The unexpected withdrawal of one of Cape Chemical’s competitors from the region
ID: 2807482 • Letter: T
Question
The unexpected withdrawal of one of Cape Chemical’s competitors from the region has provided
the opportunity to increase its blended packaged goods sales. That's the good news. The bad news is
Cape Chemical’s blending equipment is operating at capacity, thus to take advantage of this opportunity,
additional equipment must be obtained, requiring a major capital investment. It is estimated that Cape
Chemical must increase its annual blending capacity by 800,000 gallons to meet expected demand for
the next three years Annual capacity must increase by 1,400,000 gallons to meet projected demand
beyond the next three years.
Stewart is considering two alternatives proposed by the company’s engineer. The first is the
acquisition and installation of used equipment that will provide the capacity to blend an additional
800,000 gallons annually. The used equipment will cost $105,000 to acquire and $15,000 to install.
The equipment is projected to have an estimated life of three years. The second option is the acquisition
and installation of new equipment with the capacity to blend 1,600,000 gallons annually. The new
equipment would have a substantially higher cost of $360,000 to acquire and $60,000 to install, but have
a higher capacity and an economic life of seven years. The new equipment is also more efficient thus
the cost of blending is less than the blending cost of the used equipment. Stewart asked Clarkson to lead
the evaluation process.
Stewart thinks the used equipment could be obtained without a new bank loan. The acquisition
of the new equipment would require new bank borrowing.
The evaluation of each alternative will require an estimate of the financial benefits associated
with each. The marketing and sales staff estimated incremental sales of blended package material will
be 600,000 gallons the first year and increase by 15% each year thereafter.
During the last year, the average selling price for blended material has been near $4.05 per gallon
and material cost (not including a cost for blending the material) has been approximately $3.53. The
marketing staff anticipates no significant change in either future selling prices or product costs; however
they do estimate variable selling and administrative expenses associated with the increased blended
material sales to be $.20 per gallon.
PROJECT EVALUATION PROCESS
The company has no formal process for evaluating capital expenditure projects. In the past
Stewart had reviewed investment alternatives and made the decision based on her “informal” evaluation.
Clarkson plans to develop a formal capital budgeting process using the Cash Payback Period,
Discounted Cash Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR) and Modified
Internal Rate of Return (MIRR) evaluation methods. She will need to educate Stewart on the superiority
of a formal evaluation process using these methods.
136
Journal of the International Academy for Case Studies, Volume 16, Number 5, 2010
Weighted Average Cost of Capital (WACC)
Using input from an investment banking firm, Clarkson estimates the company's cost of equity
to be 18%. Their bank has indicated a long-term bank loan can be arranged to finance the new
equipment at an annual interest rate of 12% (before tax cost of debt). The bank would require the loan
to be secured with the new equipment. The loan agreement would also include a number of restrictive
covenants, including a limitation of dividends while the loans are outstanding. While long-term debt
is not included in the firm's current capital structure, Clarkson believes a 30% debt, 70% equity capital
mix would be appropriate for Cape Chemical. Last year, the company's federal-plus-state income tax
rate was 30%. Clarkson does not expect the income tax rate to change in the foreseeable future.
Used Equipment
The used equipment will cost $105,000 with another $15,000 required to install the equipment.
The equipment is projected to have an economic life of three years with a salvage value of $9,000. The
equipment will provide the capacity to blend an additional 800,000 gallons annually. The variable
blending cost is estimated to be $.20 per gallon. The equipment will be depreciated under the Modified
Accelerate Cost Recovery System (MACRS) 3-year class. Under the current tax law, the depreciation
allowances are 0.33, 0.45, 0.15, and 0.07 in years 1 through 4, respectively. The increased sales volume
will require an additional investment in working capital of 2% of sales (to be on hand at the beginning
of the year).
New Equipment
The acquisition of new equipment with the capacity to blend 1,600,000 gallons annually is the
second alternative. The new equipment would cost $360,000 to acquire with an installation cost of
$60,000 and have an economic life of seven years and a salvage value of $60,000. The new equipment
can be operated more efficiently than the used equipment. The cost to blend a gallon of material is
estimated to be $.17. The equipment will be depreciated under the MACRS 7-year class. Under the
current tax law, the depreciation allowances are 0.14, 0.25, 0.17, 0.13, 0.09, 0.09, 0.09 and 0.04 in years
1 through 8, respectively. The increased sales volume will require an additional investment in working
capital of 2% of sales (to be on hand at the beginning of the year).
The projected cash flow benefits of both projects did not include the effects of inflation. Future
cash flows were determined using a constant selling price and operating costs (real cash flows).
The cash flows were then discounted using a WACC that included the impact of inflation
(nominal WACC). Discuss the problem with using real cash flows and a nominal WACC when
calculating a project’s Discounted Payback Period, NPV, IRR and MIRR.
I found a cash flow spread sheet online but don't understand some of the calculations and all it had were cash flows not any of the calculations
Explanation / Answer
A Free Cashflow can be nominal or Real depending on whether these have been adjusted for Inflation or Not. When using Nominal Cash Flow , this must be discounted with Nominal Rates and not the Real Discount Rates.
The Key to accuracy in Investment decision is CONSISTENCY in the Revenue stream, Cost Assumption and Discount Rate used.
When we use the correct and Consistent combination of above components to a Present Value Calculation, the results would be same.
See the table below:-
NET PRESENT VALUE CALCULATIONS
NET INCOME
Revenue
REAL
Discount Rate
NOMINAL
Discount Rate
The Correct NPV would be identical when the correct combination of Revenue, Costs and Discount rates are used.
NET INCOME
Revenue
REAL
Discount Rate
NOMINAL
Discount Rate
Real Revenue - Real Costs CORRECT NPV INCORRECT NPV Real Revenue - Nominal Costs INCORRECT NPV INCORRECT NPV Nominal Revenue- Nominal Costs INCORRECT NPV CORRECT NPV Nominal Revenue- Real Costs INCORRECT NPV INCORRECT NPVRelated Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.