i only need help with number 1-5 please?

thank you

THE PINNACLE CORPORATION CAPITAL BUDGETING The Pinnacle Corporation manufactures golf balls, clubs, and accessories like golf gloves, bags, shirts, and shoes. In an industry where image is quite impor- tant, the Pinnacle label is synonymous with excellence. Pinnacle was the first company to build a mechanical golfer, which dramatically improved the relia- bility of golf ball and equipment testing. Pinnacle introduced the Surlyn (hard- covered) golf ball and in the early 1970s developed a radically different dimple design, called the icosahedron pattern. It has also been a leader in metal equip ment and in designing more "forgiving" clubs for the average player. In recent years Pinnacle entered the accessories market, partly to be known as a full- service" golf manufacturer and partly to be in a position to capitalize on expected growth in this area. The firm is organized by product line and has separate ball, equipment, and accessories divisions. Sales during the most recent fiscal year (1995) were $391 million, broken down by division as follows: ball, $213 million; equipment $157 million; and accessories. $21 million. Thus, the first two areas account for nearly 95 percent of revenue and represent the divisions most consistent with the firm's strategic policy, since Pinnacle sees itself primarily as developing and manufacturing tools to assist golfers in their quest for lower scores! Although, it is unfair to say that Pinnacle entered the accessories market as an afterthought, it is appropriate to say that top management doesn't believe the firm has any particular advantage in this area. In fact, until three years ago the accessories unit was not a separate division but simply a part of the equipment division. Top management felt, however, that this arrangement did not allow accessories to be properly represented in capital budgeting discussions and decisions The accessories that Pinnacle has marketed, though, have been consistent with the firm's reputation. This has been due mainly to the efforts of George Carrington, an energetic and flamboyant divisional manager with ten years experience in the clothing industry Carrington took the Pinnacle position even though the change was merely a lateral move in terms of salary and represented a bit of a low in prestige, since the budget he controls at Pinnacle is much less than the one he had at his former company. Still, Carrington wanted to be closer to the game he loves and felt that he was associating with the industry leader. THE PROBLEM Pinnacle is currently involved in deciding its capital budget for the coming year, and there are proposals from each division that are especially important to the long-term prospects of the firm. What is common to them all is the belief that the industry is and will continue to be in a golf boom. It is likely, therefore, that the demand for balls, equipment, and accessories will increase in real terms, that is, adjusted for inflation, for at least the next four to five years, One difficulty is that top management, for a number of reasons, doesn't think that more than one major project can be successfully implemented. First, annual sales growth of 10 percent is expected even without any new projects. Second, a major commitment to R + D has recently been made to stay ahead in the race for new products. Finally, the industry is facing a skilled labor short- age, and quality technicians and managers are hard to find. Top management, which is fiercely protective of the Pinnacle image, believes that if more than one major project is implemented, none will be done right. In fact, the corporate grapevine indicates that Elizabeth Robinson, the CEO, is not likely to approve any significant capital budgeting request from the accessories division unless it looks "extremely attractive." Robinson's thinking is that Pinnacle should capi- talize on its relative strengths, which she thinks are in balls and equipment. DIVISIONAL CONSIDERATIONS By varying the cover, core construction, and to a certain extent dimple design, manufacturers can develop balls with somewhat different flight characteristics and feel. For example, a soft (balata) cover combined with a wound, liquid center results in a ball that is relatively easy to hook or slice, it tends to fly higher and gives more "feel" on the finesse shots. A hard (Surlyn) cover with a solid two-piece interior is more difficult to hook or slice, tends to fly lower, and is more durable. Pinnacle produces six balls for the varied abilities and whims of golfers. The company recently developed a new ball, the Medallion LS, with a new cover of Lithium Surlyn, which combines some of the advantages of balata and Surlyn. A Lithium Surlyn-covered ball will fly a bit higher and farther than a Surlyn- covered one, though it is not as durable. In terms of the six balls Pinnacle eur. rently produces, the Medallion LS is closest to the ProFlite LD. Although management doesn't feel that the I would have much of an effect on the Malen of the other five balls, it does