Case Scenario: Fluid Control Systems (FCS)
Although he was hired as a financial analyst after completing his MBA, Harry Clifford’s first assignment at FCS was with the firm’s marketing department. Historically, the major focus of FRS’s sales effort was on demonstrating the technology superiority of the firm’s product line. However, many of the FRS’s traditional customers have embarked on cost-cutting programs in recent years, and as a result, FRS’s marketing director asked Clifford’s boss, the financial vice president, to lend Clifford to marketing to help them develop some analytical procedures for the sales force to use that will demonstrate the financial benefits of buying FRS’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, and control units that continuously monitor the flow rate and the pressure along a line and automatically adjust the pump to meet preset pressure specifications. Most of FRS’s systems are made up of standard components, and most complete systems are priced from $50 000 to $100 000. Because of the highly technical nature of the products, the majority of FRS’s sales force has backgrounds in engineering.
As he began to think about his assignment, Well’s 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 system’s cost effectiveness. Further, he concluded that the best way to begin was with an analysis for one of FRS’s actual customers.
From the discussions with the firm’s sales people, Clifford concluded that a proposed sale to Hoskins ChemCo was perfect to use as an illustration. Hoskins is considering the purchase of one of FRS’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 will probably be obsolete, so it will have a zero salvage value at that time.
This system would replace a control 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 (1) that it would be more energy efficient, (2) that it would reduce waste, because the chemical processes could be more carefully controlled, and (3) that it would require less human monitoring and maintenance. In total, the new system would save Hoskins $26 000 annually in before-taxes operating costs. For capital budgeting, Hoskins uses a 10 percent cost of capital, and its company tax rate is 40 percent.
Karen Evans, FRS’s marketing manager, gave Clifford a free-hand in structuring the analysis, with one exception-she told him to include the modified IRR (MIRR) as one of the decision criteria. To calculate MIRR, all the cash inflows are compounded to the terminal year, in this case Year 8, at the project’s cost of capital, and then these compounded values are summed to produce the project’s terminal value. Then, MIRR is found as the discount rate that causes the present value of the terminal value to equal the net cost of the equipment. Evans had recently attended a seminar on capital budgeting and according to the seminar leader, the MIRR method has significant advantages over the use of the regular IRR, and for that reason it is rapidly replacing IRR as a primary capital budgeting method.
Now put yourself in Clifford’s position and develop a capital budgeting analysis for the fluid control systems. As you go through the analysis, keep in mind that the purpose of the analysis is to help FRS’s sales representatives sell equipment to other non-financial people, so the analysis must be as clear as possible, yet technically correct. In other words, the analysis must not only be right, it must also be understandable to decision makers, and the presenter-Harry, in this case-must be able to answer all questions, ranging from the performance characteristics of the equipment to the assumptions underlying the capital budgeting decision criteria.
Table: Below contains the complete cash flow analysis.
Project Net Cash Flows
|
Year
|
Net Cost
|
Depreciation Tax Savings ($)
|
After-Tax Cost Savings ($)
|
Net Cash Flow ($)
|
|
0
|
(95 000)
|
|
|
(95 000)
|
|
1
|
|
7600
|
15 600
|
23 200
|
|
2
|
|
12 160
|
15 600
|
27 760
|
|
3
|
|
7220
|
15 600
|
22 820
|
|
4
|
|
4180
|
15 600
|
19 780
|
|
5
|
|
4560
|
15 600
|
20 160
|
|
6
|
|
2280
|
15 600
|
17 880
|
|
7
|
|
0
|
15 600
|
15 600
|
|
8
|
|
0
|
15 600
|
15 600
|
Required to do:
Question 1:
a. what is the project's MIRR?
b. what is the conceptual difference between the IRR and the MIRR?
c. which is better?
d. why?
Question 2. suppose a potential customer wants to know the project's profitability index (PI). what is the value of the PI for Hoskins, and what is the rationale behind this measure?
Question 3. Under what conditions do NPV, IRR, MIRR and PI all lead to the same accept/reject decision? When can conflicts occur? If a conflict rises, which method should be used and why?