Case 11

Chicago Valve Company

Capital Budgeting Decision
Methods
CASE INFORMATION
Purpose
This is the first (and simplest) of the capital budgeting cases.
It is intended to be an introduction to the various decision
methods used in capital budgeting.
Time Required
About 3 hours of student preparation are usually sufficient to
become familiar with the case. However, add another hour if the
case is to be turned in. Less time is required if the model is
used.
Complexity
A--relatively simple.
Flexibility
We generally ask students to think about this case at the same time
the text chapter on capital budgeting basics is assigned. We then
use it as a discussion vehicle to cover various facets of capital
budgeting. In our experience, students understand the material
better when we link the lecture to a case study, and this case is
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Case 11-1
easy enough for students to not get bogged down with details, yet
rich enough for them to see the context in which capital budgeting
policy issues arise.
MODEL INFORMATION
Description
The case model (filename CASE-11I) first develops the project's
cash flows on the basis of cost and operating savings data, and
then uses these flows to calculate NPV, IRR, MIRR, profitability
index (PI), and payback. It also contains some data tables for
sensitivity analysis, and the required data to find multiple IRRs
for the multiple IRR project. It also contains a graph of two NPV
profiles, a graph that shows the NPV profile of the multiple IRR
project. The model has complete flexibility regarding cost and
savings data, but some parameters, mainly project life and
depreciation data, are fixed. The INPUT DATA and KEY OUTPUT
sections with base case data are shown here:
INPUT DATA: KEY OUTPUT:
New system:
Delivered cost $200,000 NPV $36,955
Installation $12,500 IRR 16.2%
Salvage value $0 MIRR 13.2%
Annual savings $60,000 Payback 4.0
PI 1.17
Old system:
Current book value $0
Current market value $0
Removal cost $0
Other data:
Cost of capital 11.0%
Tax rate 40.0%
Model Use
If we use the case as the basis for a lecture, we probably would
not provide students with the model--rather, we would just work out
the answers in class with a calculator. However, if we use the
case as a regular case, we provide our students with the student
version of the model, but we do ask questions to make sure they
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Case 11-2
understand the mechanics of NPV, IRR, and so on. With the model
available, students can conduct sensitivity or break-even analyses
with ease.
CASE SOLUTION
Summary of Numerical Answers
2. NPV = $36,955.
3. IRR = 16.2%.
4. a. Payback = 3.96 _ 4.0 years.
5. MIRR = 13.2%.
6. PI = 1.17.
10. NPV = $15,135; IRR = 25%.
12. NPV = $7,740; IRR = 0% and 300%.
Question 1
Cash flows at t = 0:
___________________
Cost of new system ($200,000)
Installation (12,500)
________
Total cost ($212,500)
________
Sale of old system $ 0
Tax on sale 0
Removal cost 0
________
Net CF from sale $ 0
________
Net investment outlay ($212,500)
========
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Case 11-3
Operating cash flows:
____________________
Depreciable basis = $212,500.
Depreciation Depreciation
Year MACRS Allowance Expense Shield
____ _______________ ____________ ____________
1 0.20 $42,500 $17,000
2 0.32 68,000 27,200
3 0.19 40,375 16,150
4 0.12 25,500 10,200
5 0.11 23,375 9,350
6 0.06 12,750 5,100
____ ________ _______
1.00 $212,500 $85,000
Notes:
(1) Since all six years of depreciation will be taken, the MACRS
allowances sum to 1.0 and the depreciation expenses sum to the
depreciable basis, $212,500.
(2) The depreciation shield, or tax savings, in each year is the
tax rate, 0.40, times that year's depreciation expense. For
example, in Year 1, depreciation tax savings = 0.4($42,500) =
$17,000.
(3) The depreciation tax savings sum to $85,000, which equals (Tax
rate)(Depreciable basis) = 0.4($212,500) = $85,000.
Now, the after-tax operating tax savings = 0.6($60,000) =
$36,000 in each year, and this amount is added to the
depreciation tax savings to find the net after-tax operating
cash flow:
After-tax Depreciation Operating
Year Savings Tax Savings Cash Flow
____ _________ ____________ _________
1 $36,000 + $17,000 = $53,000
2 36,000 27,200 63,200
3 36,000 16,150 52,150
4 36,000 10,200 46,200
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Case 11-4
5 36,000 9,350 45,350
6 36,000 5,100 41,100
7 36,000 -- 36,000
8 36,000 -- 36,000
End-of-Project Cash Flows:
_________________________