believe that the Swould hurt sales of the Proflite LD. Still, Pinnacle thinks that the 1S represents a step forward in ball technol ogy and should sell at a premium over existing balls. Twelve months ago the firm began manufacturing its Precision line of clubs, which are machine-made from cast iron. Four factors account for their success. First, they have the largest sweet spot of any club produced. This means that the ball can be contacted considerably off center and still produce a respectable shot. This characteristic has made Precision clubs especially popular with below-average golfers. Second, the shaft is extremely lightweight, which helps get shots up in the air more easily. Thind, though the clubs are machine-made, they don't have an "assembly-line" look. Finally, a set sells for $600, about 10 percent under competitive brands. Pinnacle can produce 40.000 sets a year, but annual demand is running at about 65,000 sets. And management feels this demand will continue. Exhibit 1 shows future sales projections assuming no change in the current price of $600. The accessories division is proposing that the production of bags, gloves, shirts, and shoes be expanded. Though no real shortage exists for these items at the present time, divisional managers are convinced that sales have been hurt by the relatively low-key approach Pinnacle has taken in marketing these prod- ucts. Carrington strongly feels that additional promotion, coupled with the pro. jected golf boom, will cause the sales of accessories to more than double in three years and make an expansion of his division highly attractive." He also argues that this project would result in Pinnacle achieving greater diversification in terms of product sales Exhibit 2 shows the yearly incremental sales and cash flow estimates that Carrington has submitted to top management, THE OPTIONS The expansion of the accessories division is considered a major project and, for reasons stated, would rule out the Keep Old option of the ball project and the Expand alternative of the equipment project. These are also considered major projects and are described later) Pinnacle is considering the options with regard to the golf build decision. One alternative is simply to continue as in and not induce the Medallion IS. The cond option, called Pull Old involves prxlucing the Sand taking the Profite LD of the market. Athin possibility. Keep Old in to produce both the 1S and LD. Everyone involved finds the AS is option distasteful because the 15 would not be introduced at all, and it is probably only way before a competitor develops a similar ball. Thus, if this option chon, Pinnacle would have lost the opportunity to be the first to produce this new bal tailure that could hurt its image as an industry pracusetter If the Profite LD were discontinued full Old were selected the firm's existing manufacturing facilities would have to be designed and addi tional equipment would be required. Still, some inse in production facilities would be needed but not enough to proclude any necessary expansion of the equipment or accessories divisions. However if Keep Old selected, then the firm would lack sufficient managerial and technical expertise for any other major expansion Here is information compiled by the ball division and considered relevant to the analysis. 1. The relevant time horizon is six years 2. Cost of goods sold will run 60 cents per ball for both the Medallion LS and the ProFlite LD. 3. (a) The ProFlite LD will be sold for $1 apiece. Division managers believe and top management agrees the Medallion IS is a cut above most balls. The LS, therefore, should sell at a premium until competitors develop a similar ball. A reasonable estimate is that the LS can be sold for $1.10 a unit in years 1-3 and $1 during years 4-6, (b) Annual unit sales of various LS/LD combinations are shown in Exhibit 3. These estimates assume the above prices. 4. Working capital requirements are $0,10 per ball. 5. The appropriate tax rate is 40 percent. 6. Exhibit 4 shows yearly marketing, administrative, and miscellaneous fixed cash expenses for the As Is, Keep Old, and Pull Old options, 7. (a) The Pull Old alternative will require $4.8 million to redesign and expand existing manufacturing facilities and for the purchase of additional equipment (6) The Keep Old option will require $15.9 million for new equipment and to expand the firm's manufacturing capacity. NOTE: For purposes of analysis, the expenditures in number 7 are assumed to occur "up front, that is, at timet 0, and will be depreciated on a straight-line basis over six years, the relevant time horizon of each option. 8. The Keep Old and Pull Old options will require additional land whose mar- ket values are $2004000) and $25(000), respectively. (For tax purposes these amounts are not depreciable.) 