Case # 1

Danforth & Donnalley Laundry Products Company

Determining Relevant Cash Flows

At 3:00 pm on April 14, 2010, James Danforth, president of Danforth &

Donnalley (D&D)

Laundry Products Company, called to order a meeting for the fi

nancial directors. The purpose of

the meeting was to make a capital-budgeting decision with respe

ct to the introduction and

production of a new product, a liquid detergent called Blast.

D&D was formed in 1993 with the merger of Danforth Chemical Co

mpany (producer of Lift-Off

detergent, the leading detergent on the West Coast) and Donna

lley Home Products Company

(maker of Wave detergent, a major laundry product in the Mi

dwest). As a result of the merger,

D&D was producing and marketing two major product lines. Although there

products were in

direct competition, they were not without product differe

ntiation Lift-Off was a low-suds,

concentrated powder, and Wave was a more traditional powder de

tergent. Each line brought with

it considerable brand loyalty; and by 2010, sales from the t

wo detergent lines had increased ten-

fold from 1993 levels, with both products now being sold nation

ally.

In the face of increased competition and technological inn

ovation, D&D spent large amounts of

time and money over the past four years researching and de

veloping a new highly concentrated

liquid laundry detergent. D&D

s new detergent, which it called Blast, had many obvious

advantages over the conventional powered products. The company

felt that Blast offered the

consumer benefits in three major areas. Blast was so

highly concentrated, that only 2 ounces

were needed to do an average load of laundry, as compared wi

th 8 to 12 ounces of powdered

detergent. Moreover

,

being a liquid, it was possible to pour Blast directly on stain

s and hard-

to

-

wash spots, eliminating the need for a pre-soak and giving it cl

eaning abilities that powders

could not possibly match. And, finally, it would be packaged in a l

ightweight, unbreakable

plastic bottle with sure-grip handle, making it much easie

r to use and more convenient to store

than the bulky boxes of powdered detergents with which it woul

d compete.

The meeting participants included James Danforth, president

of D&D; Jim Donnelley, director of

the board; Guy Rainey, vice-president in charge of new product

s; Urban McDonald, controller;

and Steve Gasper, a new comer to the D&D financial staff who

was invited by McDonald to sit

in on the meeting. Danforth called the meeting to order, gav

e a brief statement of its purpose, and

immediately gave the floor to Guy Rainey.

Rainey opened with a presentation of the cost and cash f

low analysis for the new product. To

keep things clear, he passed out copies of the projected cas

h flows to those present (

se

e Exhibits

1 and 2). In support of this information, he provided some insight

s as to how these calculations

were determined. Rainey proposed that the initial cost for

Blast include $500,000 for the test

marketing, which was conducted in the Detroit area and comple

ted in June of the previous year,

and $2 million for new specialized equipment and packaging facil

ities. The estimated life for the

facilities was 15 years, after which they would have no salv

age value. This 15-year estimated life

assumption coincides with company policy set by Donnelley n

ot to consider cash flows

occurring more than 15 years into the future, as estimates

that far ahead

tend to become little

more than blind guesses

.

Rainey cautioned against taking the annual cash flows (as shown

in Exhibit 1) at face value

because portions of these cash flows actually would be a r

esult of sales that had been diverted

from Lift-Off and Wave. For this reason, Rainey also pro

duced the estimated annual cash flows

that had been adjusted to include only those cash flows incre

mental to the company as a whole

(as shown in Exhibit 2).

At this point, discussion opened between Donnelley and McDonald,

and it was concluded that

the opportunity cost on funds was 10 percent. Gasper then questio

ned the fact that no costs were

included in the proposed cash budget for plant facilities that

would be needed to produce the new

product.

Rainey replied that at the present time, Lift-Off

s production facilities were being used at only 55

percent of capacity, and because there facilities were su

itable for use in the production of Blast,

no new plant facilities would need to be acquired for the pro

duction of the new product line. It

was estimated that full production of Blast would only requi

re 10 percent of the plant capacity.

McDonald then asked if there had been any consideration of

increased working capital needs to

operate the investment project. Rainey answered that ther

e had, and that this project would

require $200,000 of additional working capital; however, as this

money would never leave the

firm and would always be in liquid form, it was not considered

an outflow and hence not

included in the calculations.

Donnelley argued that this project should be charged something f

or its use of current excess

plant facilities. His reasoning was that is another firm

had space like this and was willing to rent

it out, it could charge somewhere in the neighbourhood of

$2 million. However, he went on to

acknowledge that D&D had a strict policy that prohibits rent

ing or leasing any of its production

facilities to any party from outside the firm. If they di

dn

t charge for the facilities to any part

from outside the firm might end up accepting projects, he co

ncluded, the firm might end up

accepting projects that under normal circumstances would be r

ejected.

From here the discussion continued, centering on the ques

tion of what to do about the lost

contribution from other projects, the test marketing co

sts, and working capital.

Exhibit 1

: D&D Laundry Products Company Forecast of Annual Cash Flows

from the Blast

Product (Including cash flows resulting from sales diverted f

rom the existing product lines)

Year

Cash Flows

Year

Cash Flows

1

$280,000

9

350,000

2

280,000

10

350,000

3

280,000

11

250,000

4

280,000

12

250,000

5

280,000

13

250,000

6

350,000

14

250,000

7

350,000

15

250,000

8

350,000

Exhibit 2

: D&D Laundry Products Company Forecast of Annual Cash Flows

from the Blast

Product (Excluding cash flows resulting from sales diverted fr

om the existing product lines)

Year

Cash Flows

Year

Cash Flows

1

$250,000

9

315,000

2

250,000

10

315,000

3

250,000

11

225,000

4

250,000

12

225,000

5

250,000

13

225,000

6

315,000

14

225,000

7

315,000

15

225,000

8

315,000

Questions:

1)

If you were put in the place of Steve Gasper, would you argue fo

r the cost from market

testing to be included in a cash outflow?

2)

What would your opinion be as to how to deal with the question

of working capital?

3)

Would you suggest that the product be charged for the use of e

xcess production facilities

and building space?

4)

Would you suggest that the cash flows resulting from erosi

on 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 intro

duce Blast, would this affect

your answer?

5)

If debt were used to finance this project, should the intere

st payments associated with this

new debt be considered cash flows?

6)

What are the NPV, IRR and PI of this project, both including c

ash flows resulting from

sales diverted from the existing product lines (Exhibit 1) and exc

luding 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?