Salvage value $0
Salvage value tax 0
__
Net cash flow $0
==
Project Incremental Net Cash Flows:
__________________________________
Year Net Cash Flow
____ _____________
0 ($212,500)
1 53,000
2 63,200
3 52,150
4 46,200
5 45,350
6 41,100
7 36,000
8 36,000
Question 2
NPV(k = 11%) = $36,955. Calculated with a financial calculator, or
Lotus.
The rationale behind NPV is straightforward. If a project's NPV =
$0, then the project generates exactly enough cash (1) to recover
the capital investment and (2) to pay the debt and equity investors
their required rates of return on the capital they supplied. To
see what a positive NPV implies, consider the control system
project. With an NPV of $36,955, the cash flows are sufficient (1)
to return the $212,500 initial net investment, (2) to pay the debt
and equity investors their combined 11 percent required rate of
return, (3) to pay taxes on the project's profits, and (4) to still
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Case 11-5
leave $36,955 (the NPV) as a bonus to the original stockholders.
Since the debtholders' claims are fixed, the project's $36,955
residual value belongs entirely to the original stockholders, and
hence the value of their wealth is increased by that amount.
The value of the NPV of the system would almost certainly be
different for different Chicago Valve customers, depending on how
much it would save them, their costs of capital, their tax rates,
and whether or not they have an old machine to dispose of. Note
that if different pieces of equipment did not have different values
to different companies, then every company would have exactly the
same capital budget!
Question 3
IRR = 16.2%. Calculated with a financial calculator, or Lotus.
The IRR is simply the discount rate which forces the project's NPV
to equal zero. Thus, the two approaches are quite similar, but in
the NPV method, a discount rate is specified and the NPV is found,
while in the IRR method, the NPV is set equal to zero and the
discount rate (IRR) is found. IRR measures a project's rate of
return profitability, whereas NPV measures a project's dollar
profitability. If a project's IRR equals its cost of capital, then
NPV = $0 and its cash flows are just sufficient to provide
investors with their required rates of return. An IRR which is
greater than k implies an excess return--the project's NPV is
greater than zero--and this excess goes to the firm's shareholders.
Again, IRRs would probably differ among firms.
Question 4
a.
Cumulative
Year Net Cash Flow Cash Flow
---- -------------- ----------
0 ($212,500) ($212,500)
1 53,000 (159,500)
2 63,200 (96,300)
3 52,150 (44,150)
4 46,200 2,050
5 45,350 47,400
6 41,100 88,500
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Case 11-6
7 36,000 124,500
8 36,000 160,500
Looking at the cumulative cash flows, the project's payback is
slightly less that 4 years. If we assume that cash flows
occur uniformly over the year, then the $46,200 Year 4 cash
flow will cover the $44,150 end-of-year 3 deficiency in
$44,150/$46,200 = 0.96 years, hence the payback is 3.96 years.
b. Payback represents a type of breakeven analysis. If the cash
flows occur as predicted, then the payback tells us when the
project will break even in an accounting sense.
c. Payback has three critical deficiencies: (1) It does not
consider the timing of the cash flows, (2) it ignores all cash
flows that occur after the payback period, and (3) there is no
external (market-determined) benchmark that defines an
acceptable payback. Note that the discounted payback
criterion removes the first objection. Discounted payback is
found as follows:
Discounted Cumulative Discounted
Year Net Cash Flow Net Cash Flow
____ _____________ _____________________
0 ($212,500) ($212,500)
1 47,748 (164,752)
2 51,295 (113,458)
3 38,132 (75,326)
4 30,433 (44,893)
5 26,913 (17,980)
6 21,974 3,994
7 17,340 21,334
8 15,621 36,955
Here we have discounted each year's net cash flow to its Year
0 value at the 11 percent cost of capital rate. Then, the
payback is found in the normal manner, so discounted payback =
5.82 years. Therefore, when the time value of money is
considered, the payback increases from 3.96 to 5.82 years.
However, even the discounted payback fails to value cash flows
after the payback period. Further, there is still no
benchmark to distinguish an acceptable payback from an
unacceptable one.
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Case 11-7
d. In spite of its deficiencies, many firms still consider
payback when making capital budgeting decisions. However,
payback is rarely used to measure relative profitability, or
as the primary decision tool. Rather, it is used as a rough
measure of a project's liquidity (how quickly will the
investment be returned and hence available for other projects)
and riskiness (long payback projects have cash flows that
extend well into the future, and distant flows are usually