9. The after-tax terminal value of Pull Old is $180000 and Keep Old is $3,1806000). As is has a negligible terminal value and can be ignored. These estimates do not consider the recapture of any working capital. Management is considering two alternatives regarding the equipment deci sion. One possibility, called Price Increase is simply to raise the price of its Precision clubs in order to eliminate or at least reduce any excess demand Management thinks that price can be raised from S600 to at least $650 a set without reducing sales below the present capacity of 40.000 per year. The other option, called Expand, involves leaving the price unchanged and building additional facilities to accommodate the expected demand. If Expand is chosen then the firm would not pursue either the accessories project or the Keep Old alternative of the ball project. The equipment division has made cash flow esti- mates of Price Increase and Expand. Exhibit 5() shows the yearly incremental cash flow estimates for Price Increase assuming a $50 increase in the price of set of Precision clubs and annual sales of 40,000 sets per yerit. Exhibit 5(b) gives these estimates for Expand, assuming no change in unit price and the yearly sales shown in Exhibit 1. Management does not believe that projects in each division have the same degree of market risk. Equipment sales are considered to be relatively vulner- able to economic downturns because of their high unit price and because con sumers can easily postpone their purchase and use their old equipment a little longer. Ball sales are of the lowest risk since they are a necessity for players. Management uses a required return (cost of capital of 11 percent for projects of the ball division, 12 percent for accessories, and 14 percent for equipment projects. MANAGEMENT OPINION And there is no shortage of opinions among Pinnacle's executives about what should be done. Here is a sample of those views Paul McKinney, chemist and head of Pinnacle's research and development department. He favors introducing the new ball since "all the tests show that it really works, but he has no strong opinion about whether the old ball should be discontinued Lyle Snead, ex-touring pro and a member of the firm's Advisory board. He doesn't have much faith in McKinney's scientific tests but has played the new ball and believes it works. Thinks it will sell. Jane Sherry, director of communications. Wants either golf ball or equipment production to expand. She believes that any equipment price increase would give the firm "bad press but could be avoided simply by expanding manu- facturing facilities. And not to introduce the LS "makes little sense if Pinnacle values its reputation as an industry pacesetter Warner Covington, wnior vice president. Covington is sympathetic to Sherty's position and notes that some type of expansion will never be cheaper." He points out that the firm has $1 million of excess working capi- tal and owns the land necessary for any expansion. "Thus," observes Covington, "if we expand now we save S1 million of working capital and the land costs us nothing.' Deborah Dresnik, chief of production Dresnik is very concerned about the managerial and technical bottlenecks of the firm. She wonders (1) if doing any major expansion now would mean foregoing some profitable investment project in the future and (2) if the necessories proposal represents too much of a shift in the firm's strategic policy. Notes that the Precision clubs are proven winner Elizabeth Robinson, CEO, She thinks Drexnik has made some good points. Her gut reaction is to increase the price of the Precision equipment and discontinue production of the ProFlite LD, replacing it with the Medallion LS, because these options leave room for possible future investments John Knudson, marketing director. He's the only senior manager sympa- thetic to the accessories expansion. He thinks that quality golf shirts and shoes would be extremely popular, and he favors some option that allows this expansion. He notes that while the accessories division accounts for 5 percent of the firm's sales, it receives less than 2 percent of the advertising and marketing budget. Knudson, therefore, is very sympa thetic to the theory that the sales of accessories have been hampered by a lack of promotion QUESTIONS 1. (A) What is a firm's strategic policy? How, if at all, does it influence a firm's choice of capital budgeting projects? (b) What is an unbiased cash flow forecast? Do you find it surprising that studies have found that the actual cash flows of sales projects tend to be well below the predicted amounts? Defend your answer. 2. Management uses an 11 percent required return (cost of capital) for projects of the Ball Division, 12 percent for Accessories', and 14 percent for Equipment's projects, Some of l'innacle's plant managers feel that it is unfair" to use three different rates. They argue that we are all part of one firm so all projects should use the same rate." How would you respond to this objection? 