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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.

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Although he was hired as a financial analyst after completing his MBA, Richard Houston's first assignment at FCS was with the firm's marketing department. Historically, the major focus of FCSs sales effort was on demonstrating the reliability and technological superiority of the firm's product line. However, many of FCS traditional customers have embarked on cost-cutting programs in recent years. As a result, FCS 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 FCS's products.

FCS manufactures fluid control 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 FCS's systems are made up of standard components, and most complete systems are priced from $50,000 to 100,000. Because of the somewhat technical nature of the products, the majority of FCS'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 Hoskins chem CO was perfect to use as an illustration.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 advantages of the new system are greater reliability and lower human monitoring and maintenance requirements. In total, the new system would save Hoskin $26,000 annually in begore-tax operating costs. For capital budgeting, Hoslins an 10 percent cost of capital, and itscompany tax rate is 40 percent.

Karen Evans FCS'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 fluid system. As you go through the analysis, keep in mind that the purpose of the analysis is to help FCD'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 1 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. What is the project's NPV? Explain the economic rationale behind the NPV. Could the NPV of this particular project be different for Hoskins ChemCothan for one of FCS's other potential customers? Explain.

2. 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?

3. What is the project's payback period? 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

4. 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.

5. What is the projects MIRR?

6. Plot the projects NPV profile and explain how the graph can be used.

7. 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)

8.. 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.

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Solution Preview

Hello!
Here are your answers.

Question 1
The NPV of the a project is calculated as the sum of its discounted net cash flows. The discount rate used should be the firm's cost of capital. Since the cost of capital is 10% (0.10) the formula will be:

NPV = -95000 + 23200/1.1 + 22760/(1.1^2) + 22820/(1.1^3) + 19780/(1.1^4) + ...
NPV = -95000 + 21090.90 + 18809.91 + 17145 + ...

The result of this calculation is $13.449.19. Since the project has a positive net present value, then it should be convenient for Hoskins to purchase the system.

The main concept behind the rationale of the net present value calculation is the Time Value of Money. In this case, for instance, Hoskins knows that it will "receive" a net $23,200 next year, $22,760 two years from now, etc. However, it's clearly not the same to receive the $23,200 right now than to receive them one year from now, thus we have to adjust each of the cash flows by a discount rate, in order to find the equivalent "today's value" of the future savings.

There's an alternative explanation to this rationale. The NPV tells you how much money you could borrow today and be able to repay with the profits (or savings, they are equivalent concepts here) generated by the project. Let me illustrate this. You know, for example, that next year you will receive $23,200. The present value of this is 23200/1.10 = $21,090. So if you borrow $21,090 today, your debt will increase to 21090*1.1 = $23,200 next year (because your cost of capital is 10%, so the interest on this debt is 10%). So at the end of year 1 you would owe $23,200 - which you could immediately cover with the $23,200 cash flow that the project will have generated by then. This means that undertaking the project allowed you to have an extra $21,090 today. This same reasoning can be applied to all the other future cash flows to arrive at the NPV. If the total amount you can borrow is greater than $95,000 (that is, if the NPV is greater than zero), then clearly it's desirable to undertake the project.

Using the above explanation, what would happen if the cost of capital were higher? In this case, the amount you can borrow would be reduced, as the interests are greater and the cash flows are fixed. For example, continuing with the first cash flow as an example, if the cost of capital were 20%, you could borrow 23200/1.20 = $19,333 today. The same would happen with all the other cash flows.

We conclude that the NPV of this project CAN be different for Hoskins than for other prospective customers. Even assuming that the net cash flows were the same for all customers (which is not necessarily true, as different firms could experience different savings with the same system; and/or have a different tax rate), the cost of capital is decisive when calculating the NPV. If we assume identical cash ...

Solution Summary

Extensive computations and discussion.

$2.19