Capital Budget Analysis

Texas Pump Company (FIN5303-30; Summer 1 2013)

Although you were hired as a financial analyst after completing your MBA, your first assignment at Pump is with the firm’s marketing department. Historically, the major focus of Texas Pump’s sales effort was on demonstrating the reliability and technological superiority of the firm’s product line. However, many of Texas Pump’s traditional customers have embarked on cost-cutting programs in recent years. As a result, Texas Pump’s marketing director asked your boss, the CFO, to lend you to marketing to help them develop some analytical procedures that the sales force can use to demonstrate the financial benefits of buying Texas Pump’s products.

Texas Pump manufactures pump systems that are used in a wide variety of applications including water distribution, sewage treatment, 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-set pressure specifications. Most of Texas Pump’s systems are made up of standard components, and most complete systems are priced from $600,000 to $1,000,000. Because of the technical nature of the products, the majority of Texas Pump’s salespeople have a background in engineering, not finance and marketing.

As you think about this assignment, you quickly come to the conclusion that the best way to “sell” a system to a cost-conscious customer is to conduct a capital budgeting analysis that will demonstrate the cost effectiveness of the system. Further, you conclude that the best way to begin is with an analysis for one of Texas Pump’s actual customers.

From discussions with the firm’s salespeople, you determine that a proposed sale to the Oklahoma City Water Department is perfect to use as an illustration. OKC Water is considering the purchase of one of Texas Pump’s standard water pump systems which costs $870,000, including delivery. It will cost OKC Water another $40,000 to install the equipment, and this expense will be added to the price of the equipment to determine the depreciable basis of the system. Also, the new pump will require an increase in working capital of $20,000. OKC Water will depreciate the pump system to zero using straight-line method for eight years. They plan to sell the system at the end of nine years for $400,000. In addition to buying the pump system, OKC Water will be required to pay $18,000 per year for a service and maintenance contract beginning after the first year with payments at the beginning of each year thereafter (8 payments).

The system from Texas Pumps would replace a pump that OKC Water is now using. That pump has been depreciated to a book value of $40,000 and will be sold for $40,000 if the new system is purchased. OKC Water spent $30,000 just one year ago to upgrade their existing pump system. (OKC Water believes the $30, 000 for repairs should be a cost to the present evaluation because it did not increase the salvage value of their current pump.) By replacing the old pump, OKC Water should save $360,000 annually in pre-tax operating costs. OKC Water estimates that its cost of capital is 12% and its tax rate is 36%. If purchased, the new pump will be housed in a building owned by OKC Water and currently leased to a fishing guide service which pays OKC Pump $20,000 at the beginning of each year to use the building. Because of the noise, the fishing guide service will have to move out of the building.

After developing a capital budgeting analysis for the pump system, write a description of the analysis to be used by Texas Pump representatives to help sell the system to OKC Water. Remember that the analysis will be used to help non-finance sales representatives sell equipment to non-finance customers. The analysis must be understandable and clear. Show each step and calculation such that an intelligent person not trained in finance can understand. Also, include a spreadsheet that calculates your results (template included). Calculate Payback Period, Net Present Value, Internal Rate of Return, Profitability Index, and Modified Internal Rate of Return.