finance 593 intermediate financial management 6 Case 11 Chicago Valve Company Capital Budgeting Directed Although he was hired as a financial analyst after completing his MBA, Richard Houston's first assignment at Chicago Valve was with the
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Case 11 Czpö"
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Chicago Valve Company
Capital Budgeting
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-setpressure 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 somewhattechnical nature of the products, the majority of Chicago Valve's sales people have a backgroundin engineering.
As he began to think about his assignment, Houston quickly came to the conclusion that thebest way to "sell" a system to a cost-conscious customer would be to conduct a capital budgetinganalysis which would demonstrate the cost effectiveness of the system. Further, Houstonconcluded that the best way to begin was with an analysis for one of Chicago Valve's actualcustomers.
From discussions with the firm's sales people, Houston concluded that a proposed sale toLone Star Petroleum, Inc. was perfect to use as an illustration. Lone Star is considering thepurchase 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, andthis expense would be added to the invoice price of the equipment to determine the depreciablebasis of the system. A MACRS class-life of five years would be used, but the system has aneconomic life of eight years, and it will be used for that period. After eight years, the system willprobably 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 used for about twenty years and which has been fully depreciated. The costs for removing the current system 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 human monitoring and maintenance requirements. In total, the new system would save Lone Star $60,000 annually in pre-tax operating costs. For capital budgeting, Lone Star uses an 1 1 percent cost of capital, and its federal-plus-state tax rate is 40 percent.
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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
are compounded to the terminal year, in this case Year 8, at the
project's cost of capital,
these values summed to produce the project's
terminal value.
compounded are
Then, is
found as the discount rate which causes the present value of the
terminal value to equal
cost of the equipment. Spurrier had recently attended a seminar
on capital budgeting
according to the seminar leader, the MIRR method has
significant advantages over the
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
Net
Year Cost
Project Net Cash Flows
Depreciation
Tax Saving
After-Tax
Cost Saving
Net Cash Flow
5,
6.
'T
S.
9.
10.
0 ($212,500)
2
3
4
5
6
7
8
$17,000
27,200
16,150
10,200
9,350
5,100
0
$36,000
36,000
36,000
36,000
36,000
36,000
36,000
($212,500)
53,000
63,200
52,150
46,200
45,350
41,100
36,000 36,000
36,000
QUESTIONS l. Explain the inputs into l) the net initial investment outlay at year O, 2) the depreciation tax
savings in each year of the projects economic life, and 3) the projects incremental cash flowsO
2. What is the ? 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 Chicago3. 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 versus for budgeting decision too nd wants
fives
ome typically
payback uses
information.
the payback as a primary capitalb. What is the rationale
• &the use of payback as a project evaluation
tool?
@ 1994 South-western, a part of cengage Learning
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.
f. 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 NPYJRR, MIRR, an 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 Net Cash Flow
0 ($120,000)
1 150,000
Assuming an 1 1 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 (l) 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?
I l. Natasha Spurrier informed Houston that all sales 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 basic analysis and also sensitivity analyses, in
which they examine the effects of changes in such things as the annual cost savings, the cost of
capital, and the tax rate. Therefore, Houston and Spurrier developed the following "sensitivity
questions," which they plan to discuss with the sales reps:
a. Suppose the annual cost savings differed from the projected level; how would this affect the
various decision criteria? What is the minimum annual cost savings at which the system
would be cost justified? Discuss what is happening and, if you are using the spreadsheet
model, quantify your answers; otherwise, just discuss the nature of the effects.
b. Repeat the type of analysis done in Part a, but now, vary the cost of capital.
Again, quantify
your answers if you are using the spreadsheet model.
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c. Repeat the type of analysis done in Part a, 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 Net Cash Flow
($30,000)
150,000
2 (120,000)
Assuming an I I percent cost of capital, what is this project's NPV, IRR, and MIRR? Draw thisnew project's NPV profile on a new graph. Explain what is happening with this project.