Cengage Learning · Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, ......

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

Financial Management

Brigham / Klein

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States


Brigham / Klein

Cengage Learning

ALL RIGHTS RESERVED. No part of this work covered by the copyright herein may be reproduced, transmitted, stored or used in any form or by any means graphic, electronic, or mechanical, including but not limited to photocopying, recording, scanning, digitizing, taping, Web distribution, information networks, or information storage and retrieval systems, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the publisher.

ISBN-13:

ISBN-10:

Cengage Learning

Cengage Learning is a leading provider of customized learning solutions with office locations around the globe, including Singapore, the United Kingdom, Australia, Mexico, Brazil, and Japan. Locate your local office at: international.cengage.com/region

Cengage Learning products are represented in Canada by Nelson Education, Ltd.

For product information and technology assistance, contact us at Cengage Learning Customer & Sales Support, 1-800-354-9706

For permission to use material from this text or product, submit all requests online at cengage.com/permissions

Further permissions questions can be emailed to [email protected]

Visit our corporate website at cengage.com

For your lifelong learning solutions, visit custom.cengage.com

Michele Baird

Linda deStefano

Sara Mercurio

Donna M. Brown

Rebecca A. Walker

Kalina Hintz

Getty Images*

* Unless otherwise noted, all cover images usedby Custom Solutions, a part of Cengage Learning,have been supplied courtesy of Getty Images withthe exception of the Earthview cover image, whichhas been supplied by the National Aeronauticsand Space Administration (NASA).

Executive Editors:

Project Development Manager:

Senior Marketing Coordinators:

Production/Manufacturing Manager:

PreMedia Services Supervisor:

Rights & Permissions Specialist:

Cover Image: 5191 Natorp BoulevardMason, Ohio 45040USA

978-0-324-67793-5

0-324-67793-6

© 2008, 2007 Cengage Learning

Maureen Staudt

Michael Stranz

Lindsay Shapiro


Brigham / Klein

the United States of America

ALL RIGHTS RESERVED. No part of this work covered by the copyright herein may be reproduced, transmitted, stored or used in any form or by any means graphic, electronic, or mechanical, including but not limited to photocopying, recording, scanning, digitizing, taping, Web distribution, information networks, or information storage and retrieval systems, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the publisher.

ISBN-13:

ISBN-10:

Cengage Learning

Cengage Learning is a leading provider of customized learning solutions with office locations around the globe, including Singapore, the United Kingdom, Australia, Mexico, Brazil, and Japan. Locate your local office at: international.cengage.com/region

Cengage Learning products are represented in Canada by Nelson Education, Ltd.

For product information and technology assistance, contact us at Cengage Learning Customer & Sales Support, 1-800-354-9706

For permission to use material from this text or product, submit all requests online at cengage.com/permissions

Further permissions questions can be emailed to [email protected]

Visit our corporate website at cengage.com

For your lifelong learning solutions, visit custom.cengage.com

Michele Baird

Linda deStefano

Sara Mercurio

Donna M. Brown

Rebecca A. Walker

Kalina Hintz

Getty Images*

* Unless otherwise noted, all cover images usedby Custom Solutions, a part of Cengage Learning,have been supplied courtesy of Getty Images withthe exception of the Earthview cover image, whichhas been supplied by the National Aeronauticsand Space Administration (NASA).

Executive Editors:

Project Development Manager:

Senior Marketing Coordinators:

Production/Manufacturing Manager:

PreMedia Services Supervisor:

Rights & Permissions Specialist:

Cover Image: 5191 Natorp BoulevardMason, Ohio 45040USA

978-0-324-67793-5

0-324-67793-6

© 2008, 2007 Cengage Learning

Maureen Staudt

Michael Stranz

Lindsay Shapiro


Brigham / Klein

the United States of America

Cengage Learning

Acknowledgements

The content of this text has been adapted from the following product(s):

Abbot Nursery: Working Capital Management - Case 91, DirectedISBN-10: (0-324-53133-8)ISBN-13: (978-0-324-53133-6)

Cranfield, Inc. (B): Capital Budgeting - Case 45, DirectedISBN-10: (0-324-40447-6)ISBN-13: (978-0-324-40447-0)

New England Seafood Company: Capital Budgeting - Case 16, DirectedISBN-10: (0-324-40395-X)ISBN-13: (978-0-324-40395-4)

Johnson Window Company: Capital Structure - Case 8, DirectedISBN-10: (0-324-53109-5)ISBN-13: (978-0-324-53109-1)

Ace Repair, Inc.: Cost of Capital - Case 54, DirectedISBN-10: (0-324-40466-2)ISBN-13: (978-0-324-40466-1)

Chef's Selection: Working Capital Management - Case 86, DirectedISBN-10: (0-324-53122-2)ISBN-13: (978-0-324-53122-0)

Northern Forest Products: Cost of Capital - Case 90, DirectedISBN-10: (0-324-53131-1)ISBN-13: (978-0-324-53131-2)

Levinger Organic Snack Company: Long Term Financial Decisions - Case 98, DirectedISBN-10: (0-324-53146-X)ISBN-13: (978-0-324-53146-6)

Betsy's Best: Capital Budgeting - Case 102, DirectedISBN-10: (0-324-53150-8)ISBN-13: (978-0-324-53150-3)

Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, DirectedISBN-10: (0-324-40439-5)ISBN-13: (978-0-324-40439-5)

Cranfield, Inc. (A): Capital Budgeting - Case 44, DirectedISBN-10: (0-324-40445-X)

Acknowledgements

The content of this text has been adapted from the following product(s):

Abbot Nursery: Working Capital Management - Case 91, DirectedISBN-10: (0-324-53133-8)ISBN-13: (978-0-324-53133-6)

Cranfield, Inc. (B): Capital Budgeting - Case 45, DirectedISBN-10: (0-324-40447-6)ISBN-13: (978-0-324-40447-0)

New England Seafood Company: Capital Budgeting - Case 16, DirectedISBN-10: (0-324-40395-X)ISBN-13: (978-0-324-40395-4)

Johnson Window Company: Capital Structure - Case 8, DirectedISBN-10: (0-324-53109-5)ISBN-13: (978-0-324-53109-1)

Ace Repair, Inc.: Cost of Capital - Case 54, DirectedISBN-10: (0-324-40466-2)ISBN-13: (978-0-324-40466-1)

Chef's Selection: Working Capital Management - Case 86, DirectedISBN-10: (0-324-53122-2)ISBN-13: (978-0-324-53122-0)

Northern Forest Products: Cost of Capital - Case 90, DirectedISBN-10: (0-324-53131-1)ISBN-13: (978-0-324-53131-2)

Levinger Organic Snack Company: Long Term Financial Decisions - Case 98, DirectedISBN-10: (0-324-53146-X)ISBN-13: (978-0-324-53146-6)

Betsy's Best: Capital Budgeting - Case 102, DirectedISBN-10: (0-324-53150-8)ISBN-13: (978-0-324-53150-3)

Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, DirectedISBN-10: (0-324-40439-5)ISBN-13: (978-0-324-40439-5)

Cranfield, Inc. (A): Capital Budgeting - Case 44, DirectedISBN-10: (0-324-40445-X)

Cengage Learning

ISBN-13: (978-0-324-40445-6)

Sweet Dreams, Inc.: Financial Analysis and Forecasting - Case 68, DirectedISBN-10: (0-324-53085-4)ISBN-13: (978-0-324-53085-8)

Swan-Davis Corporation: Fundamental Concepts - Case 72, DirectedISBN-10: (0-324-53094-3)ISBN-13: (978-0-324-53094-0)

Filmore Enterprises: Fundamental Concepts - Case 84, DirectedISBN-10: (0-324-53118-4)ISBN-13: (978-0-324-53118-3)

Huber: Yang: and O'Riely: Long Term Financial Decisions - Case 97, DirectedISBN-10: (0-324-53145-1)ISBN-13: (978-0-324-53145-9)

Sun Coast Savings Bank: Long Term Financial Decisions - Case 21, DirectedISBN-10: (0-324-40404-2)ISBN-13: (978-0-324-40404-3)

ISBN-13: (978-0-324-40445-6)

Sweet Dreams, Inc.: Financial Analysis and Forecasting - Case 68, DirectedISBN-10: (0-324-53085-4)ISBN-13: (978-0-324-53085-8)

Swan-Davis Corporation: Fundamental Concepts - Case 72, DirectedISBN-10: (0-324-53094-3)ISBN-13: (978-0-324-53094-0)

Filmore Enterprises: Fundamental Concepts - Case 84, DirectedISBN-10: (0-324-53118-4)ISBN-13: (978-0-324-53118-3)

Huber: Yang: and O'Riely: Long Term Financial Decisions - Case 97, DirectedISBN-10: (0-324-53145-1)ISBN-13: (978-0-324-53145-9)

Sun Coast Savings Bank: Long Term Financial Decisions - Case 21, DirectedISBN-10: (0-324-40404-2)ISBN-13: (978-0-324-40404-3)

Cengage Learning

Table Of Contents

1. Betsy's Best: Capital Budgeting - Case 102, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

2. Cranfield, Inc. (A): Capital Budgeting - Case 44, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

3. Cranfield, Inc. (B): Capital Budgeting - Case 45, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

4. New England Seafood Company: Capital Budgeting - Case 16, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

5. Johnson Window Company: Capital Structure - Case 8, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

6. Ace Repair, Inc.: Cost of Capital - Case 54, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

7. Northern Forest Products: Cost of Capital - Case 90, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

8. Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

9. Sweet Dreams, Inc.: Financial Analysis and Forecasting - Case 68, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

10. Swan-Davis Corporation: Fundamental Concepts - Case 72, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

11. Filmore Enterprises: Fundamental Concepts - Case 84, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

12. Huber: Yang: and O'Riely: Long Term Financial Decisions - Case 97, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

13. Sun Coast Savings Bank: Long Term Financial Decisions - Case 21, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

14. Levinger Organic Snack Company: Long Term Financial Decisions - Case 98, Directed. . . . . . . . . . . . . . . . . . . . . . . . . 97

15. Abbot Nursery: Working Capital Management - Case 91, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

16. Chef's Selection: Working Capital Management - Case 86, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

Table Of Contents

1. Betsy's Best: Capital Budgeting - Case 102, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

2. Cranfield, Inc. (A): Capital Budgeting - Case 44, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

3. Cranfield, Inc. (B): Capital Budgeting - Case 45, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

4. New England Seafood Company: Capital Budgeting - Case 16, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

5. Johnson Window Company: Capital Structure - Case 8, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

6. Ace Repair, Inc.: Cost of Capital - Case 54, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

7. Northern Forest Products: Cost of Capital - Case 90, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

8. Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

9. Sweet Dreams, Inc.: Financial Analysis and Forecasting - Case 68, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

10. Swan-Davis Corporation: Fundamental Concepts - Case 72, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

11. Filmore Enterprises: Fundamental Concepts - Case 84, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

12. Huber: Yang: and O'Riely: Long Term Financial Decisions - Case 97, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

13. Sun Coast Savings Bank: Long Term Financial Decisions - Case 21, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

14. Levinger Organic Snack Company: Long Term Financial Decisions - Case 98, Directed. . . . . . . . . . . . . . . . . . . . . . . . . 97

15. Abbot Nursery: Working Capital Management - Case 91, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

16. Chef's Selection: Working Capital Management - Case 86, Directed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

Cengage Learning

Cengage Learning

In the early 1990s, the rural economy of northern Wisconsin was weak. A sizable portion of Wisconsin’s agricultural production centered on milk sold in bulk to processors. Prices fluctuated radically, depending on economic conditions and many farmers were having difficulty meeting operating expenses and debt maintenance payments. Small family farms were disappearing and non-farm jobs in the area were scarce. Although consumers were paying record prices for milk, many farmers believed that intermediaries controlled the industry and generated the majority of the profits.

