ABC Company is a leading producer of laundry detergent. ABC produces two major product lines; one is a low-suds, concentrated powder detergent and the other is a more traditional powder detergent. Sales from the two detergent lines had increased tenfold from their 2000 levels, with both products now being sold nationally. By 2019 the company had a sales turnover of over $20 million with profits in excess of $2 million.

A capital expenditure management meeting was held to consider the introduction and production of a new product, a liquid detergent. In the face of increased competition and technological innovation, ABC had spent large amounts of time and money over the past four years researching and developing a new, highly concentrated liquid detergent. The new liquid detergent, had advantages over the conventional powdered products in terms of reduced detergent usage for an average load of laundry, better cleaning abilities, much easier to use and more convenient to store.

At the meeting, the Chief Financial Officer (CFO), presented the cost and cash flow analysis for the new product. He passed out copies of the projected cash flows to those present (see Table 1). In support of this information, he provided some insight into how these calculations were determined. He proposed the initial cost for the liquid detergent included $200,000 for the test marketing, which was conducted and completed in the previous year, and $1.5 million for new specialised equipment and packaging facilities to be purchased from Alley Limited. The estimated life for the facilities was 10 years, after which they would have an expected salvage value of $80,000. This 10-year estimate life assumption coincided with company policy not to consider cash flows occurring more than 10 years into the future, as estimates that far ahead "tend to become little more than blind guesses". The depreciation rate allowed by the Tax authorities for the equipment and packaging facilities was 35% per annum on the reducing balance basis.

The CFO cautioned against taking the annual cash flows shown in column 2 of Table 1 (the increased net cash flows from the liquid detergent project) at face value since portions of these cash flows actually were a result of sales that had been diverted from the existing product lines. For this reason, he also produced the annual cash flows shown in column 3 of Table 1, which had been the amount of lost sales from existing product lines of the company as a whole.

The Chairman of the company, questioned the fact that no costs were included in the proposed cash budget for plant facilities, which would be needed to produce the new product. The CFO replied that, the existing production facilities were being utilised at only 60 percent of capacity, and since these facilities were suitable for use in the production of liquid detergent, no new plant facilities other than the specialised equipment and packaging facilities previously mentioned needed to be acquired for the production of the new product line. Full production of the liquid detergent would require only 20 percent of the plant capacity over the ten-year period.

1 This case study was adapted from Case 23: "Danforth & Donnalley Laundry Products Company" by Scott, Martin, Petty, Keown and Thatcher (1993). Cases in Finance (3rd ed.). New Jersey: Prentice Hall.

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TABLE 1

Year

Annual Cash Flows from the acceptance of liquid detergent

Increased net cash flows from the liquid detergent project

Lost sales from existing product lines

1

$630,000

$90,000

2

$630,000

$90,000

3

$660,000

$110,000

4

$660,000

$110,000

5

$690,000

$130,000

6

$690,000

$130,000

7

$690,000

$130,000

8

$590,000

$100,000

9

$590,000

$100,000

10

$590,000

$100,000

The Production Manager, argued that this project should include costs associated with the use of the current excess plant facilities. His reason was that ABC could fetch a rent of an estimated $150,000 per year if the excess plant facilities are rented out to an outside firm. Since the project would be competing with other existing projects, it should be treated as an external and be charged accordingly. However, he went on to acknowledge that ABC has a strict policy forbidding renting or leasing out of any of its production facilities. If they didn't charge for facilities, he concluded, the company might end up accepting projects that under normal circumstances would be rejected.

The Production Manager put forward a hypothetical projection that production facilities needed for the current line of powdered detergents were at 60 percent of capacity and expected to grow at a rate of 8 percent a year and the maximum production capacity was 100 percent. As current production would be at 81.63% of capacity in four years and 102.83% in seven years, ABC would need a new plant and facilities. This would involve cash outflows of $2 million in six years and should cater for future needs of all production growth.

