Fazio pump corporation


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Fazio pump corporation

  1. 1. Fazio Pump Corporation Capital Budgeting
  2. 2. Fazio Pump Corporation <ul><li>Year 2000 </li></ul><ul><ul><li>The company developed a large powerful, computer directed hydraulic pump, called Faz-Power III. The customers of the company are expected to purchase this machine in order to reduce the cost, which is expected to be $60,000 per annum (without considering the inflation rate of 4%). </li></ul></ul><ul><ul><li>The price of the new pump is $260,000, while all existing pumps are priced under $40,000. </li></ul></ul><ul><ul><li>Is it a feasible alternative for the customers to go for the new pump? </li></ul></ul>
  3. 3. Fazio Pump Corporation <ul><li>A Capital budgeting problem for the customers </li></ul><ul><ul><li>Sales representatives were required to demonstrate the cash flow advantages due to the new pump. </li></ul></ul><ul><ul><li>Essentially, it is a capital budgeting problem for the customers. </li></ul></ul>
  4. 4. Price of the Machine, Cost Reduction and Salvage Value Assumptions <ul><li>Cost of the machine and expected cost reduction </li></ul><ul><ul><li>Tentative price = $260, 000 per unit </li></ul></ul><ul><ul><li>Reduction in cost = $60,000 in 1 st year </li></ul></ul><ul><ul><li>Assumed inflation rate = 4% per annum </li></ul></ul><ul><ul><li>Economic life of the machine = 8 years </li></ul></ul><ul><ul><li>Expected value at the end of year 8 = $30,000 ( Used to estimate salvage cash flow of new machine ) </li></ul></ul><ul><li>The cost of removal and disposal of old machines completely offset any salvage value ( Zero salvage cash flow due to the replacement of old machine) . </li></ul>
  5. 5. Depreciation Schedule <ul><li>Depreciation schedule (5-year depreciable life) </li></ul>11.52 5 11.52 4 19.20 3 5.76 6 32.00 2 20.00 1 Depreciation rate (%) Year
  6. 6. Required Rate of Return and Tax Rate <ul><li>Required rate of return </li></ul><ul><ul><li>13 per cent after tax </li></ul></ul><ul><ul><li>This is the required rate of return by the middle market companies to which Fazio sold pumps. </li></ul></ul><ul><li>Tax rate </li></ul><ul><ul><li>38 per cent pf pretax profit </li></ul></ul>
  7. 7. Purpose of the Case <ul><li>The Question </li></ul><ul><ul><li>Given the required rate of return of 13% by the companies, annual cost savings of $60,000 and other assumptions (tax rate, depreciation, salvage value etc.), can the company price the pump at $260,000? </li></ul></ul><ul><ul><li>Essentially, this is a capital budgeting problem for the customers, which in turn affects the pricing and sale of the new pumps. </li></ul></ul>
  8. 8. Capital Budgeting Problem <ul><li>How do you set up the cash flows in order to analyze them? </li></ul><ul><li>What is the payback period and its implications? </li></ul><ul><li>What is the NPV of the project and implications? </li></ul><ul><li>What is the Internal Rate of Return (IRR)? </li></ul>
  9. 9. Capital Budgeting Evaluation <ul><li>Payback period = 3.86 years </li></ul><ul><ul><li>It just explains the liquidity of the project. Given the 8-year economic life of the pump, the payback period is encouraging. </li></ul></ul><ul><li>NPV and IRR </li></ul><ul><ul><li>Both measures accept the pump project. </li></ul></ul>
  10. 10. Capital Budgeting Evaluation <ul><li>Decision </li></ul><ul><ul><li>Unless, risk is felt to be great, a $260,000 price tag should result in an acceptable rate of return to the investors. </li></ul></ul>