Bruce Pitston, a third generation dairy farmer, operated one of the largest and most successful operations in the area. He kept up with trends in the industry and participated in agricultural extension programs. As a well-respected and active community leader, he was investigating the possibilities associated with milk processing and believed a dairy manufacturing plant using advanced technology for designer cheese and other milk products may diversify the local economy. He became of a similar and successful plant in New Jersey that local dairy farmers had established and operated.

Bruce’s children would be home from college in the upcoming summer to help with the dairy operation, so he decided to visit the New Jersey plant and determine first-hand how the facility operated. He arranged to meet with the production manager and other company executives to see if a similar plant could operate in the rural Wisconsin. This visit proved to be extremely fruitful. Not only did he determine that a milk processing operation could be profitable, but Sam Lund, the plant manager and a Wisconsin native, expressed an interest in helping to develop the new operation.

Bruce returned home and started talking to other dairy farmers. The farmers were convinced that vertical integration (combining the production and processing of their milk) would help them gain control over their product and help with diversification. In 1998, the top dairy farmers formed Betsy’s Best Co-op. They pledged a specific volume of milk, at a set price, for the production of high quality cheese and other processed milk products. In weak markets, dairy farmers would have an outlet for their milk. In strong markets, farmers could make money on the guaranteed sale of their milk, as well as a profit on the finished product.

The co-op hired Sam Lund to get the effort operational, and in 2002, Betsy’s Best opened a $35 million production facility. The operation was located on two rail lines and had decent highway access for distribution. The co-op bought state-of-the-art processing equipment from the manufacturer and arranged with the company to get the equipment in place and running. The co-op produced a variety of dairy products for retail grocery stores, and packaged it under customers’ store labels.

The co-op did not expect the plant to make a profit for three years due to high start-up costs. However, at the end of the second year, the plant had profits of $1.5 million. The operation provided 80 new and relatively high-paying jobs in the community, which helped to improve the local economy.

Case 102

Capital Budgeting

Directed

Betsy's Best

@ 2008, 2004 South-Western, a part of Cengage Learning

1

In the early 1990s, the rural economy of northern Wisconsin was weak. A sizable portion of Wisconsin’s agricultural production centered on milk sold in bulk to processors. Prices fluctuated radically, depending on economic conditions and many farmers were having difficulty meeting operating expenses and debt maintenance payments. Small family farms were disappearing and non-farm jobs in the area were scarce. Although consumers were paying record prices for milk, many farmers believed that intermediaries controlled the industry and generated the majority of the profits.

Bruce Pitston, a third generation dairy farmer, operated one of the largest and most successful operations in the area. He kept up with trends in the industry and participated in agricultural extension programs. As a well-respected and active community leader, he was investigating the possibilities associated with milk processing and believed a dairy manufacturing plant using advanced technology for designer cheese and other milk products may diversify the local economy. He became of a similar and successful plant in New Jersey that local dairy farmers had established and operated.

Bruce’s children would be home from college in the upcoming summer to help with the dairy operation, so he decided to visit the New Jersey plant and determine first-hand how the facility operated. He arranged to meet with the production manager and other company executives to see if a similar plant could operate in the rural Wisconsin. This visit proved to be extremely fruitful. Not only did he determine that a milk processing operation could be profitable, but Sam Lund, the plant manager and a Wisconsin native, expressed an interest in helping to develop the new operation.

Bruce returned home and started talking to other dairy farmers. The farmers were convinced that vertical integration (combining the production and processing of their milk) would help them gain control over their product and help with diversification. In 1998, the top dairy farmers formed Betsy’s Best Co-op. They pledged a specific volume of milk, at a set price, for the production of high quality cheese and other processed milk products. In weak markets, dairy farmers would have an outlet for their milk. In strong markets, farmers could make money on the guaranteed sale of their milk, as well as a profit on the finished product.

The co-op hired Sam Lund to get the effort operational, and in 2002, Betsy’s Best opened a $35 million production facility. The operation was located on two rail lines and had decent highway access for distribution. The co-op bought state-of-the-art processing equipment from the manufacturer and arranged with the company to get the equipment in place and running. The co-op produced a variety of dairy products for retail grocery stores, and packaged it under customers’ store labels.

The co-op did not expect the plant to make a profit for three years due to high start-up costs. However, at the end of the second year, the plant had profits of $1.5 million. The operation provided 80 new and relatively high-paying jobs in the community, which helped to improve the local economy.

Case 102

Capital Budgeting

Directed

Betsy's Best


1

Cengage Learning

The company currently manufactures eight different types of premium cheese as well as six flavors of yogurt and five varieties of dip made from top grade milk. The sixteen-ounce packages of cheese carry a retail value of $5.00 but have a wholesale price of $3.25 delivered. Variable cost of production for each package is $1.90 per pound, including production, packaging, and shipping. Total fixed operating costs for the company are $2,300,000. After two years of production, the company ships most of the retail product to the central section of the United States.

With increased entertaining and a focus on designer foods, customers were excited about the new high quality cheese products, and the variety of options allowed the company to expand sales. Also, the co-op expanded the customer base to include resorts and restaurants. The phenomenal success of the company requires the machinery to operate 24 hours a day. Annual output has jumped to 17 million pounds and the plant currently is running at capacity.

Demand has been much stronger than expected, and the company is having trouble filling customer orders. Because of rapid inventory turnover in the retail grocery trade, customers require delivery within one week with a maximum allowance of 14 days. It generally takes two to three days lead-time for Betsy’s Best to change production to a different specialty cheese product, and an average of 3 days to ship the product to the customer. The eight varieties of specialty cheese products and rapid inventory turnover have resulted in high levels of non-production time required to switch between product types. Betsy’s Best has been experiencing difficulties satisfying existing customers on a timely basis. After shortage problems around the Winter holiday season, several of the large grocery store chains have indicated that they might switch suppliers or stop stocking the product if they cannot get a reliable shipment of goods.

Sam is concerned about the potential loss of customers and has suggested that Betsy’s Best purchase a second production machine for $37.5 million. The company has excess space that could be used for the new machinery in the existing facility. However, another company currently leases this space on a year-to-year basis and is generating annual rent of $240,000. The lease is expected to be renewed annually for the next 10 years. If the company purchases the new equipment, they will need $83,000 for shipping and $147,000 in expenses to install the new equipment and get it operational. Also, $7,500 initially will be needed for additional spare parts inventory to keep the equipment working. After the initial set up, no additional increase in net working capital is expected and inventory replacement will be considered with operating costs. The industrial equipment falls into the seven year MACRS, although its expected economic life is 10 years. At the end of its economic life, the machine’s salvage value is $3,135,000.

Local interest for the expansion is strong, and conversation with dairy farmers indicates that a large portion of the required money can be obtained by a second stock offering. The remainder can be obtained through a collateralized loan from the bank. This financing will allow the company to maintain their optimal capital structure of 70 percent equity and 30 percent debt. Sam has recently determined that the cost of equity is 15.56 percent and the before-tax cost of debt is 9.11 percent.

Market studies have discovered a large untapped demand for Betsy’s Best. Sam believes that the extra capacity generated by the new machine will increase cheese sales by 8 million pounds per year. The company expects fixed operating costs to increase by $700,000.

To guarantee a timely supply of product, one of the largest Chicago area customers approached Betsy’s Best about the possibility of renting a refrigerated warehouse. Because of recent delivery problems, the warehouse storage would enable Betsy’s Best to produce longer runs of each type of product and save some of the time currently required to change the machinery. The company expects that the longer runs will boost existing machinery production by 1.5 million pounds. The leased building will allow the company to reduce some of the stress resulting from product shortages. An excellent secured and climate-controlled building is available in the Chicago area, and can be leased for 10 years at the rate of $105,000 per year.


Betsy's Best: Capital Budgeting - Case 102, Directed2

The company currently manufactures eight different types of premium cheese as well as six flavors of yogurt and five varieties of dip made from top grade milk. The sixteen-ounce packages of cheese carry a retail value of $5.00 but have a wholesale price of $3.25 delivered. Variable cost of production for each package is $1.90 per pound, including production, packaging, and shipping. Total fixed operating costs for the company are $2,300,000. After two years of production, the company ships most of the retail product to the central section of the United States.

With increased entertaining and a focus on designer foods, customers were excited about the new high quality cheese products, and the variety of options allowed the company to expand sales. Also, the co-op expanded the customer base to include resorts and restaurants. The phenomenal success of the company requires the machinery to operate 24 hours a day. Annual output has jumped to 17 million pounds and the plant currently is running at capacity.

Demand has been much stronger than expected, and the company is having trouble filling customer orders. Because of rapid inventory turnover in the retail grocery trade, customers require delivery within one week with a maximum allowance of 14 days. It generally takes two to three days lead-time for Betsy’s Best to change production to a different specialty cheese product, and an average of 3 days to ship the product to the customer. The eight varieties of specialty cheese products and rapid inventory turnover have resulted in high levels of non-production time required to switch between product types. Betsy’s Best has been experiencing difficulties satisfying existing customers on a timely basis. After shortage problems around the Winter holiday season, several of the large grocery store chains have indicated that they might switch suppliers or stop stocking the product if they cannot get a reliable shipment of goods.

Sam is concerned about the potential loss of customers and has suggested that Betsy’s Best purchase a second production machine for $37.5 million. The company has excess space that could be used for the new machinery in the existing facility. However, another company currently leases this space on a year-to-year basis and is generating annual rent of $240,000. The lease is expected to be renewed annually for the next 10 years. If the company purchases the new equipment, they will need $83,000 for shipping and $147,000 in expenses to install the new equipment and get it operational. Also, $7,500 initially will be needed for additional spare parts inventory to keep the equipment working. After the initial set up, no additional increase in net working capital is expected and inventory replacement will be considered with operating costs. The industrial equipment falls into the seven year MACRS, although its expected economic life is 10 years. At the end of its economic life, the machine’s salvage value is $3,135,000.

