Your task is to prepare a capital budgeting report to Mr Walker, owner of Delaware Pipe, indicating whether the company should make or buy the 10-in. and 12-in. pipe. Your report should include the answers to the following Questions 1 to 8. It is important to list your assumptions in applying the investment evaluation techniques, and show clearly the workings and calculations in deriving your results in the Appendix. Your assignment will be graded based on presentation, understanding of the issues and logical explanation, and accuracy of calculations in solving the problems. The mark allocations for individual questions (including 25 marks for writing conventions/language use, reasoning/line of argument and presentation) will total to 125 marks and will be scaled by a factor of 0.2 to produce a mark consistent with 25% weighting in the unit assessment.

QUESTIONS

1. The accountant's estimates in Exhibit 3 use the "most likely" sales projection in Exhibit 1 for each year. Are any of the 11 items listed in Exhibit 3 incorrect for application of the net present value (NPV) method? Have any relevant items been omitted from the list? Consider all information given in the case and explain why.
2. [16 marks]
3. Prepare the incremental cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) for the project over the eight years based on the "most likely" sales projection of 1,650,000 pounds per year in Exhibit 1.
4. [26 marks]
5. Based on your estimated after-tax net cash flows in Question 2, calculate the payback period, NPV, internal rate of return (IRR) and profitability index (PI) of this project. Assume DP uses a payback rule with cut-off period of five years and the appropriate after-tax discount rate is the company's cost of capital. Should the project be undertaken based on each of the investment evaluation methods?
6. [11 marks]
7. Show a sensitivity analysis of NPV to sales quantity (worst- and best-case scenarios) given in Exhibit 1.
8. [10 marks]
9. Use the NPVs for the worst-, most-likely- and best-cases of sales quantity estimates (i.e. the figures derived in Questions 3 and 4), and their probabilities of occurrence to find the project's expected NPV, standard deviation, and coefficient of variation.
10. [6 marks]

3

1. Recall that Walker is quite sceptical of the salesmen's estimate of the new sales as a result of internal production of the 10-in. and 12-in. pipe. To help him in the evaluation, Walker is interested in the minimum annual increase in new sales necessary to make the project worthwhile. What is this figure assuming equal annual sales? [You may assume that (1) only materials and distribution costs will vary with increased production; (2) no additional equipment is needed; (3) unit selling price is 56 cents per pound; and (4) the relevant after-tax discount rate is 12 percent.]
2. [8 marks]
3. Walker used a 12% discount rate to find the present value of annual cash flows caused by any increase in the unit sales of 3-in., 6-in., and 8-in. pipe. He believes this should be 13% and may be even as high as 15%. Does it make sense to use a higher discount rate in Question 6 than in Question 3? How important is this "interest rate concern" to the project if the expected rate of inflation is 3% per year? Justify your answer.
4. [8 marks]
5. Based on your answers to Questions 1 - 7 above and other information in the case, what do you recommend? Do you recommend in-house production of the 10-in. and 12-in. pipe? Defend your advice with the support of your answers.

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[15 marks]

4

CASE STUDY

Delaware Pipe: Make or Buy1

"If we do decide to produce the 10-in. and 12-in. pipe internally, it could solve our overstaffing problem," Phillip Walker, owner of Delaware Pipe, remarked to Helen Riggins, the plant manager. "I'm reluctant to lay anyone off of even cut back hours. It's not good business and it's not the right thing to do if it can be at all avoided."

The FIRM

Philip Walker has no intentions of starting his own firm in 1976. Since graduating from college in 1968 he had worked for ATV Pipe, a company based in Wilmington, Delaware. In January 2006 the company decided to relocate to New York state, and Walker went also. Walker and his wife were quite unhappy in New York, mainly because they felt so distant from their relatives, nearly all of whom were located around Wilmingtong. In May 1976 he decided to move back to Wilmington and start his own pipe company quite a bold decision, really, for a man with three children and a fourth on the way.

Walker felt he understood the manufacturing side of the piping business "inside and out". He recognised, however, that in order to be successful he needed marketing and financial expertise, and he worked very hard to strengthen himself in these areas. By his own admission Walker made "many mistakes" during the first 18 months, but nonetheless, the business surged ahead. By the third year it was clear not only that the company would be successful, but that it had the potential to prosper.

And prosper it has. Delaware Pipe (DP) operates on 14 acres and employed 31 people. In fiscal year 2005 sales totalled nearly $25 million despite regional recession and the highly competitive nature of the piping business. The company's tax rate is 30 percent, and its weighted average cost of capital is estimated to be 10 percent.

Walker attributes his success to two factors: service and dedication to quality. While many firms are concerned with the quantity of pipe they produce, right from the start Walker was dedicated to manufacturing the best quality of pipe possible. "If we achieve quality the quantity will take care of itself," he often tells his employees. The company also provided exceptional service. DP keeps an unusually large volume and selection of inventory at all times and maintains a relatively large fleet of trucks. As a result the company can fill an order quite quickly. Such fast delivery means that distributors DP sells to many of whom are nationally known wholesalers of building materials are able to keep their inventory low.