forum- Erie chemical

As part of materials, we have the practice case of Erie Chemical (which is at the end of the Note on Capital Budgeting reading). Please reference this case. For your initial post, please respond to the following questions: 1. How do we determine the appropriate discount rate to use of Erie Chemical? 2. If the company decides to purchase the new equipment for Dr. Larson, a mistake has been made somewhere, because good equipment bought only two years ago is being scrapped. How did this mistake come about? 3. What non-quantitative factors should the company consider in making this decision? How important are they?

PRACTICE CASE. ERIE CHEMICAL COMPANY Dr. Christian Larson, Chief of Research at Erie Chemical Company, was contemplating a proposal submitted to him by Dr. Francesca Michaels, head of the Garden Products Lab. Her request was to purchase some new equipment to perform operations currently being performed on different, less efficient equipment. The purchase price was $300,000 delivered and installed. Background Erie Chemical Company was a diversified conglomerate, specializing in consumer products. It was located on the shores of Lake Erie in Cleveland, Ohio, and had been in existence for some 40 years. Although it manufactured a variety of products for homeowners, its distinguishing specialty was garden products, where it prided itself on having the latest in technology and up-to-date facilities, and where it conducted state-of-the-art research. Because of the rapid changes taking place in the field of garden products, maintaining the companys cutting-edge position required constant upgrading of its facilities and equipment. In recent years, with the advent of environmental regulation, there had been increasing pressures on the companys profits. Because of this, the companys senior management was taking an increasingly hard look at all capital equipment proposals. The Request Dr. Michaels had worked closely with the equipment manufacturer to determine the potential benefits of the new equipment. She estimated that it would result in annual savings of $60,000 in labor and other direct costs, as compared with the present equipment. She also estimated that the new equipments economic life would be 10 years, with zero salvage value. The company had recently borrowed long-term to finance another project. Paul Hershey, Eries Chief Financial Officer, had informed Dr. Larson that, because of this, he was certain the company could obtain additional funds at 12 percent, although he would not plan to negotiate a loan specifically for the purchase of Dr. Michaels equipment. He did feel, however, that an investment of the type Dr. Michaels was proposing should have a return of at least 20 percent. Complicating Factors There were three complications associated with the proposed investment. First, the present equipment was in good working order and probably would last, physically, for at least 8 more years. Second, the request was for what Dr. Michaels called even better equipment, to replace some equipment purchased two years ago involving the same projected economic life and dollar amounts. Dr. Michaels had informed Dr. Larson that the new equipment would render the existing equipment completely obsolete with no resale value. The third complicating factor had arisen at a recent board meeting, when the chairman of the boards finance committee had discussed some inconsistencies between Eries capital structure and the 20 percent rate of return that Mr. Hershey was recommending. The finance committee chairman had pointed out that Eries shareholder equity and retained earnings had no interest charges. As a result, he thought the proper discount rate to use for capital investment proposals was not 20 percent, but only about 5 percent, as shown below: Weighted Cost of Capital Percent Interest Weighted of Total Rate Interest Rate Debt 40.0 12.0% 4.8% Equity 60.0 0.0 0.0 Total 100.0 4.8% The Decision Although funds were available to finance Dr. Michaels proposed new equipment purchase, Dr. Larson and Mr. Hershey were both concerned about the mistake made two years ago, and wanted to be sure that a similar mistake would not be made again.