Case Scenario:
Hoskins is considering the purchase of one of FCS's standard fluid control systems which costs $90,000 including taxes and delivery. It would cost Hoskins another $5000 to install the equipment, and this expense would be added to the invoice price of the equipment to determine the depreciable basis of the system. A life of 5 years would be used for depreciation, but the system has an economic life of 8 years, and it will be used for that period. After 8 years, the system will probably be obsolete, so it will have a zero salvage value at that time.
This system would replace a valve system which has been used for about 20 years and which has been fully depreciated. The costs for removing the current system are about equal to its scarp value, so its current net market value is zero.
The new system would save Hoskin $26,000 annually in before-tax operating costs. For capital budgeting, Hoskin use 10 percent cost of capital, and its company tax rate is 40 percent.
Table below contains the complete flow analysis
Projects Net cash Flows
Year Net Cost Depreciation Tax savings After-Tax Cost Savings Net Cash Flow
0 (95000) (95000)
1 7600 15600 23200
2 12160 15600 22760 3 7220 15600 22820
4 4180 15600 19780
5 4560 15600 20160
6 2280 15600 17880
7 0 15600 15600
8 0 15600 15600
Questions
1. 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 Hoskins than for another customer?
2. Suppose one of Hoskin's executives uses the payback method as a primary capital budgeting decision tool and wants some payback information.
a. What is the project's payback period?
b. What is the rationale behind the use of a payback period as a project evaluation tool?
c. What deficiencies does payback have as a capital budgeting decision method?
d. Does payback provide any useful information regarding capital budgeting decisions?
e. FCS has a number of different types of products, some that are relatively expensive and some that are inexpensive, and some that have very long lives and some with shorts lives. Strictly as a sales tool, without regard to validity of the analysis, would the payback be of more help sales staff for some types of equipment than for others? explain
f. people occasionally find the payback, then take its recipocal and use the reciprocal as an estimate of the project's rate of return. Would thos procedure be more appropriate for projects with very long or very short lives? explain.
3.Suppose that an Investment Allowance in the form of a bonus taxation credit of 40 percent of the capital cost of new asset is reintroduced by the Government to stimulate investment in capitals goods. what would the imapct of the tax credit on acceptability of the control sysrem project? (no calculations are necessary, Just discuss the imapct)
4. Now suppose that FCS 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
0 $ (25,000)
1 110,000
2 (85,000)
Assuming an 10 percent cost of capital, what is the project's NPV, IRR and MIRR? Draw this project's NPV profile on a new graph. Explain what is happening with the project.