Capital Budgeting Project on Clean Air Inc

On April $4^{th}$ at $3$:$00$ pm$,2019,$ Jason Smith, President of Clean Air Inc, called to order a meeting of the financial personnel. The purpose of the meeting was to make a capital budgeting decision with respect to the potential introduction and production of a new product, a liquid detergent called Blast.

In the face of increased competition and technological innovation, Clean Air spent large amounts of time and money over the past $4$ years researching and developing new, highly concentrated liquid laundry detergents.

Clean Air's new detergent, Blast, would have many obvious advantages over the conventional powdered products as it is highly concentrated, in liquid form and can be packed in light, unbreakable plastic bottles.

The meeting was attended by Jason Smith, the president, Jim Anderson, vicepresident of new products, Bob Johnson, the controller and his new assistant Steve Gasper.immediately gave the floor to Bob Johnson. Johnson opened with a presentation of the cost and cash flow analysis for the new product.

Anderson proposed that initial cost for the project should include $$1,000,000$ for a test market conducted in the Toronto area. His argument is that; without spending the $$1MM$ on test market, Clean Air would never have launched this new product!

New specialized machinery$/$equipment and packing facilities for Blast production is estimated to cost $$20MM.$ The whole investment belongs to a CCA class with a rate of $20\%.$ It is expected that this facility will operate for $15$ years, at the end of which its salvage value would be $15\%$ of its original value.

Anderson cautioned against taking the annual cash flows $($as shown in Exhibit $1)$ at face value since portions of these cash flows actually are a result of sales that had been diverted from its existing products. For this reason, Anderson also provided annual cash flows that had been adjusted to include only those cash flows incremental to the company as a whole. $($Exhibit $2).$At this point, discussions opened up and came to a consensus that the opportunity costs of funds is $10\%.$ Gasper then questioned the fact that no costs were included in the proposed cash budget for plant space which would be needed to produce the new product. Smith then replied that, at the present time, production of existing products would require $55\%$ of total floor space and the additional full production of Blast would need another $10\%$ of the total floor area.

Bob Johnson then asked if there had been any consideration of increase working capital needed to operate this project. Anderson answered that there had been and that the Blast project would require $$500,000$ in additional working capital; however, since the money would not leave the firm and always be in liquid form it was not considered as outflow; and therefore not included in the calculation. Smith argued that this project should be charged something for its use of current excess plant space, capacity. His reasoning was that if any outside firm tried to rent this space from Clean Air, this outside firm would be charged $$150,000$ as rent per year.

Clean Air has a corporate tax rate of $40\%.$Exhibit $1$

Year

$1$

$2$

$3$

$4$

$5$

$6$

$7$

$8$

$9$

$10$

$11$

$12$

$13$

$14$

$15$

Exhivit $1$

$2,800,00($years $1-5),3,500,000($years $6-10)2,500,000($years $(11-15)$

Exhibit $2$

Net Cash Flow $($$$)$

$2,500,000$

$2,500,000$

$2,500,000$

$2,500,000$

$3,150,000$

$3,150,000$

$3,150,000$

$3,150,000$

$3,150,000$

$2,250,000$

$2,250,000$

$2,250,000$

$2,250,000$

$2,250,000$

Question$)$ Would you suggest that the cash flows resulting from erosion of sales from existing powdered products be included as cash outflow? If the Blast project is not accepted, a competitor is expected to introduce a product similar to Blast, thus diverting the same amount of sales from Clean Air $\text{'}$s existing product lines as allast would have? Would this affect your answer? What is the term that explains the fact that a new product displacing some existing products manufacturing by the same company? What is the PV on after tax operating profit for Blast?