CASE PROBLEMS DANFORTH \& DONNALLEY LAUNDRY PRODUCTS COMPANY Exhibit 1. D\&D Laundry Products Company Annual Cash Chemical Company, headquartered in Seattle, Washington, producers of Lift-Off detergent, the leading laundry detergent on the West Coast, and Donnalley Home Products Company, headquartered in Detroit, Michigan, makers of Wave deterExhibit 2. D\&D Laundry Products Company Annual Cash Flows gent, a major Midwestern laundry product. As a result of the from the Acceptance of Blast (Not including flows resulting merger, D\&D was producing and marketing two major product lines. Although these products were in direct competition, they were not without product differentiation: Lift-Off was a lowsuds, concentrated powder, and Wave was a more traditional powder detergent. Each line brought with it considerable brand loyalty, and by 1998, sales from the two detergent lines had increased tenfold from 1973 levels, with both products now being sold nationally. In the face of increased competition and technological innovation, D\&D spent large amounts of time and money over the past 4 years researching and developing a new, highly concentrated liquid laundry detergent. D\&D's new detergent, which they called Blast, had many obvious advantages over the conventional powdered products. It was felt that with Blast the consumer would benefit in three major areas. Blast was so highly concentrated that only 2 ounces was needed to do an copies of the projected cash flows to those present (see Exhibits 1 average load of laundry as compared with 8 to 12 ounces of and 2). In support of this information, he provided some insights powdered detergent. Moreover, being a liquid, it was possible to as to how these calculations were determined. Rainey proposed pour Blast directly on stains and hard-to-wash spots, eliminat- that the initial cost for Blast include $500,000 for the test marketing the need for a pre-soak and giving it cleaning abilities that ing, which was conducted in the Detroit area and completed in powders could not possibly match. And, finally, it would be the previous June, and $2 million for new specialized equipment packaged in a lightweight, unbreakable plastic bottle with a and packaging facilities. The estimated life for the facilities was sure-grip handle, making it much easier to use and more conve- 15 years, after which they would have no salvage value. This 15 nient to store than the bulky boxes of powdered detergents with year estimated life assumption coincides with company policy set which it would compete. by Donnalley not to consider cash flows occurring more than 15 The meeting was attended by James Danforth, president of years into the future, as estimates that far ahead "tend to become D\&D; Jim Donnalley, director of the board; Guy Rainey, vice- little more than blind guesses." president in charge of new products; Urban McDonald, con- Rainey cautioned against taking the annual cash flows (as troller; and Steve Gasper, a newcomer to D\&D's financial staff, shown in Exhibit 1) at face value because portions of these who was invited by McDonald to sit in on the meeting. Danforth cash flows actually are a result of sales that had been diverted called the meeting to order, gave a brief statement of its purpose, from Lift-Off and Wave. For this reason, Rainey also produced and immediately gave the floor to Guy Rainey. the annual cash flows that had been adjusted to include only Rainey opened with a presentation of the cost and cash flow those cash flows incremental to the company as a whole (as analysis for the new product. To keep things clear, he passed out shown in Exhibit 2). 392 BASIC FINANGIAL MANAGEMENT At this point, discussion opened between Donnalley and HARDING PLASTIC MOLDING COMPANY McDonald, and it was concluded that the opportunity cost on funds is 10 percent. Gasper then 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, Rainey replied that, at the present time, Lift-Off's production facilities were being used at only 55 percent of capacity, and because these facilities were suitable for use in the production of Blast, no new plant facilities other than the specialized equipment and packaging facilities previously mentioned need be acquired for the production of the new product line. It was estimated that full production of Blast would only require 10 per- McDonald then asked if there had been any consideration of month to consider and make final judgment on all proposed capital cent of the plant capacity. increased working capital needs to operate the investment proj- outlays brought up for review during the period. ect. Rainey answered that there had and that this project would Harding Plastic Molding Company was founded in 1970 by require $200,000 of additional working capital; however, as this Robert L. Harding to produce plastic parts and molding for the money would never leave the firm and always would be in liquid Detroit automakers. For the first 10 years of operations, HPMC form it was not considered an outflow and hence was not worked solely as a subcontractor for the automakers, but since included in the calculations. then has made strong efforts to diversify in an attempt to avoid Donnalley argued that this project should be charged some- the cyclical problems faced by the auto industry. By 1998, this thing for its use of the current excess plant facilities. His reason-_diversification attempt has led HPMC into the production of over ing was that, if an outside firm tried to rent this space from D\&D, 1,000 different items, including kitchen utensils, camera housit would be charged somewhere in the neighborhood of $2 mil- ings, and photographic equipment. It also led to an increase in lion, and because this project would compete with the current sales of 800 percent during the 1980 to 1998 period. As this draprojects, it should be treated as an outside project and charged as matic increase in sales was paralleled by a corresponding such. However, he went on to acknowledge that D\&D has a strict increase in production volume, in late 1996, HPMC was forced to policy that forbids the renting or leasing out of any of its produc-_expand production facilities. This plant and equipment expansion tion facilities. If they didn't charge for facilities, he concluded, involved capital expenditures of approximately $10.5 million and the firm might end up accepting projects that under normal cir- resulted in an increase of production capacity of about 40 percent. Because of this increased production capacity, HPMC has From here, the discussion continued, centering on the ques- made a concerted effort to attract new business and consequentiy tions of what to do about the "lost contribution from other proj- has recently entered into contracts with a large toy firm and a ects," the test marketing costs, and the working capital. major discount department store chain. Although non-autorelated business has grown significantly, it still only represents 32 percent of HPMC's overall business. Thus HPMC has continued Questions to solicit nonautomotive business, and as a result of this effort 1. If you were put in the place of Steve Gasper, would you _ and its internal research and development, the firm has four sets argue for the cost from market testing to be included as a of mutually exclusive projects to consider at this month's finance cash outflow? committee meeting. 2. What would your opinion be as to how to deal with the ques- Over the past 10 years, HPMC's capital-budgeting approach tion of working capital? has evolved into a somewhat elaborate procedure in which new 3. Would you suggest that the product be charged for the use of proposals are categorized into three areas: profit, research and excess production facilities and building? development, and safety. Projects falling into the profit or 4. Would you suggest that the cash flows resulting from erosion research and development areas are evaluated using present value of sales from current laundry detergent products be included techniques, assuming a 10 percent opportunity rate; those falling as a cash inflow? If there were a chance of competition intro- into the safety classification are evaluated in a more subjective ducing a similar product if you do not introduce Blast, would framework. Although research and development projects have to this affect your answer? receive favorable results from the present value criteria, there is 5. If debt is used to finance this project, should the interest pay- _ also a total dollar limit assigned to projects of this category, typiments associated with this new debt be considered cash flows? cally running about $750,000 per year. This limitation was 6. What are the NPV, IRR, and PI of this project, including cash imposed by Harding primarily because of the limited availability flows resulting from lost sales from existing product lines? of quality researchers in the plastics industry. Harding felt that if What are the NPV, IRR, and PI of this project excluding these more funds than this were allocated, "we simply couldn't find the flows? Under the assumption that there is a good chance that manpower to administer them properly." The benefits derived competition will introduce a similar product if you don't, from safety projects, on the other hand, are not in terms of cash would you accept or reject this project? flows; hence present value methods are not used at all in their CHAPTER 10 CASH FLOWS AND OTHER TOPICS IN CAPITAL BUDGETING 393