more risky than near-term flows). From a liquidity and risk
perspective, the payback does provide useful information.
e. The payback method favors projects with short lives.
Therefore, from a sales standpoint, it would make more sense
for a sales representative to discuss the payback of one of
Chicago Valve's short-lived systems than the payback of a
long-lived system.
f. The reciprocal of the payback is a rough estimate of a
project's IRR. If the project has an infinite life and
constant cash flows, then the reciprocal of the payback is
exactly equal to the IRR. Under any other condition, it is
not equal to the IRR, and the shorter the life of the project,
the poorer the approximation.
Question 5
Here is the setup for finding the MIRR:
Terminal Value =
PV of Cash Net FV of Cash
Year Outflows at t=0 Cash Flow Inflows at t=8
____ _______________ ___________
________________
0 ($212,500) ($212,500)
1 53,000 $110,036
2 63,200 118,210
3 52,150 87,876
4 46,200 70,135
5 45,350 62,022
6 41,100 50,639
7 36,000 39,960
8 36,000 36,000
________ ________
($212,500) $574,879 =
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Case 11-8
TV
======== ========
MIRR is found by first discounting all cash outflows back to t=0 at
the project's cost of capital and then summing the PVs. In this
case, there is but one outflow, $212,500. Next, all inflows are
compounded at k to the end of the project's life and summed to
produce the project's terminal value ($574,879). Finally, MIRR is
that discount rate which discounts $574,879 to $212,500 over 8
years:
MIRR = 13.2%.
MIRR is a better rate of return measure than IRR because MIRR
assumes that cash flows are reinvested at the project's cost of
capital rather than at its IRR rate, which is implicitly assumed
when the IRR is calculated.
Question 6
Here is the calculation for the PI:
PV of cash inflows
PI = ___________________
PV of cash outflows
$249,455
= ________ = 1.17.
$212,500
The profitability index (PI) measures a project's "bang for the
buck." That is, PI gives the dollar return per dollar of invested
capital, all on a present value basis. Thus, the project's PI =
1.17 means that the project would generate $1.17 for each $1.00
invested when the time value of money is considered. The major
problem with the PI is that it fails to take account of the size of
the project; thus, using it could lead to the rejection of a $1
million project with a 50% rate of return in favor of a $1,000
project with a 100% rate of return by a company with a 10% cost of
capital.
Question 7
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Case 11-9
If a project's NPV > $0, then its IRR > k, its MIRR > k, and its PI
> 1.0. Thus, if the NPV method indicates that a project is
acceptable, then the other methods also indicate acceptability.
When projects are independent and have normal cash flows (one or
more outflows followed by inflows), all discounted cash flow (DCF)
methods must lead to the same decision, and hence they can be used
interchangeably.
However, when mutually exclusive projects which differ in cash
flow timing and/or scale are being evaluated, ranking conflicts can
occur. Figure 1 shows NPV profiles for the system under
consideration and another, short-term project. From the graph we
see that a conflict exists if these two projects are mutually
exclusive and if the cost of capital is below the crossover point,
about 15.3%.
It should also be noted that when projects have nonnormal cash
flows, the IRR method may not be usable. (See Question 12.) In
these situations, it is always best to use NPV as the primary
decision tool.
Question 8
If a 10 percent investment tax credit (ITC) were reinstated, then
the $212,500 cost of the project (including installation) would
produce a 0.10($212,500) = $21,250 tax savings at Time 0. If
depreciation were not affected, then the project's NPV would
increase by the full $21,250 ITC. Even if the depreciable basis
were reduced by the full amount of the ITC, the NPV would still
increase because (1) $21,250 would be a direct reduction of taxes,
while the lost depreciation tax savings are only 0.4($21,250) =
$8,500, and (2) the ITC would be received at Time 0, while the
depreciation tax savings reduction would be spread over future
years. (Note that prior to the Tax Reform Act of 1986, which
eliminated the ITC, the depreciable basis was reduced by one-half
the ITC amount. This treatment varied over time, at the whim of
Congress.)
Question 9
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Case 11-10
See figure 1 for NPV-profiles at a relevant range of the X-axis.
An NPV profile is simply a plot of NPV versus the discount rate, k:
k NPV
_____ _________
0.0% $160,500
1.0 145,634
3.0 118,531
5.0 94,512
7.0 73,142
9.0 54,058
11.0 36,955
13.0 21,575
15.0 7,698
17.0 (4,863)
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Case 11-11
FIGURE 1
COST OF CAPITAL
N
P
V

