Question 1

Danforth & Donnalley Laundry Products Company

Determining relevant cash flows

At 3:00 pm on 14 April 2015, James Danforth, president of Danforth & Donnalley (D&D) Laundry Products Company,

called to order a meeting of the financial directors. The purpose of the meeting was to make a capital budgeting

decision with respect 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 Company (producer of Lift-Off detergent, the

leading laundry detergent in Western Australia and South Australia) and Donnalley Home Products Company (maker of

Wave detergent, a major laundry product on the east coast). As a result of the merger, D&D was producing and marketing two major product fines. Although these products were in direct competition, they were not without product differentiation:

Lift-Off was a low-suds, concentrated powder, and Wave was a more traditional powder detergent. Each fine brought with it considerable brand loyalty, and, by 2015, sales from the two detergent lines had increased tenfold from 1993 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 four years researching and developing a new highly concentrated liquid laundry detergent. D&D's new detergent, which it called Blast, had many obvious advantages over the conventional powdered products. The company felt that Blast offered the consumer benefits in three major areas: (i) Blast was so highly concentrated that only 60 grams were needed to do an average load of laundry, as compared with 240 to 360 grams of powdered detergent; (ii) being a liquid, it was possible to pour Blast directly on stains and hard-to-wash spots, eliminating

the need for a pre-soak, and giving it cleaning abilities that powders could not possibly match; and (iii) it would be packaged in a lightweight, unbreakable plastic bottle with a sure-grip handle, making it much easier to use and more convenient to store than the bulky boxes of powdered detergents with which it would compete.

The meeting participants included James Danforth, president of D&D; Jim Donnalley, director of the board;

Guy Rainey, vice-president in charge of new products; Urban McDonald, controller; and Steve Gasper, a

newcomer to the D&D financial staff who was invited by McDonald to sit in on the meeting. Danforth called the meeting to order, gave a brief statement of its purpose, and immediately gave the floor to Guy Rainey.

Rainey opened with a presentation of the cost and cash-flow analysis for the new product. To keep things

clear, he passed out copies of the projected cash flows to those present (see Exhibits 1 and 2). In support of this information, he provided some insights 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 Canberra area and completed in June of the previous year, and $2 million for new specialised equipment and packaging facilities. The estimated life for the facilities was 15 years, after which they would have no salvage value. This 15-year estimated life assumption coincides with company policy set by Donnalley not to consider cash flows occurring more than 15 years into the future, because 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 result of sales that had been diverted from Lift-Off and Wave. For this reason, Rainey also produced the estimated annual cash flows that had been adjusted to include only those cash flows incremental to the company as a whole (as shown in Exhibit 2).

At this point, discussion opened between Donnalley and McDonald, and it was concluded that the opportunity cost on funds was 10%. Gasper then questioned 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% of

capacity, and because these facilities were suitable for use in the production of Blast, no new plant facilities would need to be acquired for the production of the new product line. It was estimated that full production of Blast would require only 10% 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 there had, and that this project would require $200000 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.

Donnalley argued that this project should be charged something for its use of current excess plant facilities. His reasoning was that if 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 renting or leasing any of its production facilities to any party from outside the firm. If they did not charge for facilities, he concluded, the firm might end up accepting projects that under normal circumstances would be rejected.

From here, the discussion continued, centring on the question of what to do about the lost contribution from other projects, the test marketing costs and the 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 from the existing product lines)