Brandon Joiner, president and chief executive officer of FalconvillePumpCompany, Inc., has a potentially serious problem on his hands. The earningsof the firm were essentially flat in 2015in spite of a general upturn in theindustry.Now, well into the fourth quarter of 2016, the picture is evengloomier. FPC’s performance has continued to deteriorate and, for thefirst time since2000, a loss was incurred in thethird quarter. Unless things improve quickly, it is possible that the companywill show a loss for 2016as a whole. This problem is particularly frustratingto Joiner because it comes on the heels of a report in one of the leadingtrade journals that rated FPCs products as superior to those of all competitorsin the industry in terms of durability and customer service.FalconvillePump Company is a major producer of deep-well submersiblepumps for commercial applications, irrigation equipment, and liquiddistribution systems. Originally the company specialized in agricultural systemsrequiring large pumping volumes and high lift (wells over 500 feetdeep), but that segment of the business represents less than 10 percentoftotal sales today. Most of the sales volume for the past five years has been inthe areas of sanitation control systems,chemical and petroleum production,industrial process cooling systems, and pipeline transportation systems. Althoughmost of the systems are specifically designed for individual customers, they tend to be constructed from standard modules that can beproduced in volume to realize substantial economies of scale. These systemsgenerally sell in the price range $50,000-$300,000, although it is notunusual to find contracts for several million dollars in pipeline transportationsystems. Historically, most of FPCs sales have been to companies whowere expanding their operations and therefore needed additional capacity.Recently,though, economic uncertainties have caused the firms to be morecautious in increasing their capacity, and,although interest rates have fallensubstantially, there is a reluctance to assume greater levels of debt for riskyexpansion projects.Because of these trends,FPCs major sales target hasshifted to retrofitting and upgrading existing plant and equipment.Although the original agricultural product line of the company wasbased on technology that was substantiallymore advanced than usuallyencountered in the industry, the selling skillsrequired to tailor the equipmentto the job were no greater than for other manufacturers. Over theyears, though, the degree of technological sophistication of the variousproducts increased markedly so that today a high degreeof technical expertiseis required to match theappropriate 2equipment modules with aparticular application. Consequently, the FPCsales force tends to be dominatedby engineers or persons with at least some engineering background.The sales force works closely with potential customers to demonstrate theadvantages of using FalconvillePump Company equipment. Since most salesinvolve a number of separate components or complete systems, the totaldollar volume that can be generated from a single order makesit wellworthwhile for the salespersons to devote considerable time and effort toclosing each sale.The immediate cause of Joiner’s preoccupation was a report he hadreceived that afternoon from Janet Avery, the recently appointed vice-presidentfor marketing. In an attempt to discover the causes of the firm’ssagging sales and to identify ways to turn them around, Avery had preparedan in-depth analysis of business conditions in the industry and changes inthe competitive positions of the leading firms-including FalconvillePumpCompany. Industry sales had been growing slowly for the past four years.In 2013 and 2014, FPCexperienced a growth rate that was slightly higherthan average, but since that time,they have not kept pace with the leaders.Hence, several firms were found to be increasing their share of the marketat the expense of FPC. On the basis of her analysis, Avery concluded thatthe primary cause of the market share erosion the firm is now experiencingis the change in profile characteristics of the target market, along withFPC’s failure to adapt its marketing strategy to reflect new environmentalconditions.Up to now, FalconvillePump Company’s marketing strategy has focusedonly on the engineering aspects of the products, and the firm’s promotionalliterature reflects this orientation. Such an emphasis is considered to beappropriate for two reasons. First, engineering excellence has always beenthe hallmark of FPC. The rating of the company’s products as most durablein the industry reflects this attention to technical details. Second, the primarycustomer contacts are the design engineers who must integrate theFPCequipment into larger systems. In the past, these individuals havealways been inclined to focus their attention on technicalspecifications ofthe pumping equipment,so promotional literature is designed to answerthe most frequently asked questions.This marketing strategy worked well until the late 2000s or early2010s, partly because expenditures on pumping equipment for newfacilitiestend to be a very small fraction of the total capital outlay for the largerproject and, therefore, are not usually subjected to a separate rigorousanalysis,and partly because capital was readily available at reasonable ratesto finance the purchases. As interest rates started to rise dramatically towardthe end of 2009, however, the sales force found it increasingly difficult toconvince customers to buy FPCequipment solely on the basis of engineeringperformance characteristics. 3Increasingly, economic aspects of the proposed