Local interest for the expansion is strong, and conversation with dairy farmers indicates that a large portion of the required money can be obtained by a second stock offering. The remainder can be obtained through a collateralized loan from the bank. This financing will allow the company to maintain their optimal capital structure of 70 percent equity and 30 percent debt. Sam has recently determined that the cost of equity is 15.56 percent and the before-tax cost of debt is 9.11 percent.

Market studies have discovered a large untapped demand for Betsy’s Best. Sam believes that the extra capacity generated by the new machine will increase cheese sales by 8 million pounds per year. The company expects fixed operating costs to increase by $700,000.

To guarantee a timely supply of product, one of the largest Chicago area customers approached Betsy’s Best about the possibility of renting a refrigerated warehouse. Because of recent delivery problems, the warehouse storage would enable Betsy’s Best to produce longer runs of each type of product and save some of the time currently required to change the machinery. The company expects that the longer runs will boost existing machinery production by 1.5 million pounds. The leased building will allow the company to reduce some of the stress resulting from product shortages. An excellent secured and climate-controlled building is available in the Chicago area, and can be leased for 10 years at the rate of $105,000 per year.



Cengage Learning

Betsy’s Best faces another capital budgeting issue: replacing the packaging and labeling machine. The company currently packages each customer’s products under a store brand label. Although the current machine is adequate, it produces a large percentage of defective labels, which results in repackaging. In addition, the current machine is slow, and the industry has developed new processes with increased flexibility and speed. The company paid an industry consultant $84,000 to investigate the availability of new generation labeling machines and the feasibility of replacing the existing machine. This amount has been expensed on the company’s taxes. The two best labeling options include a three-year economic life machine and a five-year economic life machine. The three-year machine costs $500,000 and is expected to reduce operating costs by $200,000 each year. The company expects the salvage value at the end of its useful life to be $150,000. The longer-term machine costs $900,000 and is expected to reduce operating cost by $250,000 each year over its five-year life. The company expects its salvage value at the end of the project's useful life to be $260,000. Through a special tax designation, both options fall under the 3-year MACRS recovery period.

Sam realizes that appropriately addressing the production and shipment issues of the company is critical to the successful operation of the company. A special shareholders’ meeting has been called to discuss possible solutions to the crisis. The agenda calls for making decisions concerning the addition of new production equipment, the replacement of the packaging and labeling machine, and entering into a leasing contract for the warehouse. Sam is responsible for explaining the issues, presenting the facts, and justifying his recommendations. Since his expertise lies in production and not finance, he has hired you as a consultant to help prepare for the meeting.

Sam knows that the degree of financial knowledge of the meeting participants varies widely. Therefore, he wants the information to include the intuition behind the numbers used in the decision making. Specifically, he would like a detailed discussion of the pertinent cash flows for each decision. He wants you to compute and explain the project’s payback, net present value, internal rate of return, and acceptability. The company is in a 35 percent tax bracket and requires a 5-year payback on all new projects. Although most companies use the IRR for capital budgeting, he has learned about problems with this method and has asked you to include the modified internal rate of return method in your presentation. Sam is also concerned about the different lives of the three- and five-year labeling machines and wants you to make sure that the comparisons are valid.

Although inflation has been relatively flat for the last few years, there is some concern that it would increase and affect costs and wholesale prices. To ensure the report is thorough, Sam asks that your discussion of the new equipment include the possible effects of inflation. Sam notes that the discount rate is based on quoted, or nominal, market-determined component costs of capital, while both the sales price and the operating cost per unit are in current dollar terms. He would like to know how that affects the decision. He also wonders whether it would be appropriate to assume neutral inflation equal to the four-percent general rate of inflation. If not, he wants to know how sensitive the results would be to alternate assumptions of differential inflation impacts on revenues and costs.

Finally, although production from the proposed new machinery will be limited to existing cheese products, some of the dairy farmers are interested in expanding the product offering. They want to know how the purchase of an additional machine for developing alternative cheese products would impacts their expansion decision for the new equipment. Specifically, they would like to know how the competition of an alternative product could affect their current cheese product revenues. Since the issue will probably be raised, Sam asks you to briefly discuss the impact of this new product on the capital budgeting expansion decision.

Your task is to help Sam perform the analysis and write up a report for the shareholders meeting. To help structure your analysis and report, he has provided you with the following questions. (Hint: With the spreadsheet model, quantified answers to the sensitivity of the inflation analysis should be developed where appropriate. If you are not using the spreadsheet model, think about the sensitivity analysis and indicate the direction in which a change would occur.)


Betsy's Best: Capital Budgeting - Case 102, Directed 3

Betsy’s Best faces another capital budgeting issue: replacing the packaging and labeling machine. The company currently packages each customer’s products under a store brand label. Although the current machine is adequate, it produces a large percentage of defective labels, which results in repackaging. In addition, the current machine is slow, and the industry has developed new processes with increased flexibility and speed. The company paid an industry consultant $84,000 to investigate the availability of new generation labeling machines and the feasibility of replacing the existing machine. This amount has been expensed on the company’s taxes. The two best labeling options include a three-year economic life machine and a five-year economic life machine. The three-year machine costs $500,000 and is expected to reduce operating costs by $200,000 each year. The company expects the salvage value at the end of its useful life to be $150,000. The longer-term machine costs $900,000 and is expected to reduce operating cost by $250,000 each year over its five-year life. The company expects its salvage value at the end of the project's useful life to be $260,000. Through a special tax designation, both options fall under the 3-year MACRS recovery period.

Sam realizes that appropriately addressing the production and shipment issues of the company is critical to the successful operation of the company. A special shareholders’ meeting has been called to discuss possible solutions to the crisis. The agenda calls for making decisions concerning the addition of new production equipment, the replacement of the packaging and labeling machine, and entering into a leasing contract for the warehouse. Sam is responsible for explaining the issues, presenting the facts, and justifying his recommendations. Since his expertise lies in production and not finance, he has hired you as a consultant to help prepare for the meeting.

Sam knows that the degree of financial knowledge of the meeting participants varies widely. Therefore, he wants the information to include the intuition behind the numbers used in the decision making. Specifically, he would like a detailed discussion of the pertinent cash flows for each decision. He wants you to compute and explain the project’s payback, net present value, internal rate of return, and acceptability. The company is in a 35 percent tax bracket and requires a 5-year payback on all new projects. Although most companies use the IRR for capital budgeting, he has learned about problems with this method and has asked you to include the modified internal rate of return method in your presentation. Sam is also concerned about the different lives of the three- and five-year labeling machines and wants you to make sure that the comparisons are valid.

Although inflation has been relatively flat for the last few years, there is some concern that it would increase and affect costs and wholesale prices. To ensure the report is thorough, Sam asks that your discussion of the new equipment include the possible effects of inflation. Sam notes that the discount rate is based on quoted, or nominal, market-determined component costs of capital, while both the sales price and the operating cost per unit are in current dollar terms. He would like to know how that affects the decision. He also wonders whether it would be appropriate to assume neutral inflation equal to the four-percent general rate of inflation. If not, he wants to know how sensitive the results would be to alternate assumptions of differential inflation impacts on revenues and costs.

Finally, although production from the proposed new machinery will be limited to existing cheese products, some of the dairy farmers are interested in expanding the product offering. They want to know how the purchase of an additional machine for developing alternative cheese products would impacts their expansion decision for the new equipment. Specifically, they would like to know how the competition of an alternative product could affect their current cheese product revenues. Since the issue will probably be raised, Sam asks you to briefly discuss the impact of this new product on the capital budgeting expansion decision.

Your task is to help Sam perform the analysis and write up a report for the shareholders meeting. To help structure your analysis and report, he has provided you with the following questions. (Hint: With the spreadsheet model, quantified answers to the sensitivity of the inflation analysis should be developed where appropriate. If you are not using the spreadsheet model, think about the sensitivity analysis and indicate the direction in which a change would occur.)



Cengage Learning

QUESTIONS

1. Define the term “incremental cash flow.” Since the company will finance the project in part by debt, should the cash flow statement include interest expenses? Explain.

Questions 2 through 11 relate to the initial decision of adding the second cheese production machine.

2. What is Betsy’s Best Year 0 net investment outlay for the new equipment expansion project? (Hint: Use Table 1 as a guide.)

3. If the company decides to expand with the additional production machine, is the existing space that Betsy’s Best in the production facility “free” or “costless”? Explain how the rent the company currently receives for space in the facility should be included in the analysis.

4. The addition of competing product lines with a lower grade cheese has been raised.

a. What additional concerns about the premium cheese expansion must be considered if the company decides to introduce a competitive product to its existing offerings? How would Betsy’s Best’s decision to purchase the new expansion machine be affected?

b. If the company believed that if they did not introduce the alternative product then a competing firm would develop a similar product, how would Betsy’s Best decision to purchase the new expansion machine be affected?

5. What are the expected non-operating cash flows when the company terminates the project at Year 10?

6. Estimate the project’s net cash flows for each year of the project’s economic life. (Hint: Use Table 2 as a guide.)

7. What discount rate should be used as the company’s cost of capital?

8. Compute the project’s NPV, IRR, modified IRR (MIRR), and payback, and explain the rationale behind each of these capital budgeting models.

9. Based on each model, explain why the project should or should not be undertaken. Are conflicting decisions possible with the various capital budgeting models?

10. A market-determined nominal cost of capital as the discount rate includes an inflation premium. However, the sales price and operating cost per unit were assumed to remain constant throughout the project’s life. This raises the following questions:



QUESTIONS

1. Define the term “incremental cash flow.” Since the company will finance the project in part by debt, should the cash flow statement include interest expenses? Explain.

Questions 2 through 11 relate to the initial decision of adding the second cheese production machine.

2. What is Betsy’s Best Year 0 net investment outlay for the new equipment expansion project? (Hint: Use Table 1 as a guide.)

3. If the company decides to expand with the additional production machine, is the existing space that Betsy’s Best in the production facility “free” or “costless”? Explain how the rent the company currently receives for space in the facility should be included in the analysis.

4. The addition of competing product lines with a lower grade cheese has been raised.

a. What additional concerns about the premium cheese expansion must be considered if the company decides to introduce a competitive product to its existing offerings? How would Betsy’s Best’s decision to purchase the new expansion machine be affected?

b. If the company believed that if they did not introduce the alternative product then a competing firm would develop a similar product, how would Betsy’s Best decision to purchase the new expansion machine be affected?

5. What are the expected non-operating cash flows when the company terminates the project at Year 10?

6. Estimate the project’s net cash flows for each year of the project’s economic life. (Hint: Use Table 2 as a guide.)

7. What discount rate should be used as the company’s cost of capital?

8. Compute the project’s NPV, IRR, modified IRR (MIRR), and payback, and explain the rationale behind each of these capital budgeting models.

9. Based on each model, explain why the project should or should not be undertaken. Are conflicting decisions possible with the various capital budgeting models?

