Question

Capital Budgeting Decision Methods 11 CHICAGOVALVE COMPANY 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 supe. riority 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 salesforce 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 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 conduct a capital budgeting analysis which would demonstrate the cost effectiveness of the system. Further, Houston con- cluded that the best way to begin was with an analysis for one of Chicago Valve's actual cus tomers From discussions with the firm's salespeople, 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 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 5-year class property are 020.032.0 19.0 12. 011 and 006 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 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 Case II-CB

Answer 1

Detailed Explanation is Below

PLYWOOD& BLOCK BOARD Book1 Microsoft Excel File Home Insert Page Layout Formulas Data Review View Cut Calibri A A Wrap Text 11 Accounting E Copy Paste BIU E A E tE Merge & Center Condit Formatt Format Painter Clipboard Font Alignment Number NPV(11 %, B4 : B11 ) C13 A E G D 2 Year Net Cash Flows 2,12,500.00 1 $ 53,000.00 2 $ 63,200.00 5 52,150.00 46,200.00 3 $ 4 $ 5 $ 45,350:00 41,100.00 36,000.00 36,000.00 6 $ 9 7 $ 10 11 12 Internal Rate of Present Value of Future 2,49,455.10 16.20% Return Cash Flows 13 2,12,500.00 Intial Investments 14 Formula Used 36,955.10 NPV 15 IRR(B3:B11) 16 Cost of Capital 11 % 17 18 19 20 21 22 23 24 Sheet2 Sheet3U Sheet1 Ready e pType here to search 4s67

Year	Net Cash Flows
0	$                       -2,12,500.00
1	$                             53,000.00
2	$                             63,200.00
3	$                             52,150.00
4	$                             46,200.00
5	$                             45,350.00
6	$                             41,100.00
7	$                             36,000.00
8	$                             36,000.00
	Present Value of Future Cash Flows	$              2,49,455.10		Internal Rate of Return	16.20%
	Initial Investments	$              2,12,500.00
	NPV	$                  36,955.10
	Cost of Capital = 11%

Note: For Calculation of NPV and IRR Excel Functions have been used.

Present value of cash flows = $249455.10

Initial Investment = $ 212500.00

Net Present Value = Present Value of Cash Flows - Initial Investment = $36955.10

NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.

1. If NPV > = 0, accept the project.
2. If NPV < 0, reject the project.

A positive NPV means that project is profitable for firm and it will increase the wealth of shareholders.

NPV depends upon factors like discount rate, present value of cash inflows and cash outflows and depriciation. Different firms use different techniques of depriciation. So, this will affect value of NPV of same project for different customers. The cost of capital is different for different firms depending on use of debt and equity in the capital structure.

It is difficult to apply this method when projects having different life spans are to be compared. It is not possible to compare a project project that has positive cash flows for five years versus a project that is expected to produce cash flows for 20 years.The NPV method is not applicable when comparing projects that have differing investment amounts. A larger project that requires more money should have a higher NPV, but that doesn't necessarily make it a better investment, compared to a smaller project.

Internal rate of return = 16.20%

IF IRR > Cost of Capital, Then Accept the Project

IF IRR < Cost of Capital, Then Reject

IF IRR = Cost of Capital Then depends

Internal Rate of Return is the rate of return which a project is likely to earn. It is a guideline which suggests whether to proceed with a particular project or not.

IRR takes into account NPV and cost of capital. NPV also takes in to account cash inflows and cash outflows which are calculated after taking into account depriciation and different firms may use different methods to calculate depriciation which will affect cash flows. Also cost of capital is different for different firms. It depends upon the use of debt and equity in the capital structure.