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 Missouri Pump's sales effort was on demonstrating the reliability and technological superiority of the firm's product line. However, many of Missouri Pump's traditional customers have embarked on cost-cutting programs in recent years. As a result, Missouri 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 Missouri Pump's products.
Missouri 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 Missouri 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 Missouri 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 Missouri Pump's actual customers.
From discussions with the firm's salespeople, you determine that a proposed sale to the Denver Water Department is perfect to use as an illustration. DENVER Water is considering the purchase of one of Missouri Pump's standard water pump systems which costs $748,000, including delivery. It will cost DENVER Water another $21,300 to install the equipment, and this expense will be added to the price of the equipment to determine the depreciable basis of the system ($769,300). Also, the new pump will require an increase in working capital of $17,000. DENVER Water will depreciate the pump system to zero using MACRS seven-year schedule but will use the system for nine years. They plan to sell the system at the end of nine years for $100,000. In addition to buying the pump system, DENVER Water will be required to pay $15,000 per year for a service and maintenance contract for the nine years, with payments at the beginning of each year.
The system from Missouri Pumps would replace a pump that DENVER Water is now using. That pump has been depreciated to a book value of $40,000and will be sold for $85,000 if the new system is purchased. DENVER Water spent $60,000 just one year ago to upgrade their existing pump system. By replacing the old pump, DENVER Water should save $321,000 annually in pre-tax operating costs. DENVER Water estimates that its cost of capital is 12% and its tax rate is 34%. If purchased, the new pump will be housed in a building owned by DENVER Water and currently leased to a fishing guide service which pays DENVER Pump $12,000 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 Missouri Pump representatives to help sell the system to DENVER 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. In addition to your written analysis, briefly answer the following questions directly.
1. What is the project's NPV? Could the NPV of this project be different for DENVER Water than for some other company if both companies expect the same cash flows? Explain.
2. What is the project's IRR? Assuming the same cash flows, could the IRR for this project differ for DENVER Water compared to another company? Explain.
3. Calculate the payback period. What are the disadvantages of the payback period? Does payback period provide any useful information regarding capital budgeting decisions?
4. Calculate the project's MIRR. Why is MIRR considered to be superior to the IRR? How does MIRR differ from IRR?
5. Calculate the project's Profitability Index.
6. Should DENVER Water purchase the new pump system? Why?
7. The management at DENVER Water tells you that they should not buy your pump system because they had spent $60,000 to upgrade the old pump just one year ago. How would you overcome this objection to buying the pump system from Missouri Pump Company?