3. The yearly cash flow estimates of the Price Increase option (se Exhibit 5a) on the equipment decision ignore any possible working capital require ments. That is, these estimates assume that no additional working capital is necessary, Is this a reasonable assumption to make? Defend your answer. NOTE: "Working capital" is defined here as A/R INV - A/P - Accruals, 4. Assuming a discount rate of 12 percent, the NPV of the proposal of the Accessories Division is 56,043000) (see Exhibit 2 for the yearly cash flow destimates). Write out the equation used to determine this NPV. 5. Assuming a discount rate of 14 percent the NPV of the Price Increase option of the Equipment Division is $4,600(000) (see Exhibit 5a for the cash flow estimates) Calculate the NPV of the Expand Option using a rate of 14 percent (see Exhibit 5b). 6. The Equipment Division really has another option, which is literally to "Do Nothing SOFTWARE QUESTION 12. (a) Pinnacle's top executives still think that it is prudent to do only one "major" project, though it appears that no other major projects are likely in the foreseeable future. They have also carefully examined the estimates of each proposal and concluded that the following assumptions are appropriate. 1. Annual unit golf ball sales should remain as originally projected (ee Exhibit 3). 2. The price of the old ball (the ProFlite LD) will be $1 in years 1-3, 5.95 in years 4 and 5, and $.90 in year 6, PART V OXITAL BLIXETING 3. The price of the new ball (the Medallion Sy will be so in var 1. $1.05 in years 2 and 3, and $1 in years 46 4. Cost of goods sold will be $.00 per unitch year for the old ball and $.63 for the new ball 5. The annual cash flow projections of Price Increase should be raised by 10 percent (see Exhibit5a), 6: The annual cash flows of the Expand equipment option remain as originally projected e Exhibit 5b). 7. The annual cash flow projections of the Accessories Division for years 1996 (+1) - 2001K1) hould be reduced by 20 percent (see Exhibit 2). 8. The appropriate discount rates are 10 percent for Keep Old, per cent for Pull Old, 10 percent for Price Increase 13 percent for Expand (equipment), and 11 percent for Accessories Analyze this scenario. What do you recommend based on these results Explain (b) Note that the above scenario uses a slightly lower discount rate on keep Old than Pull Old. The thinking is that Pull Old is a bit miskien since it D originally projected (see Exhibit 5b). 7. The annual cash flow projections of the Accessories Division for years 1996 (1 + 1) - 2001 (+6) should be reduced by 20 percent (see Exhibit 2). 8. The appropriate discount rates are 10 percent for Keep Old, 11 per- cent for Pull Old, 10 percent for Price Increase, 13 percent for Expand (equipment), and 11 percent for Accessories, Analyze this scenario. What do you recommend based on these results? Explain. (b) Note that the above scenario uses a slightly lower discount rate on Keep Old than Pull Old. The thinking is that Pull Old is a bit riskier since it involves removing from the market a "known product." A number of Pinnacle's managers, however, think this interest rate differential is inappropriate. They believe that the same discount rate should be used on Keep Old and Pull Old, either 10 percent or 11 percent. How does all this affect your recommendation in part (a)? Explain. (Keep all other inputs at the values in part (a).) EXHIBIT 1 Projected Unit Sales of Precision Clubs (000) + +1 1997 63 +2 1998 70 +3 1999 23 2100 75 +5 2001 28 6 2002 75 The projections anume no change in the current price of purset. The firm penenty producing city of EXHIBIT 2 Projected Yearly Incremental Sales and After Tax Cash Flows of the Accessories Division Project (5000) 2 + +6 0 19 1 1927 1999 ROMI Incense Incremental cash low SI 10 18 200 UNO NO (51223001 500 SNO EXHIBIT 3 Projected Unit Golf Ball Sales, Various Scenarios (Millions) + +2 1927 +3 1990 1995 + 2000 + 5 2001 +6 2002 As Is Pull Ol Keep Ow 10 47 65 40 17 65 858 10 17 65 40 47 65 10 47 65 Description of Each Scenario As Is Only the old ball, the Trollite LD, is sold. The new ball, the Medallion 15, not introduced Pull Ol The new ball is introduced and the old ball is discontinued Keep Old Both the new and the old talks are produced and sold Annual unit sales are distributed as follows 35 million due to the new; 30 (million) due to the old "These forces wure the old ball (Profite) sells for Slaunind the new ball Medallion 1.5 for 1.10 during years 1-3 and St in years EXHIBIT 4 Selected Cost Estimates of the Ball Division ($000) Marketing +1 2 +3 + +5 +6 1997 1995 19 2001 2004 100 Ass Tall Old Keep Ou $1,600 su 54.00 1.000 20 . 