Radiant Laundry Products Company is a leading producer of laundry detergent. Radiant produces two major product lines; one is a low-suds, concentrated powder detergent and the other is a more traditional powder detergent. Sales from the two detergent lines had increased tenfold from their 2000 levels, with both products now being sold nationally.
By 2011 the company had a sales turnover of over $20 million with profits in excess of $2 million.
A capital budgeting meeting was held to consider the introduction and production of a new product, a liquid detergent called Dynamo. In the face of increased competition and technological innovation, Radiant had spent large amounts of time and money over the past four years researching and developing a new, highly concentrated liquid detergent.
The new detergent, which they called Dynamo, had advantages over the conventional powdered products in terms of reduced detergent usage for an average load of laundry, better cleaning abilities, much easier to use and more convenient to store.
At the meeting, the Chief Financial Officer, Mr. McDonald, presented the cost and cash flow analysis for the new product. He passed out copies of the projected cash flows to those present (see Table 1). In support of this information, he provided some insight into how these calculations were determined. He proposed the initial cost for Dynamo included $150,000 for the test marketing, which was conducted and completed in the previous year, and $2 million for new specialised equipment and packaging facilities to be purchased from Donnalley Limited. The estimated life for the facilities was 10 years, after which they would have an expected salvage value of $80,000. This 10-year estimate life assumption coincided with company policy not to consider cash flows occurring more than 10 years into the future, as estimates that far ahead "tend to become little more than blind guesses". The depreciation rate allowed by the Tax authorities for the equipment and packaging facilities was 30% on the reducing balance basis.
Mr. McDonald cautioned against taking the annual cash flows shown in column 2 of Table 1 at face value since portions of these cash flows actually were a result of sales that had been diverted from the existing product lines. For this reason, he also produced the annual cash flows shown in column 3 of Table 1, which had been the lost sales from existing product lines of the company as a whole.
The Chairman of the company, Mr. Waldo, questioned the fact that no costs were included in the proposed cash budget for plant facilities, which would be needed to produce the new product. Mr. McDonald replied that, the existing product facilities were being utilised at only 60 percent of capacity, and since these facilities were suitable for use in the production of Dynamo, no new plant facilities other than the specialised equipment and packaging facilities previously mentioned needed be acquired for the production of the new product line. It was estimated that full production of Dynamo would only require 20 percent of the plan capacity.
TABLE 1: Annual Cash Flows from the Acceptance of Dynamo
|
Year
|
Increased net cash flows from
the Dynamo Project
|
Lost sales from existing
product lines
|
|
1
|
$580,000
|
$70,000
|
|
2
|
$580,000
|
$70,000
|
|
3
|
$580,000
|
$70,000
|
|
4
|
$580,000
|
$70,000
|
|
5
|
$650,000
|
$110,000
|
|
6
|
$650,000
|
$110,000
|
|
7
|
$650,000
|
$110,000
|
|
8
|
$550,000
|
$100,000
|
|
9
|
$550,000
|
$100,000
|
|
10
|
$550,000
|
$100,000
|
The Production Manager, Mr. Gasper, argued that this project should be charged something for its use of the current excess plant facilities. His reasoning was that if an outside firm tries to rent this space from Radiant, it would be charged somewhere in the neighbourhood of $120,000 per year, and since this project would compete with other current projects, it should be treated as an outside project and charged as such. However, he went on to acknowledge that Radiant has a strict policy forbidding the renting or leasing out of any of its production facilities. If they didn't charge for facilities, he concluded, the company might end up accepting projects that under normal circumstances would be rejected. Gasper put forward a hypothetical projection that needed production facilities for the current line of powdered detergents were at 60 percent of capacity and expected to grow at a rate of 12 percent a year and maximum production capacity was 100 percent. As production would be at 84.3% of capacity in three years and 105.74% in five years, a
ew plant and facilities would be needed. This would involve cash outflows of $5 million in four years and should cater for future needs of all production growth. Radiant is a private company, soundly financed and consistently profitable. Cash and deposits are not sufficient to buy the new specialised equipment and packaging facilities. However, Mr. Waldo is confident that part of the cost of the project could be financed with medium-term debt, privately placed with an insurance company. Radiant had borrowed via a private placement once before when it negotiated a fixed rate of 10 percent on a five-year loan. Preliminary discussions with Radiant's bankers led Mr. Waldo to believe that the firm could arrange a 12 percent 10-year term loan of $1.5 million with repayment of fixed annual interest expense in advance and the principal owing at maturity. The company's tax rate is 30 percent and its opportunity cost on funds is 15 percent in nominal terms.
Gasper questioned why McDonald rejected the specialised equipment and packaging facilities proposal from Danforth Limited which would reduce the initial project outlay and the cost of debt from $1.5 million to $0.7 million. McDonald answered that the alternative proposed by Danforth Limited would cost $1.2 million with additional shipping and installation fees of $10,000 and $20,000, respectively. The new equipment would qualify as a 5-year class life asset under MACRS depreciation rates (see Table 2) and was expected to have a market value of approximately $50,000 at the end of its economic life of 5 years. The totals costs over the project life of 10 years were more than $2 million despite an annual cost savings on operating and maintenance costs amounting to $20,000 which was not included in the annual cash flows given in Table 1. In his opinion, Radiant was better off with current proposal from Donnalley Limited.
Table 2: Depreciation Schedule
|
Year
|
5-year asset
|
|
1
|
20%
|
|
2
|
32%
|
|
3
|
19%
|
|
4
|
12%
|
|
5
|
11%
|
|
6
|
6%
|
|
Total
|
100%
|
Waldo then asked if there had been any consideration of increased working capital needed to operate the investment project. McDonald answered that they had and this project would require $100,000 of additional working capital. However, as this money would never leave the company and would always be in liquid form, it was not considered an outflow, and hence was not included in the calculation. As a shrewd financial analyst you observed that the working capital of the company has typically been about 20% of the annual cash flows presented in Table 1.
Q. On the basis of costs, would you recommend Radiant to purchase the specialised equipment and packaging facilities from Donnalley Limited or Danforth Limited? [Assume the equipments will be replaced at the end of its economic life and both companies are able to supply the equipments on the same terms indefinitely.]