each asset-both the existing asset and the replacement asset-are equal, that is, 10 years? I would agree that the existing asset is likely to last another 10 years. But I'm not so sure about the replacement asset. Yes, it's supposed to be more efficient, and it's supposed to increase our sales volumehence the additional projected pre-tax operating cash inflows each year. But I did some research on my own recently, and, on the basis of this research, I feel that a more conservative estimate of the useful life of the replacement asset may be eight rather than 10 years. So, if this is true, we're now left with the unfortunate situation of having to compare two assets of unequal lives. How do we do this analytically?" The meeting then concluded. All three team members felt comfortable that the team had identified the primary sources of uncertainty regarding the NPV analyses they were about to conduct. At the request of Lum, the next team meeting would be devoted to raising tax-related questions regarding the proposed acquisition. ADDITIONAL TAX CONSIDERATIONS At the end of the following week, the team reconvened to discuss three tax-related issues that arose from their informal conversations during the week: (1) the issue of "like-kind exchanges," (2) the possibility of taking an accelerated write-off, and (3) the possible use of a "STARKER escrow" for the sale of the existing machine (if the decision were made to replace that machine). Gonzalez began the meeting by saying: "Well, we've covered a lot of ground here so far, but I wonder whether we're missing something important from a tax standpoint. For example, our baseline DCF analysis assumes that we're going to sell the existing asset outright in the open market. In fact, we have a firm offer from a reputable buyer for the existing machine. But I wonder: (1) Would there be any tax advantage to trading in (rather than selling outright) the old asset, under the assumption that the trade-in amount would be equal to, say, the agreed-upon external sales price, $36,000? (2) If we were to negotiate a trade-in value, what would the breakeven value be? That is, can we come up with the trade-in value that would make us indifferent between keeping and replacing the existing asset? To make the analysis tractable, let's assume data associated with our base-case scenario and the use of NPV analysis to address this question." Lum agreed that Gonzalez's point was interesting and worth exploring. She pointed out that the relevant tax law pertaining to this issue is covered in IRC $1031, "Exchange of property held for productive use or investment." Water Products Company Case Gonzalez continued, "I also recall that two years ago, when we purchased the existing machine, we talked about expensing the machine immediately, under (I think) "bonus depreciation." I don't remember the details, but I do remember someone making the point that this could have saved us more than a trifling amount in terms of our tax bill. I really can't remember why we chose not to go that route. Lum, in your opinion, is this option available this year? Would it benefit us? Why or why not? I think we need to address these questions as we evaluate the present investment opportunity." Lum replied, "I remember an article from a couple of years ago that dealt with these very issues. I'll retrieve and reread it--it may be relevant to the present decision analysis." Lum continued, Speaking of additional tax-related issues, I recently read somethingin the Bozeman Daily Chronicle of all places!-that might apply to our situation: using a so-called STARKER escrow in conjunction with a possible disposal of our existing asset. I never heard of such a thing, but I'm intrigued about this possible tax-related option. I wonder whether this STARKER thing would apply to our situation."7 STRATEGIC/QUALITATIVE CONSIDERATIONS: BEYOND THE "NUMBERS" Then, Gonzalez commented: "I think we've done a pretty good job covering all of the financial dimensions of the present decision, including some interesting income tax considerations. As agreed to in our earlier meetings, our base-case analysis will be supplemented with various sensitivity analyses. At this point, I think we should ask ourselves whether we've covered all relevant aspects of the proposed decision. Why don't we call in Mark Callaway to see whether we are missing something here something that goes beyond the 'mumbers'? I'm concerned, for example, about whether we have properly considered any pertinent strategic or qualitative considerations." Gonzalez knows that, at a minimum, it will be prudent to consult with Mark Callaway, director of Investor Relations for WPC. After hearing the back story for the proposal and examining the underlying data discussed thus far by the team, Callaway skeptically responds, "We have been profitable the past two years with the current machine. What you are proposing is giving me a public relations headache-if we sell the old machine, we could very well take a hit on our published financial statements for the first quarter of 2022 and perhaps beyond." Gonzalez interjects, On paper, Callaway. The sale of the existing machine would actually provide a tax benefit." Callaway responds, Yes, we record a loss for financial reporting purposes, but it's truly a loss since we paid $120,000 for the machine, used it for only two years, and now will receive only $36,000 for it. That's quite a rental fee!" Gonzalez concedes, "You have a point there." Callaway continues, We are also pushing aside business during the transition period. Watson speaks up. "Temporarily, this should only be a minor delay." Callaway retorts, "So you say. Forgive me for my skepticism, but I would be concerned about how long this 'minor' delay will be. You were the one who promoted the current machine, which is supposed to last another decade but now isn't good enough? Two years ago we raised capital in part by promising profits through use of the current machine, which profits you have delivered thus far. Now, you're asking the company to cough up even more money for a replacement machine, which may or may not be more 6 The Internal Revenue Code in 2021 permits the immediate expensing of 100% of the cost of property used in a trade or business (not real estate). Thus WPC could deduct the entire cost of the new machine in the year placed in service. 