100 2.000 27 1.00 2.000 2.200 INO 2.000 2,700 4700 A 2 + +5 6 Ass Pull Old Keep Om SINDO 54.100 55.20 DO 4,400 JO 200 100 4. S. 10 4100 5.200 SU Macellaneous Padah) 1 16 4 Asis rul $4,000 54.500 55.00 4 4.500 LOX 500 4.00 SO 40 4000 5.100 Keep On PART V CAPITAL BUDDETING EXHIBIT 5 (8) Projected Yearly Incremental After-Tex Cash Floww of the Prlee Increase Option of the Equipment Project ($000s) 0 2 1996 1907 BORN MORI ON 1999 2000 0 SD 200 1200 200 200 20 Note Ther forecast anume the price of a set of clubs brand to come year and the relevant tan rate 40 percent EXHIBIT 5 (6) Yearly Incremental After-Tax Cash Flow Estimates of the Equipment Project Expand Option (5000) 1 (SLO 3.100 BO 2 New Thewestimates anno change in the procese yearly sales in bil THE PINNACLE CORPORATION CAPITAL BUDGETING The Pinnacle Corporation manufactures golf balls, clubs, and accessories like golf gloves, bags, shirts, and shoes. In an industry where image is quite impor- tant, the Pinnacle label is synonymous with excellence. Pinnacle was the first company to build a mechanical golfer, which dramatically improved the relia- bility of golf ball and equipment testing. Pinnacle introduced the Surlyn (hard- covered) golf ball and in the early 1970s developed a radically different dimple design, called the icosahedron pattern. It has also been a leader in metal equip ment and in designing more "forgiving" clubs for the average player. In recent years Pinnacle entered the accessories market, partly to be known as a full- service" golf manufacturer and partly to be in a position to capitalize on expected growth in this area. The firm is organized by product line and has separate ball, equipment, and accessories divisions. Sales during the most recent fiscal year (1995) were $391 million, broken down by division as follows: ball, $213 million; equipment $157 million; and accessories. $21 million. Thus, the first two areas account for nearly 95 percent of revenue and represent the divisions most consistent with the firm's strategic policy, since Pinnacle sees itself primarily as developing and manufacturing tools to assist golfers in their quest for lower scores! Although, it is unfair to say that Pinnacle entered the accessories market as an afterthought, it is appropriate to say that top management doesn't believe the firm has any particular advantage in this area. In fact, until three years ago the accessories unit was not a separate division but simply a part of the equipment division. Top management felt, however, that this arrangement did not allow accessories to be properly represented in capital budgeting discussions and decisions The accessories that Pinnacle has marketed, though, have been consistent with the firm's reputation. This has been due mainly to the efforts of George Carrington, an energetic and flamboyant divisional manager with ten years experience in the clothing industry Carrington took the Pinnacle position even though the change was merely a lateral move in terms of salary and represented a bit of a low in prestige, since the budget he controls at Pinnacle is much less than the one he had at his former company. Still, Carrington wanted to be closer to the game he loves and felt that he was associating with the industry leader. THE PROBLEM Pinnacle is currently involved in deciding its capital budget for the coming year, and there are proposals from each division that are especially important to the long-term prospects of the firm. What is common to them all is the belief that the industry is and will continue to be in a golf boom. It is likely, therefore, that the demand for balls, equipment, and accessories will increase in real terms, that is, adjusted for inflation, for at least the next four to five years, One difficulty is that top management, for a number of reasons, doesn't think that more than one major project can be successfully implemented. First, annual sales growth of 10 percent is expected even without any new projects. Second, a major commitment to R + D has recently been made to stay ahead in the race for new products. Finally, the industry is facing a skilled labor short- age, and quality technicians and managers are hard to find. Top management, which is fiercely protective of the Pinnacle image, believes that if more than one major project is implemented, none will be done right. In fact, the corporate grapevine indicates that Elizabeth Robinson, the CEO, is not likely to approve any significant capital budgeting request from the accessories division unless it looks "extremely attractive." Robinson's thinking is that Pinnacle should capi- talize on its relative strengths, which she thinks are in balls and equipment. DIVISIONAL CONSIDERATIONS By varying the cover, core construction, and to a certain extent dimple design, manufacturers can develop balls with somewhat different flight characteristics and feel. For example, a soft (balata) cover combined with a wound, liquid center results in a ball that is relatively easy to hook or slice, it tends to fly higher and gives more "feel" on the finesse shots. A hard (Surlyn) cover with a solid two-piece interior is more difficult to hook or slice, tends to fly lower, and is more durable. Pinnacle produces six balls for the varied abilities and whims of golfers. The company recently developed a new ball, the Medallion LS, with a new cover of Lithium Surlyn, which combines some of the advantages of balata and Surlyn. A Lithium Surlyn-covered ball will fly a bit higher and farther than a Surlyn- covered one, though it is not as durable. In terms of the six balls Pinnacle eur. rently produces, the Medallion LS is closest to the ProFlite LD. Although management doesn't feel that the I would have much of an effect on the Malen of the other five balls, it does believe that the Swould