Danforth &Donnalley Laundry Products Company

SOLUTIONS TO CASES

Danforth & Donnalley Laundry Products Company

(Capital Budgeting: Relevant Cash Flows)

SOLUTION OBJECTIVE: The purpose of this case is to focus on what types and which cash flows should be included in capital budgeting analysis. The students forced to decide which cash flows are actually after-tax cash flows incremental to the company as a whole. This case should be introduced toward the beginning of the introduction to capital budgeting and works well as either a homework assignment or as anin-class lecture problem.

DEGREE OF DIFFICULTY: Relatively Simple

QUESTIONS

1. If you were put in the place of Steve Gasper, would you argue for the cost from market testing to be included in a cash outflow?

No. The cash flows associated with test marketing have already occurred at the time of the case and as such should be considered "sunk costs." Within the capital- budgeting decision we are only interested in incremental cash flows on an after-tax basis. This flow is clearly not incremental; regardless of the decision with respect to acceptance or rejection of the project, this cash outflow will remain. At an earlier date, prior to the occurrence of this expenditure, it should have been included as a cash outflow in the evaluation of this project, but after its occurrence, it is no longer an incremental cash flow.

2. What would your opinion be as to how to deal with the question of working capital?

While major cash outflows for most projects will be associated with plant and equipment expenditures, many times these expenditures will be accompanied by an increase in working capital needs. These increased needs are those associated with funds needed for inventories, payroll, and other cash needs and receivables from customers. As increased working capital needs involve the tying up of funds over the life of the project, they should be considered as cash outflows with the residual working capital being recovered at the termination of operations. In this case, the$200,000 needed for working capital should be considered an initial outflow and also an inflow at the end of the life of the project in year 15. At this point, some students may still feel that the investment and subsequent recovery of funds will balance each other out; here it should be emphasized that the present value equivalents of these flows are far from equal.

3. Would you suggest that the product be charged for the use of excess production facilities and building space?

Since the production of Blast will occupy current excess capacity, no incremental cash flows are incurred; hence, none should be charged against Blast.

4. Would you suggest that the cash flows resulting from erosion of sales from current laundry detergent products be included as a cash inflow? If there was a chance of competitors introducing a similar product if you did not introduce Blast, would this affect your answer?

In a strict sense, cash flows resulting from lost sales to the existing product line should not be included as a cash inflow. These cash flows are not incremental in that if the project is not accepted, they will occur anyway. If it seems likely that a competitor may introduce a similar product, the approach to market erosion from existing product lines may change. In this case, the market erosion may exist whether or not the new project is introduced; hence, the cash flows may be incremental. In the laundry detergent industry, where the competition is vigorous, this may in fact be a rational assumption. Thus, if cash flows from sales erosion are not considered, it may result in the rejection of a project which would be acceptable to a competitor, resulting in the subsequent introduction of this product by competition. Hence, the sales erosion of the existing product lines may no longer be dependent upon the introduction of Blast. In summary, the question seems to boil down to the ability and likelihood of competition introducing a similar product.

5. If debt were used to finance this project, should the interest payments associated with this new debt be considered cash flows?

No. These flows are taken into consideration within the discounting process and are represented by the opportunity cost or "cost of capital." To include them as cash flows results in double counting these flows.

6. What are the NPV, IRR, and PI of this project, both including cash flows resulting from sales diverted from the existing product lines (Exhibit 1) and excluding cash flows resulting from sales diverted from the existing product lines (Exhibit 2)? Under the assumption that there is a good chance that competition will introduce a similar product if you don’t, would you accept or reject this project?

Determining the NPV and PI for this project gives students an excellent chance to work with the annuity tables in determining the value of future annuities (i.e., annuities for years 6-10 and 11-15). Working through the calculations slowly takes students a long way toward understanding the meaning of the annuity tables.

Including Flows from Excluding Flows From

From Sales Erosion of Existing Line Sales Erosion of Existing Line

Year

0 -2.2M -2.2M 1-5 280,000 x (3.7908) 250,000 x (3.7908) 6-10 350,000 x (6.1446 - 3.7908) 315,000 x (6.1446 -3.7908) 11-15 250,000 x (7.6061- 6.1446) 225,000 x (7.6061 -6.1446) 15* 200,000 x (.23939) 200,000 x (.23939)*

Recapture of working capital

NPV=$98,507 NPV=$134,137.50 PI=1.0447 PI=0.9390

IRR=A little less than 11% IRR=9%

If the introduction of a similar product by competition is likely, then cash flows from sales erosion of the existing product line should be included; hence, the project should be accepted as it has a positive NPV, PI > 1.0 and the IRR >opportunity rate.

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