(T
h
o
u
s
a
n
d
s
)

NPV-PROFILES
8.0% .0% 10.0% 11.0% 1!.0% 1".0% 1#.0% 1$.0% 1%.0% 1&.0% 18.0%
&0
%0
$0
#0
"0
!0
10
0
-10
-!0
NPV(LARGE) NPV(S'ALL)
19.0 (16,265)
Note the following points about the NPV profile:
(1) The Y-intercept is the NPV at k = 0%, or $160,500.
(2) The X-intercept is that k which forces NPV = $0, which is the
project's IRR, 16.2%.
(3) The profile is not a straight line; rather, it is a convex
curve which approaches the value NPV = -$212,500 as k
approaches infinity.
(4) The NPV profiles of normal projects all have the same general
appearance, but projects with nonnormal cash flows can have
unusual shapes which cross the X-axis more than once (multiple
IRRs), or never cross the X-axis (no real IRR). (See Question
12 for a further discussion of multiple IRRs.)
(5) When k < IRR, that is, when it is to the left of 16.2 percent,
the NPV profile is above the X-axis, signifying that the NPV
is positive. Thus, if the IRR method indicates project
acceptance, so will the NPV method, and vice versa.
Question 10
This short-term project's NPV at the 11% cost of capital is
$15,135, and its IRR is 25%. The MIRR is also 25%, because the
cash flows do not have to be compounded forward on a 1-year life
project. The project's NPV profile is shown on Figure 1. It has
the higher IRR, but a lower Y-axis intercept, hence there is a
crossover point at about 15.3%. Therefore, an NPV/IRR conflict
would exist if the projects were mutually exclusive and if the cost
of capital were below 15.3%, as it is. If the cost of capital were
above 15.3%, there would be no conflict.
Question 11
a. If the annual cost savings exceed the base case forecast, then
all of the decision criteria will look better; this is
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Case 11-12
demonstrated in the following data, taken from the Lotus
model: (NPV will be zero at savings of $48,031.)
Savings NPV IRR MIRR Payback PI
_______ _______ ______ ______ _______ _____
40,000 (24,798) 7.2% 9.3% 5.43 0.88
50,000 6,078 11.9% 11.4% 4.56 1.03
60,000 36,955 16.2% 13.2% 3.96 1.17
70,000 67,832 20.2% 14.9% 3.50 1.32
80,000 98,709 24.1% 16.4% 3.14 1.46
b. The cost of capital affects the NPV, the MIRR, and the PI.
The higher is k, the lower the NPV and PI, but the higher the
MIRR. If the cost of capital were equal to the IRR, then IRR
and MIRR would be equal. The IRR, 16.2 percent, indicates the
break-even point for capital costs.