hurt sales of the Proflite LD. Still, Pinnacle thinks that the 1S represents a step forward in ball technol ogy and should sell at a premium over existing balls. Twelve months ago the firm began manufacturing its Precision line of clubs, which are machine-made from cast iron. Four factors account for their success. First, they have the largest sweet spot of any club produced. This means that the ball can be contacted considerably off center and still produce a respectable shot. This characteristic has made Precision clubs especially popular with below-average golfers. Second, the shaft is extremely lightweight, which helps get shots up in the air more easily. Thind, though the clubs are machine-made, they don't have an "assembly-line" look. Finally, a set sells for $600, about 10 percent under competitive brands. Pinnacle can produce 40.000 sets a year, but annual demand is running at about 65,000 sets. And management feels this demand will continue. Exhibit 1 shows future sales projections assuming no change in the current price of $600. The accessories division is proposing that the production of bags, gloves, shirts, and shoes be expanded. Though no real shortage exists for these items at the present time, divisional managers are convinced that sales have been hurt by the relatively low-key approach Pinnacle has taken in marketing these prod- ucts. Carrington strongly feels that additional promotion, coupled with the pro. jected golf boom, will cause the sales of accessories to more than double in three years and make an expansion of his division highly attractive." He also argues that this project would result in Pinnacle achieving greater diversification in terms of product sales Exhibit 2 shows the yearly incremental sales and cash flow estimates that Carrington has submitted to top management, THE OPTIONS The expansion of the accessories division is considered a major project and, for reasons stated, would rule out the Keep Old option of the ball project and the Expand alternative of the equipment project. These are also considered major projects and are described later) Pinnacle is considering the options with regard to the golf build decision. One alternative is simply to continue as in and not induce the Medallion IS. The cond option, called Pull Old involves prxlucing the Sand taking the Profite LD of the market. Athin possibility. Keep Old in to produce both the 1S and LD. Everyone involved finds the AS is option distasteful because the 15 would not be introduced at all, and it is probably only way before a competitor develops a similar ball. Thus, if this option chon, Pinnacle would have lost the opportunity to be the first to produce this new bal tailure that could hurt its image as an industry pracusetter If the Profite LD were discontinued full Old were selected the firm's existing manufacturing facilities would have to be designed and addi tional equipment would be required. Still, some inse in production facilities would be needed but not enough to proclude any necessary expansion of the equipment or accessories divisions. However if Keep Old selected, then the firm would lack sufficient managerial and technical expertise for any other major expansion Here is information compiled by the ball division and considered relevant to the analysis. 1. The relevant time horizon is six years 2. Cost of goods sold will run 60 cents per ball for both the Medallion LS and the ProFlite LD. 3. (a) The ProFlite LD will be sold for $1 apiece. Division managers believe and top management agrees the Medallion IS is a cut above most balls. The LS, therefore, should sell at a premium until competitors develop a similar ball. A reasonable estimate is that the LS can be sold for $1.10 a unit in years 1-3 and $1 during years 4-6, (b) Annual unit sales of various LS/LD combinations are shown in Exhibit 3. These estimates assume the above prices. 4. Working capital requirements are $0,10 per ball. 5. The appropriate tax rate is 40 percent. 6. Exhibit 4 shows yearly marketing, administrative, and miscellaneous fixed cash expenses for the As Is, Keep Old, and Pull Old options, 7. (a) The Pull Old alternative will require $4.8 million to redesign and expand existing manufacturing facilities and for the purchase of additional equipment (6) The Keep Old option will require $15.9 million for new equipment and to expand the firm's manufacturing capacity. NOTE: For purposes of analysis, the expenditures in number 7 are assumed to occur "up front, that is, at timet 0, and will be depreciated on a straight-line basis over six years, the relevant time horizon of each option. 8. The Keep Old and Pull Old options will require additional land whose mar- ket values are $2004000) and $25(000), respectively. (For tax purposes these amounts are not depreciable.) 