purchase have begunto dominate the sales effort. As customers’ expansion plans were scaledback,the pumping equipment was no longer looked upon as only a smallpiece of a much larger project. Rather, prospective purchasers started toview expenditures on pumping equipment as involving, in their own right,a significant commitment of scarce and expensive capital resources.In moreand more situations, the new equipment would replace an existing pumpingsystem that was still serviceable, so FPCsalespersons were compelled todemonstrate that the economic benefits from replacing the equipment immediatelywould more than offset the capital cost. By not recognizing theimplications of this fundamental shift in the requirements for effective sellingin a differenttarget market and then adapting the marketing strategyand promotional material accordingly better to support the sales force, FPCplaced itselfat a competitive disadvantage. Other companies were quick toseize and exploit the opportunity, and, particularly in the past two years,they succeeded in taking customers away from FalconvillePump Company.Avery uncovered two additional pieces of information that both sheandJoiner believed to be of particular significance.First, the companies thatappeared to be gaining market share at FPC’s expense stressed to the greatestextent the economics of replacement decisions in their promotionalliterature and sales presentations. All of them used a discounted cash flow(DCF) approach to convince potential customers of the advantages of replacingold pumping systems with the new high-efficiency models. Second,the most successful of FPC’s salespersons in the past four years were engineerswho had received formal college training in engineering economics.These individuals, who were trained in the use of DCF methodology, hademployed their knowledge to refine their own sales approach and developsupplemental material. By doing so, they were able to generate substantiallymore sales than their untrained peers.Because of these facts, Avery concluded that as soon as possible, FalconvillePump Company should develop appropriate promotional literatureand train all its sales force in the use of discounted cash flow project evaluationtechniques. Joiner admitted that this appeared to be a sound recommendation,and he saw no reason why it should not be implementedimmediately. As he pondered the information in Avery’s report, though, hehad the uneasy feeling that the implications of thedecision were far morepervasive than they appeared to be on the surface.DCF techniques had never been used at FalconvillePump Company forany purpose, the payback method being the preferred tool for capital expenditureanalysis. The more Joiner reflected on Avery’s report, though, themore he started to question whether this was a wise policy.
FPC’s customersincluded some of the largest and best-run companies in the world.If they requiredan economic analysis based on discounted cash flow methodologytor their own capital 4budgeting decisions, then perhaps FPCwasmaking a strategic error and should reevaluate its policies. Joiner had beenexposed to the mechanics ofDCF calculations at an executive developmentseminar in the mid·I990s, but he really did not understand why DCF isconsidered superior to other economic evaluation methodologies or howusing payback could lead to less-effective resourceallocations.At the executive committee meeting the next afternoon Joiner explainedhis reservations about continued total reliance on payback and histhoughts about the introduction of discounted cash flow techniques inFPC’s internal budgeting and marketing operations. He quickly discoveredthat no one in the room knew much more than he did about the strengthsand weaknesses of the various economic analysis techniques. Richard Phillips, vice-president for finance, was generally supportive of the suggestedchanges, but he proposed that a feasibility study be conducted as a firststep. A second-year M.B.A.student with several years of work experiencein the finance area, Sharon Stewart, had recently started an internship in hisdivision, and Phillips believed this to be an excellent project for her toundertake. Avery interrupted to remind Joiner of the pressing need forprompt action in her division to develop promotional literature and trainthe sales force in the use of DCF techniques. Only after thishad been done,she asserted, should the broader implications for FPC’s internal operationsbe considered.Joiner decided that the best course of action was first, to find out howwell Stewart is versed in capital budgeting techniques, and second, if thetraining proves to be adequate, to ask her to work on the marketing divisionproject during her internship. When Joiner questioned Stewart, he wasdelighted to learn that not only had she worked in the economic evaluationdepartment in her former job, she also had taken an entire course dealingwith capital expenditure decisions. (Stewart, for her part, was surprised tolearn that FPCwas still using the payback method.) She readily agreed tothe assignment in the marketing department, and she and Avery decided tostart by analyzing one of the standard pumping systems. The following facts, which Avery indicatedwerefairly typical, were to be used in the illustrative material:1.The equipment has a delivered cost of $105,000.