7 It could, but for purposes of this assignment, it is not going to. profitable. As well, you're telling me that the new machine may actually have a shorter useful life than the existing machine it's supposed to replace." Watson rejoins, "It will be more profitable. As noted in the DCF analysis we performed, we anticipate having both operational cost savings and increased sales volume due to increased capacity of the new machine." Callaway shakes his head, saying, Look, I think it's great that you're looking for ways to increase the value the company and our bottom line. I'm concerned, however, that you're being overly optimistic. Do you have a handle on how many more units we can sell? Will the cost savings allow us to reduce price to the point where we maintain margins? Best-case scenario, we take a step back only in the next quarter, entirely due to changing the machines. Worst-case, the new machine enables us to produce much more than we can sell, and we're stuck squeezing margins to move our products." Gonzalez intercedes, "But, we have a real opportunity for growth with the new equipment." Callaway responds, "Yes, but is bigger really better? I'm leery of making this proposed financial commitment. So much has to go right for us. Let's assume that Watson is right about the cost savings from using the new machine. That would be great, but for what production range will that be valid? Will we really be able to sell enough to make it worthwhile?" Watson remains emboldened, "I guarantee that the replacement machine will be worth it. You're focusing too narrowly on the short-term adjustment period." Callaway replies, "Yeah, but how do I know that you won't come back again in two years asking the shareholders to buy another toy that you say will last 10 years?" Gonzalez brings the matter to a close. "Callaway, we'll take your concerns under advisement. I'm confident that you'll be effective in explaining to our investors any short-term hiccups in profits. But we're putting the cart before the horse here. I think that Watson, Lum, and I need to run the numbers to assess the short-term financial-reporting effect of our decision." As Callaway walks off, Gonzalez turns to Lum and Watson: "Our earlier discussion with Callaway has made me step back a bit and think more broadly about the decision we're facing. My sense is that it would be worthwhile for us to supplement our financial analysis with a listing of strategic and/or qualitative factors that are associated with this decision. I guess my concern is whether 'the numbers' capture all pertinent aspects of this decision. What do you think? At a minimum, I suggest we address the following questions: (1) Are there important strategic considerations associated with each decision alternative? If so, what are they? (2) If the answer is 'yes,' have we already captured the effect of these factors in our financial analysis? If not, what exactly do we do with this information? That is, is there a way for us to incorporate both financial and nonfinancial information formally into our decision process?" Lum and Watson agreed that these were legitimate questions to address in conjunction with the proposed acquisition. 2. Dealing with Uncertainty/Sensitivity Analysis: a. Issues related to the discount rate: How (conceptually) is the discount rate for capital budgeting purposes defined and calculated? Is this number appropriate for analyzing the asset-replacement decision at hand? Why or why not? What impact, if any, would a rate below or above 10% have on the recommended course of action for WPC Company? To address this issue, first prepare a schedule in Excel showing what the NPV results of the base-case analysis would be after letting the WACC vary from a low of 8% to a high of 13%, in increments of 1%. For each discount rate, recalculate the difference in NPV of the two investment alternatives. b. Estimates of annual pre-tax cash inflows of the replacement machine: Use Excel to determine the breakeven operating pre-tax cash inflow associated with the replacement asset (i.e., the annual pre-tax cash inflow for the replacement machine that would make WPC indifferent between keeping vs. replacing the existing machine). What keen managerial insight is yielded from this analysis? c. Addressing incremental investment in (net) working capital: Respond to the two queries raised by Watson regarding the possible need to make an up-front commitment of additional (net) working capital if the replacement machine is purchased: (1) Does the base-case analysis need to be changed? Why or why not? (2) If the team replaces the machine, WPC would have to commit to incremental (net) working capital of $20,000. Would this incremental investment affect the recommended course of action? (Show calculations.)