Capital Budgeting Decisions (DOC)

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Capital Budgeting Decisions (DOC) Powered By Docstoc
					                  Time Value of Money and Project Selection

                                    Alberta Valve Company

Although he was hired as a financial analyst, Bob Figrin’s first assignment at Alberta Valve was
with the firm’s marketing department. Historically, the major focus of Alberta Valve’s sales
effort was on demonstrating the reliability and technological superiority of the firm’s product
line. However, many of Alberta Valve’s traditional customers have embarked on cost-cutting
programs in recent years. As a result, Alberta Valve’s marketing director asked Figrin’s boss,
the financial VP, to lend Figrin to marketing to help them develop some analytical procedures
that the sales force can sue to demonstrate the financial benefits of buying Alberta Valve’s

Alberta 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 Alberta 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 Alberta Valve’s
salespeople have a background in engineering.

As he began to think about his assignment, Figrin 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, Figrin
concluded that the best way to begin was with an analysis for one of Alberta Valve’s actual

From discussions with the firm’s sales people, Figrin concluded that a proposed sale to Big Cow
Petroleum, Inc., was perfect to use as an illustration. Big Cow is considering the purchase of one
of Alberta Valve’s standard petroleum valve systems which costs $200,000, including taxes and
delivery. It would cost Big Cow 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. After 8 years, the system will probably be obsolete, so it will have a zero salvage value
at that time. After Tax Depreciation is as follows:

                Year       ATCF Depreciation
                1          $17,000
                2          $27,200
                3          $16,150
                4          $10,200
                5          $ 9,350
                6          $ 5,100

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 Big Cow $36,000 annually in after-tax operating costs. For capital budgeting, Big
Cow uses an 11 percent cost of capital.

Natasha Spurrier, Alberta Valve’s marketing manager, gave Figrin a free hand in structuring the
analysis, but with one exception – she told Figrin to be sure to include the NPV and IRR as the
decision criteria.

1. Prepare a complete cash flow analysis for the project 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.

2. What is the project’s NPV?

3. Calculate the proposed project’s IRR.

4. Now suppose that Alberta 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?

5. Now suppose that Alberta 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 and its IRR?

6. Plot the NPV profile for project A and explain how the graph can be used. (Bonus question)

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