ABC is a private company, soundly financed, and consistently profitable. Surplus cash and deposits of $0.5 million are not sufficient to buy the new specialised equipment and packaging facilities. However, the Chairman is confident to finance part of the cost of the project with a medium-term debt, privately placed with an insurance company. ABC had borrowed via a private placement once before when it negotiated a fixed rate of 10 percent on a five-year loan. Preliminary discussions with ABC's bankers led the Chairman to believe that the firm could arrange a similar 10 percent 10-year term loan of $1.0 million with repayment of fixed annual interest expense in advance and the principal owing at maturity. The company's tax rate is 30 percent, and its nominal after-tax opportunity cost on funds is 15 percent.

The Production Manager questioned why the CFO rejected the specialised equipment and packaging facilities proposal from Forth Limited that would reduce the initial project outlay and the cost of debt from $1.0 million to $0.3 million. Furthermore, there would be cost savings on operating and maintenance costs amounting to $30,000 per annum that were not included in the increased net cash flows given in Table 1. The CFO answered that the alternative

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proposed by Forth Limited would cost $0.8 million including shipping and installation fees. The new equipment would qualify as a 5-year life asset with 30% reducing balance depreciation. It would have a market value of approximately $50,000 at the end of its economic life of 5 years. The totals costs over the project life of 10 years would be a higher amount of $1.6 million. In his opinion, ABC was better off with current proposal from Alley Limited.

The Production Manager then asked if there had been any consideration of increased working capital needed to operate the investment project. The CFO answered that they had and this project would require $100,000 of additional working capital. As this money would never leave the company and would always be in liquid form, it was not considered a cash outflow, and hence was not included in the calculation.

Assume that the company is subject to 30% corporate tax and that the tax is paid at end of the same year (i.e. not the following year).ABC Company is a leading producer of laundry detergent. ABC produces two major product lines; one is a low-suds, concentrated powder detergent and the other is a more traditional powder detergent. Sales from the two detergent lines had increased tenfold from their 2000 levels, with both products now being sold nationally. By 2019 the company had a sales turnover of over $20 million with profits in excess of $2 million.

A capital expenditure management meeting was held to consider the introduction and production of a new product, a liquid detergent. In the face of increased competition and technological innovation, ABC had spent large amounts of time and money over the past four years researching and developing a new, highly concentrated liquid detergent. The new liquid detergent, had advantages over the conventional powdered products in terms of reduced detergent usage for an average load of laundry, better cleaning abilities, much easier to use and more convenient to store.

At the meeting, the Chief Financial Officer (CFO), presented the cost and cash flow analysis for the new product. He passed out copies of the projected cash flows to those present (see Table 1). In support of this information, he provided some insight into how these calculations were determined. He proposed the initial cost for the liquid detergent included $200,000 for the test marketing, which was conducted and completed in the previous year, and $1.5 million for new specialised equipment and packaging facilities to be purchased from Alley Limited. The estimated life for the facilities was 10 years, after which they would have an expected salvage value of $80,000. This 10-year estimate life assumption coincided with company policy not to consider cash flows occurring more than 10 years into the future, as estimates that far ahead "tend to become little more than blind guesses". The depreciation rate allowed by the Tax authorities for the equipment and packaging facilities was 35% per annum on the reducing balance basis.

The CFO cautioned against taking the annual cash flows shown in column 2 of Table 1 (the increased net cash flows from the liquid detergent project) at face value since portions of these cash flows actually were a result of sales that had been diverted from the existing product lines. For this reason, he also produced the annual cash flows shown in column 3 of Table 1, which had been the amount of lost sales from existing product lines of the company as a whole.

The Chairman of the company, questioned the fact that no costs were included in the proposed cash budget for plant facilities, which would be needed to produce the new product. The CFO replied that, the existing production facilities were being utilised at only 60 percent of capacity, and since these facilities were suitable for use in the production of liquid detergent, no new plant facilities other than the specialised equipment and packaging facilities previously mentioned needed to be acquired for the production of the new product line. Full production of the liquid detergent would require only 20 percent of the plant capacity over the ten-year period.

1 This case study was adapted from Case 23: "Danforth & Donnalley Laundry Products Company" by Scott, Martin, Petty, Keown and Thatcher (1993). Cases in Finance (3rd ed.). New Jersey: Prentice Hall.