10. A market-determined nominal cost of capital as the discount rate includes an inflation premium. However, the sales price and operating cost per unit were assumed to remain constant throughout the project’s life. This raises the following questions:



Cengage Learning

a. What are the problems with an analysis in which the discount rate is in nominal terms but the cash flows are measured in current dollar terms, unadjusted for inflation?

b. If cash flows are to be adjusted for inflation, is it appropriate to assume that inflation is neutral, i.e., that inflation has the same impact on all elements of the cash flow stream?

11. Answer this question quantitatively only if you are using the spreadsheet model. Consider the effects of inflation on sales price and variable operating costs with inflation beginning after Year 0. For simplicity, assume that no other cash flows (net opportunity costs, salvage value, or net working capital) are affected by inflation. Find the project’s NPV, IRR, MIRR, and payback with inflation taken into account. (Hint: The Year 1 cash flows, as well as succeeding years’ cash flows, must be adjusted for inflation because the original estimates were in Year 0 dollars.) a. What impact would a 4-percent inflation rate on price (beginning after Year 0)

and a 2-percent annual increase in cash operating costs have on the analysis? This situation may occur if more than half of the costs may be fixed by long-term contracts.

b. How would the project’s NPV change if sales price and operating cash costs-per-unit increased at the same rate, 4 percent per year?

c. How would the project’s NPV change if sales price increase by only 2 percent, but costs increase by 4 percent per year?

12. Determine the incremental cash flows associated with leasing the warehouse in Chicago. Based on the after-tax cash flows, determine the advisability of this option. Discuss some of the other factors that should be considered in this decision.

Questions 13 through 15 relate to the packaging/labeling machine.

13. Should the money spent on investigating the new technology be included in the packaging and labeling machine analysis? Explain.

14. Calculate each project’s single-cycle NPV. Based on these values, which project would be undertaken?

15. After adjusting for the life of the projects using the EAA and replacement chain approach, which recommendation should be made to the Co-op? Briefly, justify your decision.



a. What are the problems with an analysis in which the discount rate is in nominal terms but the cash flows are measured in current dollar terms, unadjusted for inflation?

b. If cash flows are to be adjusted for inflation, is it appropriate to assume that inflation is neutral, i.e., that inflation has the same impact on all elements of the cash flow stream?

11. Answer this question quantitatively only if you are using the spreadsheet model. Consider the effects of inflation on sales price and variable operating costs with inflation beginning after Year 0. For simplicity, assume that no other cash flows (net opportunity costs, salvage value, or net working capital) are affected by inflation. Find the project’s NPV, IRR, MIRR, and payback with inflation taken into account. (Hint: The Year 1 cash flows, as well as succeeding years’ cash flows, must be adjusted for inflation because the original estimates were in Year 0 dollars.) a. What impact would a 4-percent inflation rate on price (beginning after Year 0)

and a 2-percent annual increase in cash operating costs have on the analysis? This situation may occur if more than half of the costs may be fixed by long-term contracts.

b. How would the project’s NPV change if sales price and operating cash costs-per-unit increased at the same rate, 4 percent per year?

c. How would the project’s NPV change if sales price increase by only 2 percent, but costs increase by 4 percent per year?

12. Determine the incremental cash flows associated with leasing the warehouse in Chicago. Based on the after-tax cash flows, determine the advisability of this option. Discuss some of the other factors that should be considered in this decision.

Questions 13 through 15 relate to the packaging/labeling machine.

13. Should the money spent on investigating the new technology be included in the packaging and labeling machine analysis? Explain.

14. Calculate each project’s single-cycle NPV. Based on these values, which project would be undertaken?

15. After adjusting for the life of the projects using the EAA and replacement chain approach, which recommendation should be made to the Co-op? Briefly, justify your decision.



Cengage Learning

Table 1 Expansion Machine’s Initial Investment and Depreciation

Net Investment Outlay: Depreciation Schedule: Basis: xxxxx Equipment cost xxxxx Freight xxxxx MACRS Dep. End of Year Installation xxxxx Year Factor Expense Book Value Change in NWC xxxxx 1 14% $5,282,200 $32,447,800 2 25 xxxxx xxxxx 3 17 xxxxx xxxxx 4 13 $4,904,900 11,696,300 5 9 $3,395,700 8,300,600 6 9 $3,395,700 4,904,900 7 9 $3,395,700 1,509,200 8 4 $1,509,200 0

Total 100.00% xxxxx



Table 1 Expansion Machine’s Initial Investment and Depreciation

Net Investment Outlay: Depreciation Schedule: Basis: xxxxx Equipment cost xxxxx Freight xxxxx MACRS Dep. End of Year Installation xxxxx Year Factor Expense Book Value Change in NWC xxxxx 1 14% $5,282,200 $32,447,800 2 25 xxxxx xxxxx 3 17 xxxxx xxxxx 4 13 $4,904,900 11,696,300 5 9 $3,395,700 8,300,600 6 9 $3,395,700 4,904,900 7 9 $3,395,700 1,509,200 8 4 $1,509,200 0

Total 100.00% xxxxx



Cengage Learning

Table 2 Expansion Machine Net Cash Flows

Cash Flows: Year Year Year Year Year Year 0 1 2 3 4 5

Initial Investment XXXXX Unit price XXXXX XXXXX $3.25 $3.25 $3.25 $3.25 Unit sales XXXXX 8,000,000 8,000,000 8,000,000 8,000,000 Revenues XXXXX $26,000,000 $26,000,000 $26,000,000 $26,000,000 Fixed operating costs XXXXX 700,000 700,000 700,000 700,000 Variable operating costs

XXXXX 15,200,000 15,200,000 15,200,000 15,200,000

Opportunity costs XXXXX 240,000 240,000 240,000 240,000 Total costs XXXXX $16,140,000 $16,140,000 $16,140,000 $16,140,000 Depreciation XXXXX 9,432,500 6,414,100 4,904,900 3,395,700 Before tax income XXXXX $427,500 $3,445,900 $4,955,100 $6,464,300 Taxes XXXXX 149,625 1,206,065 1,734,285 2,262,505 Net income XXXXX $277,875 $2,239,835 $3,220,815 $4,201,795 Plus depreciation XXXXX 9,432,500 6,414,100 4,904,900 3,395,700 Net op cash flow XXXXX $9,710,375 $8,653,935 $8,125,715 $7,597,495

Salvage value SV tax Recovery of NWC

Termination CF

Project NCF XXXXX XXXXX $9,710,375 $8,653,935 $8,125,715 $7,597,495



Table 2 Expansion Machine Net Cash Flows

Cash Flows: Year Year Year Year Year Year 0 1 2 3 4 5

Initial Investment XXXXX Unit price XXXXX XXXXX $3.25 $3.25 $3.25 $3.25 Unit sales XXXXX 8,000,000 8,000,000 8,000,000 8,000,000 Revenues XXXXX $26,000,000 $26,000,000 $26,000,000 $26,000,000 Fixed operating costs XXXXX 700,000 700,000 700,000 700,000 Variable operating costs

XXXXX 15,200,000 15,200,000 15,200,000 15,200,000

Opportunity costs XXXXX 240,000 240,000 240,000 240,000 Total costs XXXXX $16,140,000 $16,140,000 $16,140,000 $16,140,000 Depreciation XXXXX 9,432,500 6,414,100 4,904,900 3,395,700 Before tax income XXXXX $427,500 $3,445,900 $4,955,100 $6,464,300 Taxes XXXXX 149,625 1,206,065 1,734,285 2,262,505 Net income XXXXX $277,875 $2,239,835 $3,220,815 $4,201,795 Plus depreciation XXXXX 9,432,500 6,414,100 4,904,900 3,395,700 Net op cash flow XXXXX $9,710,375 $8,653,935 $8,125,715 $7,597,495

Salvage value SV tax Recovery of NWC

Termination CF

Project NCF XXXXX XXXXX $9,710,375 $8,653,935 $8,125,715 $7,597,495



Cengage Learning

Table 2 (Continued)

Expansion Machine Net Cash Flows

Cash Flows: Year Year Year Year Year 6 7 8 9 10

Initial Investment Unit price $3.25 $3.25 $3.25 $3.25 XXXXX Unit sales 8,000,000 8,000,000 8,000,000 8,000,000 XXXXX Revenues $26,000,000 $26,000,000 $26,000,000 $26,000,000 XXXXX Fixed operating costs 700,000 700,000 700,000 700,000 XXXXX Variable operating costs 15,200,000 15,200,000 15,200,000 15,200,000 XXXXX Opportunity costs 240,000 240,000 240,000 240,000 XXXXX Total costs $16,140,000 $16,140,000 $16,140,000 $16,140,000 XXXXX Depreciation 3,395,700 3,395,700 1,509,200 0 XXXXX Before tax income $6,464,300 $6,464,300 $8,350,800 $9,860,000 XXXXX Taxes 2,262,505 2,262,505 2,922,780 3,451,000 XXXXX Net income $4,201,795 $4,201,795 $5,428,020 $6,409,000 XXXXX Plus depreciation 3,395,700 3,395,700 1,509,200 0 XXXXX Net op cash flow $7,597,495 $7,597,495 $6,937,220 $6,409,000 XXXXX

Salvage value XXXXX SV tax XXXXX Recovery of NWC XXXXX

Termination CF XXXXX

Project NCF $7,597,495 $7,597,495 $6,937,220 $6,409,000 XXXXX



Table 2 (Continued)

Expansion Machine Net Cash Flows

Cash Flows: Year Year Year Year Year 6 7 8 9 10

Initial Investment Unit price $3.25 $3.25 $3.25 $3.25 XXXXX Unit sales 8,000,000 8,000,000 8,000,000 8,000,000 XXXXX Revenues $26,000,000 $26,000,000 $26,000,000 $26,000,000 XXXXX Fixed operating costs 700,000 700,000 700,000 700,000 XXXXX Variable operating costs 15,200,000 15,200,000 15,200,000 15,200,000 XXXXX Opportunity costs 240,000 240,000 240,000 240,000 XXXXX Total costs $16,140,000 $16,140,000 $16,140,000 $16,140,000 XXXXX Depreciation 3,395,700 3,395,700 1,509,200 0 XXXXX Before tax income $6,464,300 $6,464,300 $8,350,800 $9,860,000 XXXXX Taxes 2,262,505 2,262,505 2,922,780 3,451,000 XXXXX Net income $4,201,795 $4,201,795 $5,428,020 $6,409,000 XXXXX Plus depreciation 3,395,700 3,395,700 1,509,200 0 XXXXX Net op cash flow $7,597,495 $7,597,495 $6,937,220 $6,409,000 XXXXX

Salvage value XXXXX SV tax XXXXX Recovery of NWC XXXXX

Termination CF XXXXX

Project NCF $7,597,495 $7,597,495 $6,937,220 $6,409,000 XXXXX



Cengage Learning

Cranfield, Inc., is a leading producer of fresh, frozen, and made-from-concentrate cranberry drinks.The firm was founded in 1949 by Charles Ahab, an Air Force veteran who returned to Nantucket andwent into business after World War II. The Ahabs were long-time residents of Nantucket, and theyowned several cranberry bogs. When Ahab returned to the island, the family business consistedprimarily of harvesting and selling cranberries to wholesalers for distribution to grocery stores. Thebusiness and its cash flows were necessarily seasonal. Based on his conviction that there was a grow-ing market for cranberry juices and cocktails, Ahab decided to expand the scope of the business.Accordingly, he joined several other growers to form Cranfield, Inc., which processes its own juices.The company purchases concentrates of apple, orange, cherry, and raspberry juices, and it marketsa whole range of cranberry cocktails. With its skilled marketing and strong emphasis on productquality, the company has prospered. Today its brands are sold throughout the United States, withcranapple cocktail being its most successful product.

