Cengage Learning. Financial Management. Financial Management. Brigham / Klein. Brigham / Klein

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1 Financial Management Financial Management Brigham / Klein Brigham / Klein Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States

2 Financial Management 2008, 2007 Financial Management 2008, 2007 Brigham / Klein Executive Editors: Michele Baird Maureen Staudt Michael Stranz Project Development Manager: Linda destefano Senior Marketing Coordinators: Sara Mercurio Lindsay Shapiro 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. For product information and technology assistance, contact us at Customer & Sales Support, For permission to use material from this text or product, submit all requests online at cengage.com/permissions Further permissions questions can be ed to permissionrequest@cengage.com Brigham / Klein Executive Editors: Michele Baird Maureen Staudt Michael Stranz Project Development Manager: Linda destefano Senior Marketing Coordinators: Sara Mercurio Lindsay Shapiro 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. For product information and technology assistance, contact us at Customer & Sales Support, For permission to use material from this text or product, submit all requests online at cengage.com/permissions Further permissions questions can be ed to permissionrequest@cengage.com Production/Manufacturing Manager: Donna M. Brown PreMedia Services Supervisor: Rebecca A. Walker Rights & Permissions Specialist: Kalina Hintz Cover Image: Getty Images* ISBN-13: ISBN-10: Natorp Boulevard Mason, Ohio USA Production/Manufacturing Manager: Donna M. Brown PreMedia Services Supervisor: Rebecca A. Walker Rights & Permissions Specialist: Kalina Hintz Cover Image: Getty Images* ISBN-13: ISBN-10: Natorp Boulevard Mason, Ohio USA * Unless otherwise noted, all cover images used by Custom Solutions, a part of, have been supplied courtesy of Getty Images with the exception of the Earthview cover image, which has been supplied by the National Aeronautics and Space Administration (NASA). 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 products are represented in Canada by Nelson Education, Ltd. For your lifelong learning solutions, visit custom.cengage.com Visit our corporate website at cengage.com * Unless otherwise noted, all cover images used by Custom Solutions, a part of, have been supplied courtesy of Getty Images with the exception of the Earthview cover image, which has been supplied by the National Aeronautics and Space Administration (NASA). 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 products are represented in Canada by Nelson Education, Ltd. For your lifelong learning solutions, visit custom.cengage.com Visit our corporate website at cengage.com the United States of America the United States of America

3 Acknowledgements Acknowledgements The content of this text has been adapted from the following product(s): Abbot Nursery: Working Capital Management - Case 91, Directed ISBN-10: ( ) ISBN-13: ( ) Cranfield, Inc. (B): Capital Budgeting - Case 45, Directed ISBN-10: ( ) ISBN-13: ( ) New England Seafood Company: Capital Budgeting - Case 16, Directed ISBN-10: ( X) ISBN-13: ( ) Johnson Window Company: Capital Structure - Case 8, Directed ISBN-10: ( ) ISBN-13: ( ) Ace Repair, Inc.: Cost of Capital - Case 54, Directed ISBN-10: ( ) ISBN-13: ( ) Chef's Selection: Working Capital Management - Case 86, Directed ISBN-10: ( ) ISBN-13: ( ) Northern Forest Products: Cost of Capital - Case 90, Directed ISBN-10: ( ) ISBN-13: ( ) Levinger Organic Snack Company: Long Term Financial Decisions - Case 98, Directed ISBN-10: ( X) ISBN-13: ( ) Betsy's Best: Capital Budgeting - Case 102, Directed ISBN-10: ( ) ISBN-13: ( ) Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, Directed ISBN-10: ( ) ISBN-13: ( ) Cranfield, Inc. (A): Capital Budgeting - Case 44, Directed ISBN-10: ( X) The content of this text has been adapted from the following product(s): Abbot Nursery: Working Capital Management - Case 91, Directed ISBN-10: ( ) ISBN-13: ( ) Cranfield, Inc. (B): Capital Budgeting - Case 45, Directed ISBN-10: ( ) ISBN-13: ( ) New England Seafood Company: Capital Budgeting - Case 16, Directed ISBN-10: ( X) ISBN-13: ( ) Johnson Window Company: Capital Structure - Case 8, Directed ISBN-10: ( ) ISBN-13: ( ) Ace Repair, Inc.: Cost of Capital - Case 54, Directed ISBN-10: ( ) ISBN-13: ( ) Chef's Selection: Working Capital Management - Case 86, Directed ISBN-10: ( ) ISBN-13: ( ) Northern Forest Products: Cost of Capital - Case 90, Directed ISBN-10: ( ) ISBN-13: ( ) Levinger Organic Snack Company: Long Term Financial Decisions - Case 98, Directed ISBN-10: ( X) ISBN-13: ( ) Betsy's Best: Capital Budgeting - Case 102, Directed ISBN-10: ( ) ISBN-13: ( ) Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, Directed ISBN-10: ( ) ISBN-13: ( ) Cranfield, Inc. (A): Capital Budgeting - Case 44, Directed ISBN-10: ( X)