9. The after-tax terminal value of Pull Old is $180000 and Keep Old is $3,1806000). As is has a negligible terminal value and can be ignored. These estimates do not consider the recapture of any working capital. Management is considering two alternatives regarding the equipment deci sion. One possibility, called Price Increase is simply to raise the price of its Precision clubs in order to eliminate or at least reduce any excess demand Management thinks that price can be raised from S600 to at least $650 a set without reducing sales below the present capacity of 40.000 per year. The other option, called Expand, involves leaving the price unchanged and building additional facilities to accommodate the expected demand. If Expand is chosen then the firm would not pursue either the accessories project or the Keep Old alternative of the ball project. The equipment division has made cash flow esti- mates of Price Increase and Expand. Exhibit 5() shows the yearly incremental cash flow estimates for Price Increase assuming a $50 increase in the price of set of Precision clubs and annual sales of 40,000 sets per yerit. Exhibit 5(b) gives these estimates for Expand, assuming no change in unit price and the yearly sales shown in Exhibit 1. Management does not believe that projects in each division have the same degree of market risk. Equipment sales are considered to be relatively vulner- able to economic downturns because of their high unit price and because con sumers can easily postpone their purchase and use their old equipment a little longer. Ball sales are of the lowest risk since they are a necessity for players. Management uses a required return (cost of capital of 11 percent for projects of the ball division, 12 percent for accessories, and 14 percent for equipment projects. MANAGEMENT OPINION And there is no shortage of opinions among Pinnacle's executives about what should be done. Here is a sample of those views Paul McKinney, chemist and head of Pinnacle's research and development department. He favors introducing the new ball since "all the tests show that it really works, but he has no strong opinion about whether the old ball should be discontinued Lyle Snead, ex-touring pro and a member of the firm's Advisory board. He doesn't have much faith in McKinney's scientific tests but has played the new ball and believes it works. Thinks it will sell. Jane Sherry, director of communications. Wants either golf ball or equipment production to expand. She believes that any equipment price increase would give the firm "bad press but could be avoided simply by expanding manu- facturing facilities. And not to introduce the LS "makes little sense if Pinnacle values its reputation as an industry pacesetter Warner Covington, wnior vice president. Covington is sympathetic to Sherty's position and notes that some type of expansion will never be cheaper." He points out that the firm has $1 million of excess working capi- tal and owns the land necessary for any expansion. "Thus," observes Covington, "if we expand now we save S1 million of working capital and the land costs us nothing.' Deborah Dresnik, chief of production Dresnik is very concerned about the managerial and technical bottlenecks of the firm. She wonders (1) if doing any major expansion now would mean foregoing some profitable investment project in the future and (2) if the necessories proposal represents too much of a shift in the firm's strategic policy. Notes that the Precision clubs are proven winner Elizabeth Robinson, CEO, She thinks Drexnik has made some good points. Her gut reaction is to increase the price of the Precision equipment and discontinue production of the ProFlite LD, replacing it with the Medallion LS, because these options leave room for possible future investments John Knudson, marketing director. He's the only senior manager sympa- thetic to the accessories expansion. He thinks that quality golf shirts and shoes would be extremely popular, and he favors some option that allows this expansion. He notes that while the accessories division accounts for 5 percent of the firm's sales, it receives less than 2 percent of the advertising and marketing budget. Knudson, therefore, is very sympa thetic to the theory that the sales of accessories have been hampered by a lack of promotion QUESTIONS 1. (A) What is a firm's strategic policy? How, if at all, does it influence a firm's choice of capital budgeting projects? (b) What is an unbiased cash flow forecast? Do you find it surprising that studies have found that the actual cash flows of sales projects tend to be well below the predicted amounts? Defend your answer. 2. Management uses an 11 percent required return (cost of capital) for projects of the Ball Division, 12 percent for Accessories', and 14 percent for Equipment's projects, Some of l'innacle's plant managers feel that it is unfair" to use three different rates. They argue that we are all part of one firm so all projects should use the same rate." How would you respond to this objection? 