Cranfield’s management is currently evaluating a new product, lite cranapple cocktail. A testmarketing program carried out in 1995 at a cost of $150,000 showed enthusiastic acceptance forthe product, which would cost more than regular cranapple but offer 30 percent fewer calories. MariaLopez and Robert Walker, recent business school graduates now working at the firm as financial ana-lysts, must analyze this project and then present their findings to the company’s executive commit-tee. Assume that you work for a consulting company that Cranfield uses to help with decisionssuch as this, and you have been assigned to work with Maria and Robert on the analysis.

Production facilities for the lite cranberry product would be set up in an unused section ofCranfield’s main plant. Relatively inexpensive used machinery with an estimated cost of only$400,000 would be purchased, but shipping costs to move the machinery to Cranfield’s plant wouldadd another $20,000, and installation charges would amount to another $40,000. Further, Cranfield’sinventories (raw materials, work-in-process, and finished goods) would have to be increased by$15,000 at the time of the initial investment. If the used machinery is purchased, it would have aremaining economic life of 4 years, and the company has obtained a special tax ruling that wouldallow it to depreciate the equipment under the MACRS 3-year class. The depreciation allowances are0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively. The machinery is expected to have asalvage value of $50,000 after 4 years of use.

Copyright © 1994. The Dryden Press. All rights reserved.

Case 44

Cranfi eld, Inc. (A)

Capital Budgeting

Directed


2

Cranfield, Inc., is a leading producer of fresh, frozen, and made-from-concentrate cranberry drinks.The firm was founded in 1949 by Charles Ahab, an Air Force veteran who returned to Nantucket andwent into business after World War II. The Ahabs were long-time residents of Nantucket, and theyowned several cranberry bogs. When Ahab returned to the island, the family business consistedprimarily of harvesting and selling cranberries to wholesalers for distribution to grocery stores. Thebusiness and its cash flows were necessarily seasonal. Based on his conviction that there was a grow-ing market for cranberry juices and cocktails, Ahab decided to expand the scope of the business.Accordingly, he joined several other growers to form Cranfield, Inc., which processes its own juices.The company purchases concentrates of apple, orange, cherry, and raspberry juices, and it marketsa whole range of cranberry cocktails. With its skilled marketing and strong emphasis on productquality, the company has prospered. Today its brands are sold throughout the United States, withcranapple cocktail being its most successful product.

Cranfield’s management is currently evaluating a new product, lite cranapple cocktail. A testmarketing program carried out in 1995 at a cost of $150,000 showed enthusiastic acceptance forthe product, which would cost more than regular cranapple but offer 30 percent fewer calories. MariaLopez and Robert Walker, recent business school graduates now working at the firm as financial ana-lysts, must analyze this project and then present their findings to the company’s executive commit-tee. Assume that you work for a consulting company that Cranfield uses to help with decisionssuch as this, and you have been assigned to work with Maria and Robert on the analysis.

Production facilities for the lite cranberry product would be set up in an unused section ofCranfield’s main plant. Relatively inexpensive used machinery with an estimated cost of only$400,000 would be purchased, but shipping costs to move the machinery to Cranfield’s plant wouldadd another $20,000, and installation charges would amount to another $40,000. Further, Cranfield’sinventories (raw materials, work-in-process, and finished goods) would have to be increased by$15,000 at the time of the initial investment. If the used machinery is purchased, it would have aremaining economic life of 4 years, and the company has obtained a special tax ruling that wouldallow it to depreciate the equipment under the MACRS 3-year class. The depreciation allowances are0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively. The machinery is expected to have asalvage value of $50,000 after 4 years of use.


Case 44

Cranfi eld, Inc. (A)

Capital Budgeting

Directed


2

Cengage Learning

Cranfield’s management expects to sell 400,000 16-ounce cartons of the new lite product ineach of the next 4 years. The price is expected to be $2.00 per carton. Fixed costs are estimated tobe $100,000, and variable cash operating costs are estimated at $1.25 per unit. Note that operatingcosts are a function of the number of units sold rather than unit price, so unit price changes have nodirect effect on operating costs.

In examining the sales figures, Maria Lopez noted a short memo from Cranfield’s sales man-ager which expressed concern that the lite cocktail project would cut into the firm’s sales of theregular cocktail-this type of effect is called cannibalization. Specifically, the sales manager estimatedthat regular cranapple sales would fall by 5 percent if lite cocktail were introduced. Maria pursuedthis further with both the sales and production managers, and they estimated that the new projectwould probably lower the firm’s regular cranapple sales by $40,000 per year. However, this vol-ume reduction would also reduce regular cranapple production costs by $20,000 per year on a pre-tax basis, so the net pretax cannibalization effect would be ($40,000) + $20,000 = ($20,000).

Cranfield’s federal-plus-state tax rate is 40 percent, and its overall cost of capital is 10 percent,calculated as follows:

WACC = wd kd (1 - T) + wsks = 0.5(10%) (0.6) + 0.5(14%) = 10.0%.

As they began to look into the situation, Maria and Robert learned that the Nantucket Cran-berry Association has expressed an interest in leasing the space that would be used to produce litecranapple juice. The terms of the lease, if it were made, would call for Cranfield to receive rentalpayments of $25,000 at the end of each year, and, at the association’s insistence, the lease wouldhave to run for 20 years. However, it is not at all certain that the association will ultimately agreeto rent the space. Yet another consideration is the possibility that Cranfield could itself rent spacein the local Coca-Cola bottling facilities during the off-season. In that event, almost no capital wouldhave to be invested in the project, but rental payments would have to be made to the Coke bottler.Finally, Maria and Robert are aware of a concern the production VP has raised, namely, thatalthough the space is not being used now, it will be needed for other products within the next 2 or 3years, assuming normal growth in sales of those products.

Your task is to work with Maria and Robert to analyze the situation. You must recommendacceptance or rejection, and evaluate the project’s acceptability using the NPV, IRR, modified IRR(MIRR), and payback criteria. For the initial analysis, assume that the lite project is of averagerisk, so the 10 percent WACC is the appropriate discount/hurdle rate. Maria and Robert are also con-cerned about the proper estimation of the relevant cash flows associated with the project. For exam-ple, should the test marketing costs be charged to the project? How should the cannibalizationeffect be handled under different assumptions of expected competitor actions? How about theCranberry Association’s interest in leasing the space that would be used for lite juice production, andthe other divisions’ plant needs 2 or 3 years hence? Maria also noted that the 10 percent discount rateis based on quoted, nominal, market-determined costs of capital, while both the sales price and theoperating cost per unit are in current dollar terms; does that present a problem? Maria and Robertwondered whether it would be appropriate to assume neutral inflation equal to the 5 percent gen-eral rate of inflation, and, if not, how sensitive the results would be to alternative assumptions of dif-ferential inflation impacts on revenues and costs. Also, if the Coke plant is really available, howshould this factor be taken into account?

Maria and Robert expect these and other questions to be raised when they present their rec-ommendation to the executive committee. Your task is to help them perform the analysis and writea report for the executive committee. To help structure your analysis and report, answer the follow-ing questions. (Hint: If you are not using the spreadsheet model, it would be very time-consuming toquantify your answers to some of the questions. Therefore, in some instances, it would be appro-priate to simply think about the situation and indicate the direction in which a change would occur.With the model, quantified answers can be developed for most of the questions.)


Cranfield, Inc. (A): Capital Budgeting - Case 44, Directed10

Cranfield’s management expects to sell 400,000 16-ounce cartons of the new lite product ineach of the next 4 years. The price is expected to be $2.00 per carton. Fixed costs are estimated tobe $100,000, and variable cash operating costs are estimated at $1.25 per unit. Note that operatingcosts are a function of the number of units sold rather than unit price, so unit price changes have nodirect effect on operating costs.

In examining the sales figures, Maria Lopez noted a short memo from Cranfield’s sales man-ager which expressed concern that the lite cocktail project would cut into the firm’s sales of theregular cocktail-this type of effect is called cannibalization. Specifically, the sales manager estimatedthat regular cranapple sales would fall by 5 percent if lite cocktail were introduced. Maria pursuedthis further with both the sales and production managers, and they estimated that the new projectwould probably lower the firm’s regular cranapple sales by $40,000 per year. However, this vol-ume reduction would also reduce regular cranapple production costs by $20,000 per year on a pre-tax basis, so the net pretax cannibalization effect would be ($40,000) + $20,000 = ($20,000).

Cranfield’s federal-plus-state tax rate is 40 percent, and its overall cost of capital is 10 percent,calculated as follows:

WACC = wd kd (1 - T) + wsks = 0.5(10%) (0.6) + 0.5(14%) = 10.0%.

As they began to look into the situation, Maria and Robert learned that the Nantucket Cran-berry Association has expressed an interest in leasing the space that would be used to produce litecranapple juice. The terms of the lease, if it were made, would call for Cranfield to receive rentalpayments of $25,000 at the end of each year, and, at the association’s insistence, the lease wouldhave to run for 20 years. However, it is not at all certain that the association will ultimately agreeto rent the space. Yet another consideration is the possibility that Cranfield could itself rent spacein the local Coca-Cola bottling facilities during the off-season. In that event, almost no capital wouldhave to be invested in the project, but rental payments would have to be made to the Coke bottler.Finally, Maria and Robert are aware of a concern the production VP has raised, namely, thatalthough the space is not being used now, it will be needed for other products within the next 2 or 3years, assuming normal growth in sales of those products.

Your task is to work with Maria and Robert to analyze the situation. You must recommendacceptance or rejection, and evaluate the project’s acceptability using the NPV, IRR, modified IRR(MIRR), and payback criteria. For the initial analysis, assume that the lite project is of averagerisk, so the 10 percent WACC is the appropriate discount/hurdle rate. Maria and Robert are also con-cerned about the proper estimation of the relevant cash flows associated with the project. For exam-ple, should the test marketing costs be charged to the project? How should the cannibalizationeffect be handled under different assumptions of expected competitor actions? How about theCranberry Association’s interest in leasing the space that would be used for lite juice production, andthe other divisions’ plant needs 2 or 3 years hence? Maria also noted that the 10 percent discount rateis based on quoted, nominal, market-determined costs of capital, while both the sales price and theoperating cost per unit are in current dollar terms; does that present a problem? Maria and Robertwondered whether it would be appropriate to assume neutral inflation equal to the 5 percent gen-eral rate of inflation, and, if not, how sensitive the results would be to alternative assumptions of dif-ferential inflation impacts on revenues and costs. Also, if the Coke plant is really available, howshould this factor be taken into account?

