Case Scenario:
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 sue 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-set pressure 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 somewhat technical nature of the products, the majority of Chicago Valve's salespeople have a background in engineering.
As he began to think about his assignment, Houston quickly came to the conclusion that the best way to "sell" a system to a cost-conscious customer would be to conducting a capital budgeting analysis which would demonstrate the cost effectiveness of the system. Further, Houston concluded that the best way to begin was with an analysis for one of Chicago Valve's actual customers.
From discussions with the firm's sales people, Houston concluded that a proposed sale to Lone Star Petroleum, Inc., was perfect to use as an illustration. Lone Star is considering the purchase 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, and this expense would be added to the invoice price of the equipment to determine the depreciable basis of the system. A MACRS class-life of 5 years would be used, 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. Current depreciation allowances for the 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 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 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 11 percent cost of capital, and its federal-plus-state-tax rate is 40 percent.
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.
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.
Required to do:
Part A:
Question 1. Prepare a complete cash flow analysis for the project, showing for each year, the Depreciation Cash Savings, After-Tax Cost Savings, and Net Cash Flow, as well as the initial cash outflow for Year 0.
Question 2. What is the project's NPV? 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 Chicago Valve's other potential customers? Explain.
Question 3. 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 another customer?
Question 4. What is the project's MIRR? What is the difference between the IRR and the MIRR? Which is better? Why?
Question 5. Under what conditions do NPV, IRR, and MIRR all lead to the same accept/reject decision? When can conflicts occur? If a conflict arises, which method should be used, and why?
Question 6. Plot the project's NPV profile and explain how the graph can be used.
Question 7. 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 11 percent cost of capital, what is the 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 discuss (1) mutually exclusive versus independent projects, (2) conflicts between projects, and (3) the effect of the cost of capital on the existence of conflicts, (4) the crossover rate - what is that rate, and what is its significance. What timing and project size conditions must exist for conflicts to arise?
Question 8. 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
0 $(30,000)
1 150,000
2 (120,000)
Assuming an 11 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 cash flows on this project.