Capital Budgeting Case

Jack Tar, CFO of Sheetbend & Halyard Inc. opened the company confidential envelope. It contained a draft of a competitive bid for a contract to supply duffel canvas to the U.S. Navy. The cover memo from Sheetbend's CEO asked Mr. Tar to review the bid before it was submitted.

The bid and its supporting documents had been prepared by Sheetbend's sales staff. It called for Sheetbend to supply 100,000 yards of duffel canvas per year for 5 years. The proposed selling price was fixed at $30 per yard.

Mr. Tar was not usually involved in sales, but this bid was unusual in at least two respects. First, if accepted by the navy, it would commit Sheetbend to a fixed-price, long-term contract. Second, producing the duffel canvas would require an investment of $1.5 million to purchase machinery and to refurbish Sheetbend's plant in Pleasantboro, Maine.

Mr. Tar set to work and by the end of the week had collected the following facts and assumptions:

The plant in Pleasantboro had been built in the early 1900s and is now idle. The plant was fully depreciated on Sheetbend's books, except for the purchase cost of the land (in 1947) of $10,000.

Now that the land was valuable shorefront property, Mr. Tar thought the land and the idle plant could be sold, immediately or in the near future, for $600,000.

Refurbishing the plant would cost $500,000. This investment would be depreciated for tax purposes using straight-line depreciation over 10 years.

The new machinery would cost $1 million. This investment could be depreciated straight-line over 5 years.

The refurbished plant and new machinery would last for many years. However, the remaining market for duffel canvas was small, and it was not clear that additional orders could be obtained once the navy contract was finished. The machinery was custom-built and could be used only for duffel canvas. Its secondhand value at the end of 5 years was probably zero.

The excel table shows the sales staff's forecasts of income from the navy contract. Mr. Tar reviewed this forecast and decided that its assumptions were reasonable.

But the forecast income statement contained no mention of working capital. Mr. Tar thought that working capital would average about 10% of sales.

Armed with this information, Mr. Tar constructed a spreadsheet to calculate the NPV of the duffel canvas project, assuming that Sheetbend's bid would be accepted by the navy.

He had just finished debugging the spreadsheet when another confidential envelope arrived from Sheetbend's CEO. It contained a firm offer from a Maine real estate developer to purchase Sheetbend's Pleasantboro land and plant for $1.5 million in cash.

Excel Table: Forecast income statement for the U.S. Navy duffel canvas project

(dollar values in thousands, except price per yard)

Year	0	1	2	3	4	5
1. Yards sold		100.00	100.00	100.00	100.00	100.00
2. Price per yard		30.00	30.00	30.00	30.00	30.00
3. Revenue (1 2)		3,000.00	3,000.00	3,000.00	3,000.00	3,000.00
4. Cost of goods sold		2,100.00	2,184.00	2,271.36	2,362.21	2,456.70
5. Operating cash flow (3 4)		900.00	816.00	728.64	637.79	543.30
6. Depreciation		250.00	250.00	250.00	250.00	250.00
7. Income (5 6)		650.00	566.00	478.64	387.79	293.30
8. Tax at 35%		227.50	198.10	167.52	135.73	102.66
9. Net Income (7 8)		422.50	367.90	311.12	252.06	190.65

Notes:

1. Yards sold and price per yard would be fixed by contract.

2. Cost of goods includes fixed cost of $300,000 per year plus variable costs of $18 per yard.

Costs are expected to increase at the inflation rate of 4% per year.

3.Depreciation:

A $1 million investment in machinery is depreciated straight-line over 5 years ($200,000 per year).

The $500,000 cost of refurbishing the Pleasantboro plant is depreciated straight-line over 10 years ($50,000 per year).

Using a spreadsheet (e.g. Excel) analyze the minicase for Chapter 9 (Brealey, et al) onpage 295.

Notes:

(i) To calculate the depreciation expense, use the MACRS table (Table 9.2) given onpage 286 of the text. The machinery and the plant renovation should bedepreciated separately. The depreciation of these two items replaces the straight-

line depreciation shown on line 6 of Table 9.4 in the problem.

(ii) Assume that if the project is undertaken, the property may be sold in 5 years at aprice of $600,000. This includes the value of the land, the plant and themachinery (the value of the plant and machinery themselves will be 0). (iii) When any asset is sold, it is subject to taxation. If the asset is sold at a gain, thegain (not the total sales price) is subject to tax payment. If the asset is sold at aloss, the loss creates a tax savings (positive cash flow). To calculate the amountof the tax gain or loss, take the difference between the selling price and the bookvalue of the asset. If the book value of the asset is below the selling price, youhave a gain. If the book value of the asset is above the selling price, you have aloss. If an asset is disposed of (scrapped) with zero market value, its remainingbook value may be used as a tax write-off (creating a tax saving). The tax rateapplied to gain (or loss) on sale is the same as the tax rate on ordinary income. (iv) To find the book value of an asset at the time of sale or disposal, take the originalcost minus the accumulated depreciation. The accumulated depreciation is thesum of all depreciation expense taken on that asset since it was placed intoservice. Note that land is not depreciated for tax purposes. Therefore, the book

value of land is always its historical cost.

(v) The working capital is needed in advance of the sales, that is, in Year 0. Theinvestment in working capital would be recovered at the end of the project in Year

5.

2. Suppose that Mr. Tar revises his estimate of the value for which the property may be soldin Year 5 to $1,500,000. How does this change affect the valuation of the project? Does

it affect your decision to proceed (or not to proceed) with the project?