Maria and Robert expect these and other questions to be raised when they present their rec-ommendation to the executive committee. Your task is to help them perform the analysis and writea report for the executive committee. To help structure your analysis and report, answer the follow-ing questions. (Hint: If you are not using the spreadsheet model, it would be very time-consuming toquantify your answers to some of the questions. Therefore, in some instances, it would be appro-priate to simply think about the situation and indicate the direction in which a change would occur.With the model, quantified answers can be developed for most of the questions.)



Cengage Learning

QUESTIONS

1. Define the term incremental cash flow. Since the project will be financed in part by debt,should the cash flow statement include interest expenses? Explain.

2. Should the $150,000 test marketing cost be included in the analysis? Explain.

3. Suppose the Cranberry Association actually made a firm offer to lease the lite juice produc-tion site for $25,000 a year for 20 years. How should that information be incorporated intothe analysis?

4. If Cranfield does not have an opportunity to lease the space, does this mean that the space is“free” or costless, from the standpoint of the lite product project?

5. Should the erosion of profits from regular cranapple sales be charged to the lite cranappleproject? What if management believed that, if Cranfield did not introduce the lite product, acompeting firm very likely would, so regular cranapple sales would be adversely affectedregardless of whether the project in question is accepted?

6. What is Cranfield’s Year 0 net investment outlay on this project? What is the expected non-operating cash flow when the project is terminated at Year 4? (Hint: Use Table 1 as a guide.)

7. Estimate the product’s operating cash flows inclusive of cannibalization effects. (Hint:Again, use Table l as a guide.) What are the project’s NPV, IRR, modified IRR (MIRR), andpayback? Should the project be undertaken? [Remember: The MIRR is found in three steps:(1) compound all cash inflows out to the terminal year at the cost of capital, (2) sum thecompounded cash inflows to obtain the terminal value of the inflows, and (3) find the dis-count rate that forces the present value of the terminal value to equal the present value of thenet investment outlays. This discount rate is defined as the MIRR.]

8. At this point in the analysis Maria drew Robert’s attention to the fact that, whereas theywere using the market-determined nominal cost of capital as the discount rate, the sales priceand operating cost per unit were assumed to remain constant throughout the project’s life.This raised the following questions:

a. What are the problems with such an analysis in which the discount rate is in nominalterms but the cash flows are measured in current dollar terms, unadjusted for inflation?

b. If cash flows are to be adjusted for inflation, is it appropriate to assume that inflation isneutral—that is, that inflation has the same impact on all elements of the cash flowstream?

9. Now assume that the sales price will increase by the 5 percent inflation rate beginning afterYear 0. However, cash operating costs will increase by only 2 percent annually from the ini-tial cost estimate, because over half the costs are either depreciation or are fixed by long-term contracts. For simplicity, assume that no other cash flows (net cannibalization costs,salvage value, or net working capital) are affected by inflation. Find the project’s NPV, IRR,MIRR, and payback with inflation taken into account. (Hint: The Year 1 cash flows as wellas succeeding years’ cash flows must be adjusted for inflation because the original estimateswere in Year 0 dollars.)


Cranfield, Inc. (A): Capital Budgeting - Case 44, Directed 11

QUESTIONS

1. Define the term incremental cash flow. Since the project will be financed in part by debt,should the cash flow statement include interest expenses? Explain.

2. Should the $150,000 test marketing cost be included in the analysis? Explain.

3. Suppose the Cranberry Association actually made a firm offer to lease the lite juice produc-tion site for $25,000 a year for 20 years. How should that information be incorporated intothe analysis?

4. If Cranfield does not have an opportunity to lease the space, does this mean that the space is“free” or costless, from the standpoint of the lite product project?

5. Should the erosion of profits from regular cranapple sales be charged to the lite cranappleproject? What if management believed that, if Cranfield did not introduce the lite product, acompeting firm very likely would, so regular cranapple sales would be adversely affectedregardless of whether the project in question is accepted?

6. What is Cranfield’s Year 0 net investment outlay on this project? What is the expected non-operating cash flow when the project is terminated at Year 4? (Hint: Use Table 1 as a guide.)

7. Estimate the product’s operating cash flows inclusive of cannibalization effects. (Hint:Again, use Table l as a guide.) What are the project’s NPV, IRR, modified IRR (MIRR), andpayback? Should the project be undertaken? [Remember: The MIRR is found in three steps:(1) compound all cash inflows out to the terminal year at the cost of capital, (2) sum thecompounded cash inflows to obtain the terminal value of the inflows, and (3) find the dis-count rate that forces the present value of the terminal value to equal the present value of thenet investment outlays. This discount rate is defined as the MIRR.]

8. At this point in the analysis Maria drew Robert’s attention to the fact that, whereas theywere using the market-determined nominal cost of capital as the discount rate, the sales priceand operating cost per unit were assumed to remain constant throughout the project’s life.This raised the following questions:

a. What are the problems with such an analysis in which the discount rate is in nominalterms but the cash flows are measured in current dollar terms, unadjusted for inflation?

b. If cash flows are to be adjusted for inflation, is it appropriate to assume that inflation isneutral—that is, that inflation has the same impact on all elements of the cash flowstream?

9. Now assume that the sales price will increase by the 5 percent inflation rate beginning afterYear 0. However, cash operating costs will increase by only 2 percent annually from the ini-tial cost estimate, because over half the costs are either depreciation or are fixed by long-term contracts. For simplicity, assume that no other cash flows (net cannibalization costs,salvage value, or net working capital) are affected by inflation. Find the project’s NPV, IRR,MIRR, and payback with inflation taken into account. (Hint: The Year 1 cash flows as wellas succeeding years’ cash flows must be adjusted for inflation because the original estimateswere in Year 0 dollars.)



Cengage Learning

10. How would the project’s NPV change if

a. sales prices and operating cash costs per unit increased at the same rate, 5 percent peryear?

b. sales prices rise by only 2 percent, but costs increase by 5 percent per year?

11. If you are using the model, return to the initial inflation assumptions (5 percent for price and2 percent for cash operating costs).

a. Assume that the estimate of unit sales remains at 400,000 units per year. To the closestpenny, what Year 0 unit price would the company have to set to cause the project to justbreak even—that is, to force NPV = $0?

b. Now assume that the sales price starts at $2, and that prices increase by 5 percent per yearthereafter while cash costs increase by 2 percent per year. To the closest 1,000, how lowcould annual unit sales be and still have the project break even?

12. What recommendation should Maria and Robert make to the executive committee? Shouldthey recommend that the project be accepted, rejected, or studied further? Justify youranswer.



10. How would the project’s NPV change if

a. sales prices and operating cash costs per unit increased at the same rate, 5 percent peryear?

b. sales prices rise by only 2 percent, but costs increase by 5 percent per year?

11. If you are using the model, return to the initial inflation assumptions (5 percent for price and2 percent for cash operating costs).

a. Assume that the estimate of unit sales remains at 400,000 units per year. To the closestpenny, what Year 0 unit price would the company have to set to cause the project to justbreak even—that is, to force NPV = $0?

b. Now assume that the sales price starts at $2, and that prices increase by 5 percent per yearthereafter while cash costs increase by 2 percent per year. To the closest 1,000, how lowcould annual unit sales be and still have the project break even?

12. What recommendation should Maria and Robert make to the executive committee? Shouldthey recommend that the project be accepted, rejected, or studied further? Justify youranswer.



Cengage Learning

TABLE 1

Model-Generated Data

Depreciation Schedule: Basis: $460,000MACRS Dep. End-of-Year

Net Investment Outlay: Year Factor Expense Book ValueEquipment cost 1 33% $151,800 $308,200Freight 2Installation 3 15% 69,000 32,200Change in NWC 4 7% 32,200 (0)

100% $460,000

Cash Flows:Year 0 Year 1 Year 2 Year 3 Year 4

Unit price $2.00 $ 2.00 $ 2.00 $ 2.00Unit sales 400,000 400,000 400,000Revenues $800,000 $800,000 $800,000Fixed operating costs 100,000 100,000 100,000Variable operating costs 500,000 500,000 500,000Total operating costs 600,000 600,000 600,000Depreciation 151,800 69,000 32,200Net cannibalization effects 20,000 20,000 20,000Before-tax income $ 28,200 $111,000 $147,800Taxes 11,280 44,400 59,120Net income $ 16,920 $ 66,600 $ 88,680Plus depreciation 151,800 69,000 32,200Net operating cash flow $168,720 $135,600 $120,880Salvage valueSV taxRecovery of NWCTermination CFProject NCF ($475,000) $168,720 $135,600

Decision Measures: Cumulative Cash Flows:NPV 0IRR 1TV 2MIRR 3Payback 4



TABLE 1

Model-Generated Data


Net Investment Outlay: Year Factor Expense Book ValueEquipment cost 1 33% $151,800 $308,200Freight 2Installation 3 15% 69,000 32,200Change in NWC 4 7% 32,200 (0)

100% $460,000


Unit price $2.00 $ 2.00 $ 2.00 $ 2.00Unit sales 400,000 400,000 400,000Revenues $800,000 $800,000 $800,000Fixed operating costs 100,000 100,000 100,000Variable operating costs 500,000 500,000 500,000Total operating costs 600,000 600,000 600,000Depreciation 151,800 69,000 32,200Net cannibalization effects 20,000 20,000 20,000Before-tax income $ 28,200 $111,000 $147,800Taxes 11,280 44,400 59,120Net income $ 16,920 $ 66,600 $ 88,680Plus depreciation 151,800 69,000 32,200Net operating cash flow $168,720 $135,600 $120,880Salvage valueSV taxRecovery of NWCTermination CFProject NCF ($475,000) $168,720 $135,600

Decision Measures: Cumulative Cash Flows:NPV 0IRR 1TV 2MIRR 3Payback 4



Cengage Learning





Cengage Learning

In Case 12A, Maria Lopez and Robert Walker analyzed a lite cranberry cocktail project for Cran-field, Inc. The project is expected to require an initial investment of $460,000 in fixed assets (includ-ing shipping and installation charges), plus a $15,000 addition to net working capital. The machinerywould be used for 4 years and be depreciated on the basis of a 3-year MACRS class life. The appro-priate MACRS depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respec-tively, and the machinery is expected to have a salvage value of $50,000. If the project is undertaken,the firm expects to sell 400,000 cartons of lite cranapple juice at a current dollar (Year 0) whole-sale price of $2 per carton. However, the sales price will be adjusted for inflation, which is expectedto average 5 percent annually, so the actual expected sales price at the end of the first year is $2.10,the expected price at the end of the second year is $2.205, and so on.