3. The yearly cash flow estimates of the Price Increase option (se Exhibit 5a) on the equipment decision ignore any possible working capital require ments. That is, these estimates assume that no additional working capital is necessary, Is this a reasonable assumption to make? Defend your answer. NOTE: "Working capital" is defined here as A/R INV - A/P - Accruals, 4. Assuming a discount rate of 12 percent, the NPV of the proposal of the Accessories Division is 56,043000) (see Exhibit 2 for the yearly cash flow destimates). Write out the equation used to determine this NPV. 5. Assuming a discount rate of 14 percent the NPV of the Price Increase option of the Equipment Division is $4,600(000) (see Exhibit 5a for the cash flow estimates) Calculate the NPV of the Expand Option using a rate of 14 percent (see Exhibit 5b). 6. The Equipment Division really has another option, which is literally to "Do Nothing SOFTWARE QUESTION 12. (a) Pinnacle's top executives still think that it is prudent to do only one "major" project, though it appears that no other major projects are likely in the foreseeable future. They have also carefully examined the estimates of each proposal and concluded that the following assumptions are appropriate. 1. Annual unit golf ball sales should remain as originally projected (ee Exhibit 3). 2. The price of the old ball (the ProFlite LD) will be $1 in years 1-3, 5.95 in years 4 and 5, and $.90 in year 6, PART V OXITAL BLIXETING 3. The price of the new ball (the Medallion Sy will be so in var 1. $1.05 in years 2 and 3, and $1 in years 46 4. Cost of goods sold will be $.00 per unitch year for the old ball and $.63 for the new ball 5. The annual cash flow projections of Price Increase should be raised by 10 percent (see Exhibit5a), 6: The annual cash flows of the Expand equipment option remain as originally projected e Exhibit 5b). 7. The annual cash flow projections of the Accessories Division for years 1996 (+1) - 2001K1) hould be reduced by 20 percent (see Exhibit 2). 8. The appropriate discount rates are 10 percent for Keep Old, per cent for Pull Old, 10 percent for Price Increase 13 percent for Expand (equipment), and 11 percent for Accessories Analyze this scenario. What do you recommend based on these results Explain (b) Note that the above scenario uses a slightly lower discount rate on keep Old than Pull Old. The thinking is that Pull Old is a bit miskien since it D originally projected (see Exhibit 5b). 7. The annual cash flow projections of the Accessories Division for years 1996 (1 + 1) - 2001 (+6) should be reduced by 20 percent (see Exhibit 2). 8. The appropriate discount rates are 10 percent for Keep Old, 11 per- cent for Pull Old, 10 percent for Price Increase, 13 percent for Expand (equipment), and 11 percent for Accessories, Analyze this scenario. What do you recommend based on these results? Explain. (b) Note that the above scenario uses a slightly lower discount rate on Keep Old than Pull Old. The thinking is that Pull Old is a bit riskier since it involves removing from the market a "known product." A number of Pinnacle's managers, however, think this interest rate differential is inappropriate. They believe that the same discount rate should be used on Keep Old and Pull Old, either 10 percent or 11 percent. How does all this affect your recommendation in part (a)? Explain. (Keep all other inputs at the values in part (a).) EXHIBIT 1 Projected Unit Sales of Precision Clubs (000) + +1 1997 63 +2 1998 70 +3 1999 23 2100 75 +5 2001 28 6 2002 75 The projections anume no change in the current price of purset. The firm penenty producing city of EXHIBIT 2 Projected Yearly Incremental Sales and After Tax Cash Flows of the Accessories Division Project (5000) 2 + +6 0 19 1 1927 1999 ROMI Incense Incremental cash low SI 10 18 200 UNO NO (51223001 500 SNO EXHIBIT 3 Projected Unit Golf Ball Sales, Various Scenarios (Millions) + +2 1927 +3 1990 1995 + 2000 + 5 2001 +6 2002 As Is Pull Ol Keep Ow 10 47 65 40 17 65 858 10 17 65 40 47 65 10 47 65 Description of Each Scenario As Is Only the old ball, the Trollite LD, is sold. The new ball, the Medallion 15, not introduced Pull Ol The new ball is introduced and the old ball is discontinued Keep Old Both the new and the old talks are produced and sold Annual unit sales are distributed as follows 35 million due to the new; 30 (million) due to the old "These forces wure the old ball (Profite) sells for Slaunind the new ball Medallion 1.5 for 1.10 during years 1-3 and St in years EXHIBIT 4 Selected Cost Estimates of the Ball Division ($000) Marketing +1 2 +3 + +5 +6 1997 1995 19 2001 2004 100 Ass Tall Old Keep Ou $1,600 su 54.00 1.000 20 . 100 2.000 27 1.00 2.000 2.200 INO 2.000 2,700 4700 A 2 + +5 6 Ass Pull Old Keep Om SINDO 54.100 55.20 DO 4,400 JO 200 100 4. S. 10 4100 5.200 SU Macellaneous Padah) 1 16 4 Asis rul $4,000 54.500 55.00 4 4.500 LOX 500 4.00 SO 40 4000 5.100 Keep On PART V CAPITAL BUDDETING EXHIBIT 5 (8) Projected Yearly Incremental After-Tex Cash Floww of the Prlee Increase Option of the Equipment Project ($000s) 0 2 1996 1907 BORN MORI ON 1999 2000 0 SD 200 1200 200 200 20 Note Ther forecast anume the price of a set of clubs brand to come year and the relevant tan rate 40 percent EXHIBIT 5 (6) Yearly Incremental After-Tax Cash Flow Estimates of the Equipment Project Expand Option (5000) 1 (SLO 3.100 BO 2 New Thewestimates anno change in the procese yearly sales in bil