The Baldwin Company, originally established 16 years ago to make footballs, is now a leading producer of tennis balls, baseballs, footballs, and golf balls. Nine years ago, the company introduced High Flite, its first line of high-performance golf balls. Baldwin management has sought opportunities in whatever businesses seem to have some potential for cash flow. Recently W. C. Meadows, vice president of the Baldwin Company, identified another segment of the sports ball market that looked promising and that he felt was not adequately served by larger manufacturers.

As a result, the Baldwin Company investigated the marketing potential of brightly colored bowling balls. Baldwin sent a questionnaire to consumers in three markets: Philadelphia, Los Angeles, and New Haven. The results of the three questionnaires were much better than expected and supported the conclusion that the brightly colored bowling balls could achieve a 10 to 15 percent share of the market. Of course, some people at Baldwin complained about the cost of the test marketing, which was $250,000. (As we shall see later, this is a sunk cost and should not be included in project evaluation.)

In any case, the Baldwin Company is now considering investing in a machine to produce bowling balls. The bowling balls would be manufactured in a building owned by the firm and located near Los Angeles. This building, which is vacant, and the land can be sold for $150,000 after taxes.

Working with his staff, Meadows is preparing an analysis of the proposed new product. He summarizes his assumptions as follows: The cost of the bowling ball machine is $100,000 and it is expected to last five years. At the end of five years, the machine will be sold at a price estimated to be $30,000. The machine is depreciated on straight line basis. The company is exempt form capital gains tax. Production by year during the five-year life of the machine is expected to be as follows: 5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling balls in the first year will be $20. The bowling ball market is highly competitive, so Meadows believes that the price of bowling balls will increase at only 2 percent per year, as compared to the anticipated general inflation rate of 5 percent.

Conversely, the plastic used to produce bowling balls is rapidly becoming more expensive. Because of this, production cash outflows are expected to grow at 10 percent per year. First-year production costs will be $10 per unit. Meadows has determined, based on Baldwins taxable income, that the appropriate incremental corporate tax rate in the bowling ball project is 34 percent.

Like any other manufacturing firm, Baldwin finds that it must maintain an investment in working capital. It will purchase raw materials before production and sale, giving rise to an investment in inventory. It will maintain cash as a buffer against unforeseen expenditures. And, its credit sales will not generate cash until payment is made at a later date. Management determines that an initial investment (at Year 0) in net working capital of $10,000 is required. Subsequently, net working capital at the end of each year will be equal to 10 percent of sales for that year. In the final year of the project, net working capital will decline to zero as the project is wound down. In other words, the investment in working capital is to be completely recovered by the end of the projects life.