Cap Cost NPV IRR MIRR Payback PI
________ _______ _____ _____ _______ ____
8.0% 63,334 16.2% 11.6% 3.96 1.30
9.0% 54,058 16.2% 12.1% 3.96 1.25
10.0% 45,276 16.2% 12.7% 3.96 1.21
11.0% 36,955 16.2% 13.2% 3.96 1.17
12.0% 29,064 16.2% 13.8% 3.96 1.14
13.0% 21,575 16.2% 14.4% 3.96 1.10
14.0% 14,460 16.2% 14.9% 3.96 1.07
15.0% 7,698 16.2% 15.5% 3.96 1.04
16.0% 1,263 16.2% 16.1% 3.96 1.01
17.0% (4,863) 16.2% 16.7% 3.96 0.98
18.0% (10,700) 16.2% 17.2% 3.96 0.95
c. At a tax rate of 64.92 percent, NPV will be zero. The tax
rate affects all criteria, as shown below:

Tax rate NPV IRR MIRR Payback PI
________ ______ _____ _____ _______ ____
20.0% 66,611 19.7% 14.8% 3.72 1.31
30.0% 51,783 18.0% 14.1% 3.83 1.24
40.0% 36,955 16.2% 13.2% 3.96 1.17
50.0% 22,127 14.3% 12.4% 4.10 1.10
60.0% 7,299 12.1% 11.5% 4.28 1.03
d. The ability to do sensitivity analysis would be a big help to
the sales representatives. For example, if one of the
customer's people questioned the size of the cost savings,
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Case 11-13
then it would be possible to show almost instantly just how
low the savings could go without causing the project to become
unprofitable. Similarly, if the customer felt that tax rates
or the cost of capital might be going to increase, the effects
of changes here could be demonstrated.
We know of no problems with sensitivity analysis per se,
other than the fact that it is sometimes hard for
inexperienced people to get the Lotus models to work properly,
which can be embarrassing. Of course, the term GIGO, or
"garbage in, garbage out" is still applicable, and if the
basic data are incorrect, then so will be the output.
However, data errors are not the fault of the computer.
Question 12
At an 11 percent cost of capital, NPV = $7,740. However, solving
for IRR is not so straightforward. On a HP-12C calculator, the
message "Error 3" appears when the IRR key is pressed. This is
because the project has multiple IRRs. However, the IRRs can be
found with a HP-17B. To see what is happening, consider the
project's NPV profile, which is plotted in Figure 2 using the
following data, taken from the Lotus model:

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Case 11-14
Basic Inputs:
Cost of Capital NPV Year Cash Flow
1 (30,000)
-10%(11,481.5) 2 150,000
0% 0.0 3 (120,000)
10% 7,190.1
20% 11,666.7 NPV = $7,740
30% 14,378.7 IRR(1) = 0.0%
40% 15,918.4 IRR(2) = 300.0%
50% 16,666.7
60% 16,875.0 Note: When multiple IRRs exist, Lotus
70% 16,712.8 reports the one closest to the
80% 16,296.3 initial guess. Therefore, we
90% 15,706.4 guessed 10% and 400% to obtain
100% 15,000.0 the two IRRs.
110% 14,217.7
120% 13,388.4 Also Release 2.0 will not permit
130% 12,533.1 the use of negative costs of
140% 11,666.7 capital, so ERR is reported for
150% 10,800.0 k = -10%. Release 2.01 would
160% 9,940.8 show NPV = -$11,481
170% 9,094.7
180% 8,265.3
190% 7,455.4
200% 6,666.7
210% 5,900.1
220% 5,156.2
230% 4,435.3
240% 3,737.0
250% 3,061.2
260% 2,407.4
270% 1,775.0
280% 1,163.4
290% 572.0
300% 0.0
310% (553.2)
320% (1,088.4)
330% (1,606.3)
Note these additional points:
(1) The project has two (multiple) IRRs: one at k = 0% and
another at k = 300%.
(2) The project's NPV is maximized at k _ 60%, when it reaches a
value of $16,875.
(3) At k = 11%, the project's NPV is positive, hence it should be
accepted.
FIGURE !
Cos( o) Ca*+(a,
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V

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'u,(+*,- IRR I,,us(.a(+on
0% "0% %0% 0% 1!0% 1$0% 180% !10% !#0% !&0% "00% ""0%
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