5

TABLE 1

Year

Annual Cash Flows from the acceptance of liquid detergent

Increased net cash flows from the liquid detergent project

Lost sales from existing product lines

1

$630,000

$90,000

2

$630,000

$90,000

3

$660,000

$110,000

4

$660,000

$110,000

5

$690,000

$130,000

6

$690,000

$130,000

7

$690,000

$130,000

8

$590,000

$100,000

9

$590,000

$100,000

10

$590,000

$100,000

The Production Manager, argued that this project should include costs associated with the use of the current excess plant facilities. His reason was that ABC could fetch a rent of an estimated $150,000 per year if the excess plant facilities are rented out to an outside firm. Since the project would be competing with other existing projects, it should be treated as an external and be charged accordingly. However, he went on to acknowledge that ABC has a strict policy forbidding renting or leasing out of any of its production facilities. If they didn't charge for facilities, he concluded, the company might end up accepting projects that under normal circumstances would be rejected.

The Production Manager put forward a hypothetical projection that production facilities needed for the current line of powdered detergents were at 60 percent of capacity and expected to grow at a rate of 8 percent a year and the maximum production capacity was 100 percent. As current production would be at 81.63% of capacity in four years and 102.83% in seven years, ABC would need a new plant and facilities. This would involve cash outflows of $2 million in six years and should cater for future needs of all production growth.

ABC is a private company, soundly financed, and consistently profitable. Surplus cash and deposits of $0.5 million are not sufficient to buy the new specialised equipment and packaging facilities. However, the Chairman is confident to finance part of the cost of the project with a medium-term debt, privately placed with an insurance company. ABC had borrowed via a private placement once before when it negotiated a fixed rate of 10 percent on a five-year loan. Preliminary discussions with ABC's bankers led the Chairman to believe that the firm could arrange a similar 10 percent 10-year term loan of $1.0 million with repayment of fixed annual interest expense in advance and the principal owing at maturity. The company's tax rate is 30 percent, and its nominal after-tax opportunity cost on funds is 15 percent.

The Production Manager questioned why the CFO rejected the specialised equipment and packaging facilities proposal from Forth Limited that would reduce the initial project outlay and the cost of debt from $1.0 million to $0.3 million. Furthermore, there would be cost savings on operating and maintenance costs amounting to $30,000 per annum that were not included in the increased net cash flows given in Table 1. The CFO answered that the alternative

6

proposed by Forth Limited would cost $0.8 million including shipping and installation fees. The new equipment would qualify as a 5-year life asset with 30% reducing balance depreciation. It would have a market value of approximately $50,000 at the end of its economic life of 5 years. The totals costs over the project life of 10 years would be a higher amount of $1.6 million. In his opinion, ABC was better off with current proposal from Alley Limited.

The Production Manager then asked if there had been any consideration of increased working capital needed to operate the investment project. The CFO answered that they had and this project would require $100,000 of additional working capital. As this money would never leave the company and would always be in liquid form, it was not considered a cash outflow, and hence was not included in the calculation.

Assume that the company is subject to 30% corporate tax and that the tax is paid at end of the same year (i.e. not the following year).

1. On the basis of costs, would you recommend ABC to purchase the specialised equipment and packaging facilities from Alley Limited or Forth Limited? [You may assume both companies are able to supply the equipment on the same terms indefinitely.]

1. Based on your chosen specialised equipment and packaging facilities in Question 1, prepare cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) using the information given in the case. Calculate the payback period, net present value (NPV) and internal rate of return (IRR) of this project. Assume the payback rule used by ABC was a cut-off period of five years. Based on each of the three different methods of investment evaluation, would you accept or reject this project?
2. Clearly state the assumptions with justification used to arrive at the cash flows in Q2. Undertake research to identify the qualitative factors that would affect the accept/reject decision of the project.
3. It is necessary to check if the project made financial sense before it is accepted. Based on the cash flow table derived in Question 2 [Hint: Provide the answers for this question even if your decision is to reject the project.]:

a)Show a sensitivity analysis of NPVs to changes in annual increased net cash flows and cost of capital individually. Assume each of these variables can deviate from its estimated value by plus or minus 15%.

b)Calculate the minimum level of annual increased net cash flows necessary for the project to be accepted.

5. Consider all information given in the case study and the results derived in Questions 1 to 4. Advise the executive committee and the CFO on whether they should invest in the new liquid detergent project. Discuss the reasons for your recommendation and any reservations you may have in given this advice.