The equipment has a delivered cost of $105,000. An additional $3,000is requiredto install and test the new system.2.The new pumping system is classified by the IRS as 5-year property,although it has an8-year estimated service life. For assets classified by the IRS as 5-year property, the Modified Accelerated Cost Recovery System (MACRS) permits the company to depreciate the asset over 6years at the following rates: Year 1 = 20percent, Year 2 = 32 percent, Year 3 = 19 percent, Year 4 = 12 percent, Year 5 = 11 percent, Year 6 = 6percent.At the 5end of 8 years,the salvage value is expected to be around 5percent of the originalpurchase price, so the best estimate of salvage value at the end of the equipment’sservice life is $5,300, with removal costs of $1,200.3.The existing pumping system was purchased at $45,000 eight years ago and has been depreciated on a straight-linebasisover its economic life of 10years. If the existing systemis removed fromthe well and crated for pickup, it can be sold for $3,500 before tax.It will cost $1,000 to removethe system and crate it. 4.At the time of replacement, the firm will need to increase its net working capital requirements by $4,500 to support inventories.5.The new pumping system offers lower maintenance costs and freespersonnel who would otherwise have to monitor the system. In addition,it reduces product wastage because of a higher cooling efficiency.In total, it is estimated that the yearly savings will amount to$25,000 if the new pumping system is used.6.The firm has its target debt ratio of 30 percent, and its cost of new debt is 10 percent. Its expected dividend per share next year, D1, is $2.00 with a future growth rate of 6 percent per year. The firm’s current stock price, P0, is $40.00. The firm uses its overall weighted average cost of capital in evaluating average risk projects, and the replacement project is perceived to be of average risk. 7.The firm’s federal-plus-state tax rate is 30 percent, and this rate is projected to remain fairly constant into the future.QUESTIONS(Please show all your work either through Excel formulas/equations on the Cash Flow Estimation Worksheetor in separate tablesat the bottom of yourspreadsheet, whenever applicable.NO WORK SHOWN, NO POINTS.)(8pts)1.Compute the firm’s weighted average cost of capital given the info/data in the case. What other approaches/methodscan be used to measure the firm’s cost of equity and thus its WACC? To that end, what additional info/data would you need? (Hint: Afirm’s weighted average cost of capital is equal to ????= ????(????)(1 -t) + ????????, where ????and ????are the weights of debt and equity in the capital structure;????and ????are the respective costs of debt and equity;and t is the corporate tax rate; Do no round up your WACC figure.) 6(34 pts)2.Develop a capital budgeting schedule using the attached Cash Flow Estimation Worksheet (Excel spreadsheet)that should listshould list all relevant cash flow items and amounts related to the replacement project over the 8-year expected life of the new pumping system. (Reference Reading:“Cash Flow Analysis Example (RICProject)”, one of required Readings for the course.)(8 pts)3.Based on the capital budgeting schedule, evaluate the replacement project by computing NPV, IRR, MIRR, and Payback Period. Would you recommend to accept or reject the replacement project based solely on your DCF analysis so far?(10 pts)4.Before you make the final accept/reject decision, what other factors andapproaches would you consider further? Discuss alsohow to PRACTICALLY take into account those factors andapproaches in the capital budgeting decision process, whenever applicable.