4 ISBN-13: ( ) Sweet Dreams, Inc.: Financial Analysis and Forecasting - Case 68, Directed ISBN-10: ( ) ISBN-13: ( ) Swan-Davis Corporation: Fundamental Concepts - Case 72, Directed ISBN-10: ( ) ISBN-13: ( ) Filmore Enterprises: Fundamental Concepts - Case 84, Directed ISBN-10: ( ) ISBN-13: ( ) Huber: Yang: and O'Riely: Long Term Financial Decisions - Case 97, Directed ISBN-10: ( ) ISBN-13: ( ) Sun Coast Savings Bank: Long Term Financial Decisions - Case 21, Directed ISBN-10: ( ) ISBN-13: ( ) ISBN-13: ( ) Sweet Dreams, Inc.: Financial Analysis and Forecasting - Case 68, Directed ISBN-10: ( ) ISBN-13: ( ) Swan-Davis Corporation: Fundamental Concepts - Case 72, Directed ISBN-10: ( ) ISBN-13: ( ) Filmore Enterprises: Fundamental Concepts - Case 84, Directed ISBN-10: ( ) ISBN-13: ( ) Huber: Yang: and O'Riely: Long Term Financial Decisions - Case 97, Directed ISBN-10: ( ) ISBN-13: ( ) Sun Coast Savings Bank: Long Term Financial Decisions - Case 21, Directed ISBN-10: ( ) ISBN-13: ( )

5 Table Of Contents Table Of Contents 1. Betsy's Best: Capital Budgeting - Case 102, Directed Cranfield, Inc. (A): Capital Budgeting - Case 44, Directed Cranfield, Inc. (B): Capital Budgeting - Case 45, Directed New England Seafood Company: Capital Budgeting - Case 16, Directed Johnson Window Company: Capital Structure - Case 8, Directed Ace Repair, Inc.: Cost of Capital - Case 54, Directed Northern Forest Products: Cost of Capital - Case 90, Directed Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, Directed Sweet Dreams, Inc.: Financial Analysis and Forecasting - Case 68, Directed Swan-Davis Corporation: Fundamental Concepts - Case 72, Directed Filmore Enterprises: Fundamental Concepts - Case 84, Directed Huber: Yang: and O'Riely: Long Term Financial Decisions - Case 97, Directed Sun Coast Savings Bank: Long Term Financial Decisions - Case 21, Directed Levinger Organic Snack Company: Long Term Financial Decisions - Case 98, Directed Abbot Nursery: Working Capital Management - Case 91, Directed Chef's Selection: Working Capital Management - Case 86, Directed Betsy's Best: Capital Budgeting - Case 102, Directed Cranfield, Inc. (A): Capital Budgeting - Case 44, Directed Cranfield, Inc. (B): Capital Budgeting - Case 45, Directed New England Seafood Company: Capital Budgeting - Case 16, Directed Johnson Window Company: Capital Structure - Case 8, Directed Ace Repair, Inc.: Cost of Capital - Case 54, Directed Northern Forest Products: Cost of Capital - Case 90, Directed Advanced Fuels Corporation: Financial Analysis and Forecasting - Case 41, Directed Sweet Dreams, Inc.: Financial Analysis and Forecasting - Case 68, Directed Swan-Davis Corporation: Fundamental Concepts - Case 72, Directed Filmore Enterprises: Fundamental Concepts - Case 84, Directed Huber: Yang: and O'Riely: Long Term Financial Decisions - Case 97, Directed Sun Coast Savings Bank: Long Term Financial Decisions - Case 21, Directed Levinger Organic Snack Company: Long Term Financial Decisions - Case 98, Directed Abbot Nursery: Working Capital Management - Case 91, Directed Chef's Selection: Working Capital Management - Case 86, Directed

