Question 4.

Now assume that needed production facilities for the current line of powdered detergents were at 55% of capacity but were expected to grow at a rate of 20% a year and maximum production capacity is 100%. In other words, in three years the current line of powdered detergents will utilize almost 100% of existing production facilities, at which point the firm needs to spend $5 million to expand these production facilities. However, if the Blast project is implemented, the firm will reach 100% capacity utilization rate a year earlier so that the $5 million expansion cost needs to be incurred in two years instead of three years. If the Blast project is implemented, should it be charged for all or a portion of this expansion cost and what would be the present value of such a charge?

Danforth & Donnalley Laundry Products Company On April 17, 2013, James Danforth, president of Danforth 3r. Donnalley (D&D) Laundry Products Company, called to order a meeting of the nancial 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. DSzD was formed in 1985 with the merger of Danforth Chemical Company, headquartered in Seattle, WA, producers of Li-Off detergent, the leading detergent on the West Coast; and Donnalley Home Products Company, headquartered in Detroit, MI, makers of Wave detergent, a major Midwestern laundry product As a result of the merger, D&D was producing and marketing two major product lines: Lift-Off was a low- suds, concentrated powder, while Wave was a more traditional powder detergent. In the face of increased competition and technological innovation, D&D had spent large amounts of time and $40,000 over the past four 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. First, Blast was so highly concentrated that only 2 ounces was needed to do an average load of laundry as compared with 8 to 12 ounces of powdered detergent. Second, because it was a liquid, it was possible to pour Blast directly on stains and hard-to-wash spots, eliminating the need for a presoak and giving Blast cleaning abilities that powders could not possibly match. And third, Blast 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 was attended by 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 D&D's nancial staff, who was invited by McDonald to sit in on the meeting. Rainey opened with a presentation of the cost and cash ow analysis for the new product, and passed out copies of the projected operating cash ows (see Exhibits 1 and 2). In support of this information, he provided some insight into how these calculations were done. Rainey proposed that the initial cost for Blast included $500,000 for the test marketing [which was conducted in the Detroit area and completed in the previous June}, the $40,000 of research and development expenses, and $2 million for new specialized machinery and packaging equipment. The estimated life for the machinery and equipment was 15 years, aer which they would have no salvage value. This 15-year estimated life assumption coincides with company policy set by Donnelley not to consider cash ows occurring more than 15 years into the future, as estimates that far ahead \"tend to become little more than blind guesses.\" Rainey cautioned against taking the annual operating cash ows shown in Exhibit 1 at face value since portions of these cash flows actually are a result of sales that had been diverted from Lift-Off and Wave. For this reason, Rainey also produced the annual cash flows shown in Exhibit 2, which had been adjusted to include only those cash ows incremental to the company as awhole. At this point, discussion opened between Donnalley and McDonald, and it was concluded that the opportunity cost of flmds (cost of capital) is 10%. Gasper then questioned the fact that no costs were included in the proposed capital budget for plant facilities {buildings and structures), which would be needed to produce the new product. EXHIBIT 1. D&D Laundry Products Company Total Annual Cash Flows from the Acceptance of Blast (including those flows resulting from sales diverted from the existing product lines) Year Cash Flows HAWN $280,000 280,000 280,000 280,000 280,000 10 00 - 350,000 350,000 350,000 350,000 10 350,000 11 250,000 12 250,000 13 250,000 14 250,000 15 250,000 Rainey replied that, presently, Lift-Off's production facilities were being utilized at only 55% of capacity, and since these facilities were suitable for use in the production of Blast, no new plant facilities other than the specialized machinery and packaging equipment mentioned above need to be acquired for the new product line. It was estimated that full production of Blast would only require 10% of the plant capacity. McDonald asked about working capital needed to operate the investment project. Rainey answered that this project would require $200,000 of additional working capital at the start of the project. Further, at the end of project's estimated life, this money would be transferred to other projects and thus will never leave the firm and will always be in liquid form; therefore it was not considered an inflow in fifteen years and, hence, the recovery of working capital at the end of project's life was not included in calculations. Donnalley argued that Blast should be charged something for its use of the current excess plant facilities. He reasoned that, if an outside firm tried to rent this space from D&D, it would be charged $100,000 annually, and since this project would compete with other current projects, it should be treated as an outside project and charged as such. However he went on to acknowledge that D&D has a strict policy forbidding the renting out of its production facilities. If they didn't charge for facilities, he concluded, the firm might end up accepting projects that under normal circumstances would be rejected. Danforth asked whether Blast should be charged for a portion of existing plant facilities' heating expenses, since Blast will be housed in those facilities. These heating expenses amounted to $5,000 annually. Danforth was also wondering whether Blast should be charged for the services of a lawyer hired by D&D, who was providing the firm with legal counsel and was getting an annual fee of $20,000 from the firm regardless of the amount of work performed. Rainey did not have answers to these questions but promised to come back with answers after collecting some additional information. From here, the discussion continued about what to do with the "lost contribution from other projects," the test marketing costs, the working capital, and opportunity cost of renting existing excess plant facilities, and heating and legal counsel expenses. 2