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  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-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  sales people 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 conduct 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 five years would be used, but the system has an economic  life of eight years, and it will be used for  that period. After eight years, the system will

probably  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.

0  1994  South-Western, a part of Cengage Learning

49Natasha 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.’TS.9.10.0 ($212,500)2345678

$17,000 27,200 16,150 10,200 9,350 5,1000 $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 projects 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 valves other potential customers? explain

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 ?

4.  suppose one of the lone stars executives typically use payback as a primary capital budgeting decision too  nd wants fives ome typically payback uses information.the payback

as a primary capitalb. 

a what is the projects payback period

b What  is the rationale • &the use of payback as a project [email protected]  1994 South-western, a part  of cengage Learning

c 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  isbetter? Why?

6. Suppose  a potential customer wants to know  the project’s  profitability index (PI). What is thevalue  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 Flow0 ($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.

1994  South-Western, a part of Cengage Learning

51c.  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 this new project’s NPV profile on a new graph. Explain what is happening  with  this project.