Because the two product lines are somewhat competitive, the lite cranapple project is expectedto cannibalize the before-tax profit Cranfield earns on its regular cranapple sales by $20,000. Fixedcosts (other than depreciation) associated with production of the lite product are expected to be$100,000 per year, and Year 0 variable costs per unit are estimated at $1.25. Variable costs per unitare expected to increase by 2 percent per year. Therefore, total cash operating costs during the firstyear of operation (Year 1) are expected to be $100,000 + ($1.25)(1.02)(400,000) = $610,000. Cran-field’s tax rate is 40 percent, and its cost of capital for an average project is 10 percent. Cash flowdata and other information, as developed by Maria and Robert using a spreadsheet model, are givenin Table 1.

When Maria and Robert presented their initial analysis to Cranfield’s executive committee,things went well, and they were congratulated on both their analysis and their presentation. How-ever, several questions were raised. In particular, the executive committee wanted to see more riskanalysis on the project—it appeared to be profitable, but what were the chances that it might never-theless turn out to be a loser, and how should risk be analyzed and worked into the decision process?As the meeting was winding down, Maria and Robert were asked to start with the base case situationthey had developed and then to discuss risk analysis, both in general terms and as it should be appliedto the lite cranapple project.

To begin, Maria and Robert met with the marketing and production managers to get a feelfor the uncertainties involved in the cash flow estimates. After several sessions, they concludedthat the greatest uncertainty regarded unit sales and salvage value. Cost and sales price estimates


Case 45

Cranfi eld, Inc. (B)

Capital Budgeting

Directed


3

In Case 12A, Maria Lopez and Robert Walker analyzed a lite cranberry cocktail project for Cran-field, Inc. The project is expected to require an initial investment of $460,000 in fixed assets (includ-ing shipping and installation charges), plus a $15,000 addition to net working capital. The machinerywould be used for 4 years and be depreciated on the basis of a 3-year MACRS class life. The appro-priate MACRS depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respec-tively, and the machinery is expected to have a salvage value of $50,000. If the project is undertaken,the firm expects to sell 400,000 cartons of lite cranapple juice at a current dollar (Year 0) whole-sale price of $2 per carton. However, the sales price will be adjusted for inflation, which is expectedto average 5 percent annually, so the actual expected sales price at the end of the first year is $2.10,the expected price at the end of the second year is $2.205, and so on.

Because the two product lines are somewhat competitive, the lite cranapple project is expectedto cannibalize the before-tax profit Cranfield earns on its regular cranapple sales by $20,000. Fixedcosts (other than depreciation) associated with production of the lite product are expected to be$100,000 per year, and Year 0 variable costs per unit are estimated at $1.25. Variable costs per unitare expected to increase by 2 percent per year. Therefore, total cash operating costs during the firstyear of operation (Year 1) are expected to be $100,000 + ($1.25)(1.02)(400,000) = $610,000. Cran-field’s tax rate is 40 percent, and its cost of capital for an average project is 10 percent. Cash flowdata and other information, as developed by Maria and Robert using a spreadsheet model, are givenin Table 1.

When Maria and Robert presented their initial analysis to Cranfield’s executive committee,things went well, and they were congratulated on both their analysis and their presentation. How-ever, several questions were raised. In particular, the executive committee wanted to see more riskanalysis on the project—it appeared to be profitable, but what were the chances that it might never-theless turn out to be a loser, and how should risk be analyzed and worked into the decision process?As the meeting was winding down, Maria and Robert were asked to start with the base case situationthey had developed and then to discuss risk analysis, both in general terms and as it should be appliedto the lite cranapple project.

To begin, Maria and Robert met with the marketing and production managers to get a feelfor the uncertainties involved in the cash flow estimates. After several sessions, they concludedthat the greatest uncertainty regarded unit sales and salvage value. Cost and sales price estimates


Case 45

Cranfi eld, Inc. (B)

Capital Budgeting

Directed


3

Cengage Learning

were fairly well defined, but unit sales could vary widely, and the realized salvage value could bequite different from the $50,000 estimate. The sales price is also uncertain. However, companies incompetitive markets typically set sales prices on the basis of competitors’ prices, so, at least initially,they decided to treat the sales price as being fairly certain. However, the supply of agriculturalproducts like cranberries can rise or fall sharply due to favorable or unfavorable growing conditions,and that can lead to large price swings in both variable costs and product sales prices.

As estimated by the marketing staff, if product acceptance is “normal,” then sales quantity dur-ing Year 1 would be 400,000 units; if acceptance is poor, then only 150,000 units would be sold(the price would be kept at the forecasted level); and if consumer response is strong, then the Year1 sales volume would be 650,000 units. In all cases, the price would probably increase at the infla-tion rate (currently estimated to be 5 percent), so Year 1 revenues stated in Year 1 dollars, as theywould appear on the cash flow statement, would be $840,000 under the expected conditions; theywould be only $315,000 if things went badly; and they would amount to $1,365,000 if things wentespecially well. Cash variable costs per unit would remain at $1.25 before adjusting for inflation,so total cash operating costs in Year 1 would be $610,000 under normal conditions, $291,250 inthe worst-case scenario, and $928,750 in the best-case scenario. These costs would probably increasein each successive year at a 2 percent rate.

The production manager believes that the equipment’s Year 4 salvage value could be as lowas zero and as high as $75,000, depending on the demand for such equipment after 4 years.

Maria and Robert also discussed the scenarios’ probabilities with the marketing staff. After con-siderable debate, they finally agreed on a “guesstimate” of 25 percent probability of poor accep-tance, 50 percent probability of average acceptance, and 25 percent probability of excellentacceptance. In addition, Cranfield’s executive committee requires that all sensitivity analyses considerchanges in at least the following three variables: sales quantity, salvage value, and the cost of capi-tal. Company policy also mandates that each of the variables be allowed to deviate from its expectedvalue by plus or minus 10 percent, 20 percent, and 30 percent in such an analysis.

Maria and Robert also discussed with Peter Brady, Cranfield’s director of capital budgeting,both the risk inherent in Cranfield’s average project and how the company typically adjusts forrisk. Based on historical data, most of Cranfield’s projects have had coefficients of variation of NPVin the range of 0.50 to 1.00, and Brady has been adding or subtracting 3 percentage points to the costof capital for projects whose CVs lie outside that range to adjust for differential project risk. Mariaand Robert wonder about whether the cash flows from the lite cranapple project would be posi-tively or negatively correlated with the sales of Cranfield’s other products and the S&P 500, and theyalso wondered how those correlations should be dealt with in the analysis.

The discussion with Brady raised another issue: Should the project’s cost of capital be basedon its stand-alone risk, on its risk as measured within the context of the firm’s portfolio of assets(within-firm, or corporate, risk), or in a market risk context? Cranfield’s target capital structurecalls for 50 percent debt and 50 percent common equity, and the before-tax marginal cost of debt iscurrently 10 percent. Maria and Robert also determined that the T-bond rate, which they use as therisk-free rate, is 8.3 percent, and that the market risk premium is 6 percent. In addition, they esti-mated that the market beta for the project would be about 1.8.

Since most members of Cranfield’s executive committee are unfamiliar with modern tech-niques of risk analysis, Maria and Robert decided to first discuss the types of risk that are normallyconsidered in capital budgeting, and then consider the strengths and weaknesses of risk analysis.Next, they plan to discuss a comprehensive risk analysis including sensitivity analysis (refer to Table2), scenario analysis (refer to Table 3), and an estimate of the project’s differential risk-adjusted prof-itability. Last, they plan to carry out or at least discuss Monte Carlo simulation, and then provide acomparison of the various risk-analysis techniques.


Cranfield, Inc. (B): Capital Budgeting - Case 45, Directed16

were fairly well defined, but unit sales could vary widely, and the realized salvage value could bequite different from the $50,000 estimate. The sales price is also uncertain. However, companies incompetitive markets typically set sales prices on the basis of competitors’ prices, so, at least initially,they decided to treat the sales price as being fairly certain. However, the supply of agriculturalproducts like cranberries can rise or fall sharply due to favorable or unfavorable growing conditions,and that can lead to large price swings in both variable costs and product sales prices.

As estimated by the marketing staff, if product acceptance is “normal,” then sales quantity dur-ing Year 1 would be 400,000 units; if acceptance is poor, then only 150,000 units would be sold(the price would be kept at the forecasted level); and if consumer response is strong, then the Year1 sales volume would be 650,000 units. In all cases, the price would probably increase at the infla-tion rate (currently estimated to be 5 percent), so Year 1 revenues stated in Year 1 dollars, as theywould appear on the cash flow statement, would be $840,000 under the expected conditions; theywould be only $315,000 if things went badly; and they would amount to $1,365,000 if things wentespecially well. Cash variable costs per unit would remain at $1.25 before adjusting for inflation,so total cash operating costs in Year 1 would be $610,000 under normal conditions, $291,250 inthe worst-case scenario, and $928,750 in the best-case scenario. These costs would probably increasein each successive year at a 2 percent rate.

The production manager believes that the equipment’s Year 4 salvage value could be as lowas zero and as high as $75,000, depending on the demand for such equipment after 4 years.

Maria and Robert also discussed the scenarios’ probabilities with the marketing staff. After con-siderable debate, they finally agreed on a “guesstimate” of 25 percent probability of poor accep-tance, 50 percent probability of average acceptance, and 25 percent probability of excellentacceptance. In addition, Cranfield’s executive committee requires that all sensitivity analyses considerchanges in at least the following three variables: sales quantity, salvage value, and the cost of capi-tal. Company policy also mandates that each of the variables be allowed to deviate from its expectedvalue by plus or minus 10 percent, 20 percent, and 30 percent in such an analysis.

Maria and Robert also discussed with Peter Brady, Cranfield’s director of capital budgeting,both the risk inherent in Cranfield’s average project and how the company typically adjusts forrisk. Based on historical data, most of Cranfield’s projects have had coefficients of variation of NPVin the range of 0.50 to 1.00, and Brady has been adding or subtracting 3 percentage points to the costof capital for projects whose CVs lie outside that range to adjust for differential project risk. Mariaand Robert wonder about whether the cash flows from the lite cranapple project would be posi-tively or negatively correlated with the sales of Cranfield’s other products and the S&P 500, and theyalso wondered how those correlations should be dealt with in the analysis.

The discussion with Brady raised another issue: Should the project’s cost of capital be basedon its stand-alone risk, on its risk as measured within the context of the firm’s portfolio of assets(within-firm, or corporate, risk), or in a market risk context? Cranfield’s target capital structurecalls for 50 percent debt and 50 percent common equity, and the before-tax marginal cost of debt iscurrently 10 percent. Maria and Robert also determined that the T-bond rate, which they use as therisk-free rate, is 8.3 percent, and that the market risk premium is 6 percent. In addition, they esti-mated that the market beta for the project would be about 1.8.

