Edit question The unexpected withdrawal of one of Cape Chemical’s competitors fr

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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).

What other issues should Stewart and Clarkson considered before a final decision regarding the

expansion alternatives is made?

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

The Question raised here is "

What other issues should Stewart and Clarkson considered before a final decision regarding the

expansion alternatives is made?"

Under Option of Used Equipment, it is required to understand what would happen after the used equipment exhausts the useful life and is sold. The capacity additionally generated by the used equipment would have to be taken care of after disposing the used asset.

1) The Cash Flow generated by both the Options after tax for the period of First Three Years.

2) The Cash Pay Back by each of the Options (Shorter payback is the better Option).

3) The Net Present value of the Free Cash Flow over the 3 years discounted at 18%. (Select the Higher of the two)

4) The Internal Rate of Return for each of the options. ( Select the Higher of the two)

5) The Working Capital Investment additionally required.

6) Before going into any of the options, the company must be making profits to enable tax deductible benefits on the Interest cost borrowings.

(Note :The Question DOES NOT require full working of the INVESTMENT OPTION comparisons, hence not done here)

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