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7 1 Case 102 Betsy's Best Capital Budgeting Directed 1 Case 102 Betsy's Best Capital Budgeting Directed 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 nonfarm 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. 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 nonfarm 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 2008, 2004 South-Western, a part of 2008, 2004 South-Western, a part of

8 2 Betsy's Best: Capital Budgeting - Case 102, Directed 2 Betsy's Best: Capital Budgeting - Case 102, Directed 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 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. 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 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 2008, 2004 South-Western, a part 2008, 2004 South-Western, a part of

9 Betsy's Best: Capital Budgeting - Case 102, Directed 3 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 fiveyear 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 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 fiveyear 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 2008, 2004 South-Western, a part of 2008, 2004 South-Western, a part of

10 4 Betsy's Best: Capital Budgeting - Case 102, Directed 4 Betsy's Best: Capital Budgeting - Case 102, Directed 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. 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. 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. 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. 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? 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? 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.) 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? 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. 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? 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: 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 2008, 2004 South-Western, a part 2008, 2004 South-Western, a part of

11 Betsy's Best: Capital Budgeting - Case 102, Directed 5 Betsy's Best: Capital Budgeting - Case 102, Directed 5 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 longterm contracts. b. How would the project s NPV change if sales price and operating cash costsper-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 longterm contracts. b. How would the project s NPV change if sales price and operating cash costsper-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 2008, 2004 South-Western, a part of 2008, 2004 South-Western, a part of

12 6 Betsy's Best: Capital Budgeting - Case 102, Directed 6 Betsy's Best: Capital Budgeting - Case 102, Directed Table 1 Expansion Machine s Initial Investment and Depreciation 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, xxxxx xxxxx 3 17 xxxxx xxxxx 4 13 $4,904,900 11,696, $3,395,700 8,300, $3,395,700 4,904, $3,395,700 1,509, $1,509,200 0 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, xxxxx xxxxx 3 17 xxxxx xxxxx 4 13 $4,904,900 11,696, $3,395,700 8,300, $3,395,700 4,904, $3,395,700 1,509, $1,509,200 0 Total % xxxxx Total % 2008, 2004 South-Western, a part 2008, 2004 South-Western, a part of

13 Betsy's Best: Capital Budgeting - Case 102, Directed 7 Betsy's Best: Capital Budgeting - Case 102, Directed 7 Table 2 Expansion Machine Net Cash Flows Table 2 Expansion Machine Net Cash Flows Cash Flows: Year Year Year Year Year Year 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 Variable operating costs XXXXX 15,200,000 15,200,000 15,200,000 15,200,000 Opportunity costs XXXXX 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 Cash Flows: Year Year Year Year Year Year 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 Variable operating costs XXXXX 15,200,000 15,200,000 15,200,000 15,200,000 Opportunity costs XXXXX 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, , 2004 South-Western, a part of 2008, 2004 South-Western, a part of

14 8 Betsy's Best: Capital Budgeting - Case 102, Directed 8 Betsy's Best: Capital Budgeting - Case 102, Directed Table 2 (Continued) Expansion Machine Net Cash Flows Table 2 (Continued) Expansion Machine Net Cash Flows Cash Flows: Year Year Year Year Year 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 Cash Flows: Year Year Year Year Year 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 XXXXX Variable operating costs 15,200,000 15,200,000 15,200,000 15,200,000 XXXXX Opportunity costs 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 Fixed operating costs 700, , , ,000 XXXXX Variable operating costs 15,200,000 15,200,000 15,200,000 15,200,000 XXXXX Opportunity costs 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 SV tax Recovery of NWC XXXXX XXXXX XXXXX Salvage value SV tax Recovery of NWC XXXXX XXXXX XXXXX Termination CF XXXXX Termination CF XXXXX Project NCF $7,597,495 $7,597,495 $6,937,220 $6,409,000 XXXXX Project NCF $7,597,495 $7,597,495 $6,937,220 $6,409, , 2004 South-Western, a part 2008, 2004 South-Western, a part of