Since most members of Cranfield’s executive committee are unfamiliar with modern tech-niques of risk analysis, Maria and Robert decided to first discuss the types of risk that are normallyconsidered in capital budgeting, and then consider the strengths and weaknesses of risk analysis.Next, they plan to discuss a comprehensive risk analysis including sensitivity analysis (refer to Table2), scenario analysis (refer to Table 3), and an estimate of the project’s differential risk-adjusted prof-itability. Last, they plan to carry out or at least discuss Monte Carlo simulation, and then provide acomparison of the various risk-analysis techniques.



Cengage Learning

QUESTIONS

1. a. Why should firms be concerned with the riskiness of individual projects?b. (1) What are the three types of risk that are normally considered in capital budgeting?

(2) Which type of risk is most relevant?(3) Which type of risk is easiest to measure?(4) Would you normally expect the three types of risk to be highly correlated? Would

they be highly correlated in this specific instance?

2. a. What is sensitivity analysis?b. Complete the sensitivity tables in Table 2, assuming initially that the project has average risk.

Also, develop new tables that show sensitivity of NPV and the other variables to the initialvariable cost and the cost of capital. Assume that each of these variables can deviate from itsbase case, or expected value, by plus or minus 10 percent, 20 percent, and 30 percent.

c. Prepare a sensitivity diagram and discuss the results.d. What are the primary weaknesses of sensitivity analysis? What are its primary advantages?

3. Complete the scenario analysis in Table 3. What is the base case NPV? The best-case IRR?Use the worst-case, most likely, and best-case NPVs, and their probabilities of occurrence, tofind the project’s expected NPV, standard deviation, and coefficient of variation.

4. What are the primary advantages and disadvantages of scenario analysis?

5. What is Monte Carlo simulation, and what are the advantages and disadvantages of simulationvis-à-vis scenario analysis?

6. a. Would the lite cranapple project be classified as high risk, average risk, or low risk by youranalysis thus far? (Hint: Consider the project’s coefficient of variation of NPV.) What typeof risk have you been measuring?

b. What do you think the project’s corporate, or within-firm, risk would be, and how couldyou measure it?

c. How would it affect your risk assessment if you were told that the cash flows from this pro-ject were totally uncorrelated with Cranfield’s other cash flows? What if they were expectedto be negatively correlated?

d. How would the project’s cash flows probably be correlated with the cash flows of mostother firms, say the S&P 500, hence with the stock market? What difference would thatmake in your capital budgeting analysis?

7. Calculate the project’s risk-adjusted NPV. Should the project be accepted? What if it had acoefficient of variation (CV) of NPV of only 0.15 and was judged to be a low-risk project?

8. Maria and Robert thought long and hard about the lite cranapple project’s market beta. Theyfinally agreed to use 1.8 as their best estimate of the beta for the equity invested in the project.a. On the basis of market risk, what is the project’s required rate of return?b. Describe briefly two methods that might be used to estimate the project’s beta. Do you

think those methods would be feasible in this situation?c. What are the advantages and disadvantages of focusing on a project’s market risk rather

than on the other types of risk?

9. What is your recommendation? Should Cranfield accept or reject the lite cranapple juiceproject?


Cranfield, Inc. (B): Capital Budgeting - Case 45, Directed 17

QUESTIONS

1. a. Why should firms be concerned with the riskiness of individual projects?b. (1) What are the three types of risk that are normally considered in capital budgeting?

(2) Which type of risk is most relevant?(3) Which type of risk is easiest to measure?(4) Would you normally expect the three types of risk to be highly correlated? Would

they be highly correlated in this specific instance?

2. a. What is sensitivity analysis?b. Complete the sensitivity tables in Table 2, assuming initially that the project has average risk.

Also, develop new tables that show sensitivity of NPV and the other variables to the initialvariable cost and the cost of capital. Assume that each of these variables can deviate from itsbase case, or expected value, by plus or minus 10 percent, 20 percent, and 30 percent.

c. Prepare a sensitivity diagram and discuss the results.d. What are the primary weaknesses of sensitivity analysis? What are its primary advantages?

3. Complete the scenario analysis in Table 3. What is the base case NPV? The best-case IRR?Use the worst-case, most likely, and best-case NPVs, and their probabilities of occurrence, tofind the project’s expected NPV, standard deviation, and coefficient of variation.

4. What are the primary advantages and disadvantages of scenario analysis?

5. What is Monte Carlo simulation, and what are the advantages and disadvantages of simulationvis-à-vis scenario analysis?

6. a. Would the lite cranapple project be classified as high risk, average risk, or low risk by youranalysis thus far? (Hint: Consider the project’s coefficient of variation of NPV.) What typeof risk have you been measuring?

b. What do you think the project’s corporate, or within-firm, risk would be, and how couldyou measure it?

c. How would it affect your risk assessment if you were told that the cash flows from this pro-ject were totally uncorrelated with Cranfield’s other cash flows? What if they were expectedto be negatively correlated?

d. How would the project’s cash flows probably be correlated with the cash flows of mostother firms, say the S&P 500, hence with the stock market? What difference would thatmake in your capital budgeting analysis?

7. Calculate the project’s risk-adjusted NPV. Should the project be accepted? What if it had acoefficient of variation (CV) of NPV of only 0.15 and was judged to be a low-risk project?

8. Maria and Robert thought long and hard about the lite cranapple project’s market beta. Theyfinally agreed to use 1.8 as their best estimate of the beta for the equity invested in the project.a. On the basis of market risk, what is the project’s required rate of return?b. Describe briefly two methods that might be used to estimate the project’s beta. Do you

think those methods would be feasible in this situation?c. What are the advantages and disadvantages of focusing on a project’s market risk rather

than on the other types of risk?

9. What is your recommendation? Should Cranfield accept or reject the lite cranapple juiceproject?



Cengage Learning

TABLE 1

Model-Generated Data: Cranfield, Inc. (Part II)


Net Investment Outlay: Year Factor Expense Book ValueEquipment cost $400,00 1 33% $151,800 $308,200Freight 2 45Installation 3 15Change in NWC 4 7 32,200 (0)

$475,00 100% $460,000


Unit price $2.00 $ 2.10 $ 2.43Unit sales 400,000 400,000 400,000 400,000Revenues $840,000 $972,405Fixed operating costs 100,000 100,000Variable operating costs 510,000 541,216Total operating costs 610,000 641,216Depreciation 151,800 32,200Net cannibalization effects 20,000 20,000 20,000 20,000Before-tax income $ 58,200 $278,989Taxes 23,280 11,596Net income $ 34,920 $167,393Plus depreciation 151,800 32,200Net operating cash flow $186,720 $199,593Salvage value $ 50,000SV tax 20,000Recovery of NWC 15,000Termination CF $ 45,000Project NCF ($475,000) $186,720 $244,593

Decision Measures: Cumulative Cash Flows:NPV $195,063 0 ($475,000)IRR 1 (288,280)MIRR 19.9% 2 (60,400)Payback 2.3% 3TV 981,040 4 377,091



TABLE 1

Model-Generated Data: Cranfield, Inc. (Part II)


Net Investment Outlay: Year Factor Expense Book ValueEquipment cost $400,00 1 33% $151,800 $308,200Freight 2 45Installation 3 15Change in NWC 4 7 32,200 (0)

$475,00 100% $460,000


Unit price $2.00 $ 2.10 $ 2.43Unit sales 400,000 400,000 400,000 400,000Revenues $840,000 $972,405Fixed operating costs 100,000 100,000Variable operating costs 510,000 541,216Total operating costs 610,000 641,216Depreciation 151,800 32,200Net cannibalization effects 20,000 20,000 20,000 20,000Before-tax income $ 58,200 $278,989Taxes 23,280 11,596Net income $ 34,920 $167,393Plus depreciation 151,800 32,200Net operating cash flow $186,720 $199,593Salvage value $ 50,000SV tax 20,000Recovery of NWC 15,000Termination CF $ 45,000Project NCF ($475,000) $186,720 $244,593

Decision Measures: Cumulative Cash Flows:NPV $195,063 0 ($475,000)IRR 1 (288,280)MIRR 19.9% 2 (60,400)Payback 2.3% 3TV 981,040 4 377,091



Cengage Learning

TABLE 2

Sensitivity Analysis Results

Summary of Sensitivity Analysis

Variable Change NPV after Indicated Changefrom Base Level Unit Salvage

Sales Price Value VC k–30% ($19,255) ($318,390)–20% (147,239)–10% 123,624 23,912 193,014

Base Case 195,063 195,063 195,063+10% 266,503 366,215 197,112+20%+30% 409,382 708,517 201,211

Inflation (Data Table 2 with NPV as Output Variable)

Price Inflation Cost Inflation+$C$97 0% 1% 2% 3% 4%

0% $ 51,244 $ 28,384 $ 5,087 ($ 18,654) ($ 42,845)1 87,821 64,961 41,663 17,922 (6,268)2 125,097 102,236 55,198 31,0083 163,082 140,221 116,924 93,183 68,9934 178,926 155,629 131,8885 241,221 218,361 195,063 171,323 147,1326 281,396 258,536 235,238 187,3077 322,322 276,164 252,423 228,2338 364,009 341,148 317,851 294,110 269,920

TABLE 3

Scenario Analysis Results

Scenario Prob. NPV IRR MIRR Worst 25% ($271,924) –22.4 % –11.1 %Base 50% 27.2 % 19.9 %Best 25% 651,805

Expected value 23.35% 16.31%Standard deviation 28.56% 16.01% Coefficient of variation 1.2 1.0



TABLE 2

Sensitivity Analysis Results

Summary of Sensitivity Analysis

Variable Change NPV after Indicated Changefrom Base Level Unit Salvage

Sales Price Value VC k–30% ($19,255) ($318,390)–20% (147,239)–10% 123,624 23,912 193,014

Base Case 195,063 195,063 195,063+10% 266,503 366,215 197,112+20%+30% 409,382 708,517 201,211

Inflation (Data Table 2 with NPV as Output Variable)

Price Inflation Cost Inflation+$C$97 0% 1% 2% 3% 4%

0% $ 51,244 $ 28,384 $ 5,087 ($ 18,654) ($ 42,845)1 87,821 64,961 41,663 17,922 (6,268)2 125,097 102,236 55,198 31,0083 163,082 140,221 116,924 93,183 68,9934 178,926 155,629 131,8885 241,221 218,361 195,063 171,323 147,1326 281,396 258,536 235,238 187,3077 322,322 276,164 252,423 228,2338 364,009 341,148 317,851 294,110 269,920

TABLE 3

Scenario Analysis Results

Scenario Prob. NPV IRR MIRR Worst 25% ($271,924) –22.4 % –11.1 %Base 50% 27.2 % 19.9 %Best 25% 651,805

Expected value 23.35% 16.31%Standard deviation 28.56% 16.01% Coefficient of variation 1.2 1.0



Cengage Learning





Cengage Learning

Cengage Learning · Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, ......

Documents

Transcript of Cengage Learning · Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, ......