Most corporations have standard procedures for the submission of capital budgeting requests. These requests include a detailed enumeration of all costs involved. Capital budgeting is normally done on an annual basis and the requests from the various operating units are compiled to determine the total amount of the capital requests for the year. Each project and its estimated future cash flows are analyzed by a capital budgeting committee, and in many cases the operating unit managers must justify the rationale behind the estimates. American Grain Company (AGC) is a multinational firm with total revenues in excess of $5 billion per year. The firm is made up of four major divisions and each division must submit its annual capital budgeting requests to AGC headquarters in Minneapolis by May 15. Michael Paschall is the plant manager at AGC's pet food plant in Louisville. The plant produces both wet and dry food for a wide variety of pets, from tropical fish to greyhounds. Michael's job includes determining the capital needs of the plant and preparing the capital request. At this time he is preparing a capital request for a new pellet mill system that will increase his plant's productivity. PRODUCTION OF DRY PET FOOD At the Louisville plant, the dry pet food pellets are produced through an extrusion process. The process begins with the grinding of all grains into a meal; the different grains are then mixed with other ingredients, including vitamins, in 3 -ton mixers. Each 3-ton mix is called a batch. The process is not unlike what an individual would do when making a batch of pancake mix or bread dough. Each batch is then moved through a system of conveyors and elevators into a holding bin above pellet mills. In the Louisville plant there are four pellet mills, each driven by a 120 horsepower electric motor and rated at a capacity of 10 tons per hour. The mixed ingredients are fed by a conveyor into the top of the pellet mill where steam is added to the dry mix as a binder. The wet mixture is then forced through a fixed die. The die is a round steel drum about 3 feet in diameter and about 3 inches thick. (A die looks like a car tire in size and shape.) The die contains hundreds of holes all the same diameter. Three rotating rollers roll around the inside surface of the die, forcing the ingredients through the holes. On the outside of the die a rotating knife cuts the extruded pellets off at various lengths depending on the type of pet food being produced. These hot pellets are then conveyed to a cooler, which cools and drys the pellets. The drying process is needed before the pet food is bagged to reduce the moisture; if the pellets had a high moisture content before being placed in a paper bag or a cardboard box, they would "sweat" and then mildew in the container. After drying, the pellets are held in a bin above the bagging and sewing line. The bagging and sewing operation is highly automated: a measured amount of the pellets is dumped into a paper bag and the bag is sewed shut. The bags are then moved on conveyors to the warehouse, where they are stacked on pallets ready for shipping to grocery and other retail stores' distribution centers. Currently the four pellet mills are producing an average of 400 tons of pellets per 12-hour day. The plant has two full shifts, but the pellet line runs only 12 hours. The mill, which is rated at 10 tons per hour, is producing only 8.3 tons per hour. The reason for this seeming inefficiency is that a cleaning-out process is required after each type of feed is nun through the dies. the cleaning process is needed to push the last of the previous batch out through the dies before the new batch is started. The length of each run is constrained by the amount of available floor space in the warehouse and an estimate on the amount of orders that will be received. (A run is the number of batches of a single type of pet food that is produced before stopping and switching to another type of pet food.) The best way to achieve greater production efficiency is to have longer runs and/or produce more pellets per mill. For this reason, Michael has been looking at a new pellet mill that is produced by the California Pellet Mill Company. CALIFORNIA PELLET MILL California Pellet Mill Company, a major manufacturer of pellet mills, has introduced a new pellet mill that is rated at 10.6 tons per hour. Based on the current production efficiency, the actual production rate would be 8.82 tons per hour. The new pellet mills will cost $120,000 each, including installation. If four new mills are purchased, a one-time $15,000 improvement in the steam line to the mills will be required. The new pellet mills would be depreciated over a fiveyear period according to the Modified Acceleration Cost Recovery System (MACRS) that was created by the Tax Reform Act of 1986. (Depreciation rates are given in Exhibit 1.) The four old machines have been fully depreciated but could be sold as junk for $10,000 each. If the four new mills are purchased there would also be a net increase in working capital of $12,000. THE CAPITAL BUDGETING PROCESS AT AGC Among other capital projects, the plant capital budgeting committee thinks that the purchase of the new pellet mills should be given a high priority. Paschall knows that he must present any capital budgeting requests before the divisional capital budgeting committee. Each year he is given certain guidelines for the preparation of capital requests. Among these guidelines are the specific instructions for preparing the capital budget requests. It was noted in this year's instructions that the cost of capital for plant production is 16 percent and the company has a combined state and federal tax rate of 38 percent for its Kentucky plants. The Louisville plant operates five days a week and 50 weeks a year (10 holidays) with the pellet line averaging 12 hours of operation per day. The average sales price per ton of pet food is $280. The raw materials cost $152 per ton, and operating costs-including all overhead, selling, and administrative expenses-are $108 per ton. Both sales and costs are expected to increase 6 percent per year over the seven-year economic life of these mills. At the end of their economic life the mills are expected to have a salvage value of $10,000 each. QUESTIONS 1. Determine the initial net cash outflow for this project. 2. Determine the net cash flows (years 1 to 7) if the new pellet mills are purchased. 3. Calculate the NPV for the pellet mill project. 4. Calculate the IRR for the pellet mill project. 5. What is the payback for the pellet mill project? 6. Should AGC invest in the new pellet mills? 7. For what reasons besides those presented in this case might this project be unacceptable? 8. How would you respond if a member of the divisional budget committee made the comment at the end of your presentation that he was against the project because it only made a profit of $35,000