Learning Team – Caledonia Products Integrative Problem

Prepare a response to the Caledonia Products Mini-Case located near the end of Ch. 12 in Financial

4. Sketch out a cash flow diagram for this project. Ok I will start, Stefany

Mini-Cases
Danforth & Donnalley Laundry Products Company
Determining Relevant Cash Flows

At 3:00 p.m. on April 14, 2010, James Danforth, president of Danforth & Donnalley (D&D) Laundry Products Company, called to order a meeting of the financial directors. The purpose of the meeting was to make a capital-budgeting decision with respect to the introduction and production of a new product, a liquid detergent called Blast.

D&D was formed in 1993 with the merger of Danforth Chemical Company (producer of Lift-Off detergent, the leading laundry detergent on the West Coast) and Donnalley Home Products Company (maker of Wave detergent, a major Midwestern laundry product). As a result of the merger, D&D was producing and marketing two major product lines. Although these products were in direct competition, they were not without product differentiation: Lift-Off was a low-suds, concentrated powder, and Wave was a more traditional powder detergent. Each line brought with it considerable brand loyalty; and, by 2010, sales from the two detergent lines had increased ten-fold from 1993 levels, with both products now being sold nationally.

In the face of increased competition and technological innovation, D&D spent large amounts of time and money over the past 4 years researching and developing a new, highly concentrated liquid laundry detergent. D&D’s new detergent, which they call Blast, had many obvious advantages over the conventional powdered products. The company felt that Blast offered the consumer benefits in three major areas. Blast was so highly concentrated that only 2 ounces were needed to do an average load of laundry, as compared with 8 to 12 ounces of powdered detergent. Moreover, being a liquid, it was possible to pour Blast directly on stains and hard-to-wash spots, eliminating the need for a pre-soak and giving it cleaning abilities that powders could not possibly match. And, finally, it would be packaged in a lightweight, unbreakable plastic bottle with a sure-grip handle, making it much easier to use and more convenient to store than the bulky boxes of powdered detergents with which it would compete.

The meeting participants included James Danforth, president of D&D; Jim Donnalley, director of the board; Guy Rainey, vice-president in charge of new products; Urban McDonald, controller; and Steve Gasper, a newcomer to the D&D financial staff who was invited by McDonald to sit in on the meeting. Danforth called the meeting to order, gave a brief statement of its purpose, and immediately gave the floor to Guy Rainey.

Rainey opened with a presentation of the cost and cash flow analysis for the new product. To keep things clear, he passed out copies of the projected cash flows to those present (see Exhibits 1 and 2). In support of this information, he provided some insights as to how these calculations were determined. Rainey proposed that the initial cost for Blast include $500,000 for the test marketing, which was conducted in the Detroit area and completed in June of the previous year, and $2 million for new specialized equipment and packaging facilities. The estimated life for the facilities was 15 years, after which they would have no salvage value. This 15-year estimated life assumption coincides with company policy set by Donnalley not to consider cash flows occurring more than 15 years into the future, as estimates that far ahead “tend to become little more than blind guesses.”

Exhibit 1 D&D Laundry Products Company Forecast of Annual Cash Flows from the Blast Product (Including cash flows resulting from sales diverted from the existing product lines.)
Year Cash flows
1
$280,000
2
280,000
3
280,000
4
280,000
5
280,000
6
350,000
7
350,000
8
350,000
9
$350,000
10
350,000
11
250,000
12
250,000
13
250,000
14
250,000
15
250,000

Exhibit 2 D&D Laundry Products Company Forecast of Annual Cash Flows from the Blast Product (Excluding cash flows resulting from sales diverted from the existing product lines.)
Year Cash flows
1
$250,000
2
250,000
3
250,000
4
250,000
5
250,000
6
315,000
7
315,000
8
315,000
9
$315,000
10
315,000
11
225,000
12
225,000
13
225,000
14
225,000
15
225,000

Rainey cautioned against taking the annual cash flows (as shown in Exhibit 1) at face value because portions of these cash flows actually would be a result of sales that had been diverted from Lift-Off and Wave. For this reason, Rainey also produced the estimated annual cash flows that had been adjusted to include only those cash flows incremental to the company as a whole (as shown in Exhibit 2).

At this point, discussion opened between Donnalley and McDonald, and it was concluded that the opportunity cost on funds was 10%. Gasper then questioned the fact that no costs were included in the proposed cash budget for plant facilities that would be needed to produce the new product.

Rainey replied that, at the present time, Lift-Off’s production facilities were being used at only 55% of capacity, and because these facilities were suitable for use in the production of Blast, no new plant facilities would need to be acquired for the production of the new product line. It was estimated that full production of Blast would only require 10% of the plant capacity.

McDonald then asked if there had been any consideration of increased working capital needs to operate the investment project. Rainey answered that there had, and that this project would require $200,000 of additional working capital; however, as this money would never leave the firm and would always be in liquid form, it was not considered an outflow and hence not included in the calculations.

Donnalley argued that this project should be charged something for its use of current excess plant facilities. His reasoning was that if another firm had space like this and was willing to rent it out, it could charge somewhere in the neighborhood of $2 million. However, he went on to acknowledge that D&D had a strict policy that prohibits renting or leasing any of its production facilities to any party from outside the firm. If they didn’t charge for facilities, he concluded, the firm might end up accepting projects that under normal circumstances would be rejected.

From here the discussion continued, centering on the question of what to do about the lost contribution from other projects, the test marketing costs, and the working capital.

Questions

1.If you were put in the place of Steve Gasper, would you argue for the cost from market testing to be included in a cash outflow?

2.What would your opinion be as to how to deal with the question of working capital?

3.Would you suggest that the product be charged for the use of excess production facilities and building space?

4.Would you suggest that the cash flows resulting from erosion of sales from current laundry detergent products be included as a cash inflow? If there was a chance of competitors introducing a similar product if you did not introduce Blast, would this affect your answer?

5.If debt were used to finance this project, should the interest payments associated with this new debt be considered cash flows?

6.What are the NPV, IRR, and PI of this project, both including cash flows resulting from sales diverted from the existing product lines (Exhibit 1) and excluding cash flows resulting from sales diverted from the existing product lines (Exhibit 2)? Under the assumption that there is a good chance that competition will introduce a similar product if you don’t, would you accept or reject this project?

Caledonia Products
Calculating Free Cash Flow and Project Valuation

It’s been two months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation, but also to respond to a number of questions aimed at judging your understanding of the capital-budgeting process. The memorandum you received outlining your assignment follows:

To: The Assistant Financial Analyst

From: Mr. V. Morrison, CEO, Caledonia Products

Re: Cash Flow Analysis and Capital Rationing

We are considering the introduction of a new product. Currently we are in the 34% tax bracket with a 15% discount rate. This project is expected to last five years and then, because this is somewhat of a fad project, it will be terminated. The following information describes the new project:
Cost of new plant and equipment:
$ 7,900,000
Shipping and installation costs:
$ 100,000
Unit sales:

Year Units Sold
1
70,000
2
120,000
3
140,000
4
80,000
5
60,000
Sales price per unit:
$300/unit in years 1–4 and $260/unit in year 5.
Variable cost per unit:
$180/unit
Annual fixed costs:
$200,000 per year

Working capital requirements: There will be an initial working capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.

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