DANFORTH & DONNALLEY LAUNDRY PRODUCTS COMPANY

CAPITAL BUDGETING: RELEVANT CASH FLOWS On April 14, 1993, at 3:00 p.m., 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 1968 with the merger of Danforth Chemical Company, headquartered in Seattle, Washington, producers of Lift-Off detergent, the leading laundry detergent on the West Coast, and Donnalley Home Products Company, headquartered in Detroit, Michigan, makers 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 powdered detergent. Each line brought with it considerable brand loyalty, and by 1993, sales from the two detergent lines had increased tenfold from 1968 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 four years researching and developing a new, highly concentrated liquid laundry detergent. D&Ds new detergent, which they called Blast, had many obvious advantages over the conventional powdered products. It was felt that with Blast the consumer would benefit 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 was attended by James Danforth; Jim Donnalley, director of the board; Guy Rainey, vice-president in charge of new products; Urban McDonald, controller; and Steve Gasper, a newcomer to D&Ds 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 insight as to how these calculations were determined. Rainey proposed that the initial cost for Blast included $500,000 for the test marketing, which was conducted in the Detroit area and completed in the previous June, 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." Rainey cautioned against taking the annual cash flows (as shown in Exhibit 1) at face value because portions of these cash flows actually are a result of sales that had been diverted from Lift-Off and Wave. For this reason, Rainey also produced the 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 is 10%. Gasper then 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. EXHIBIT 1. D&D Laundry Products Company Annual Cash Flows from the Acceptance of Blast (Including flows resulting from sales diverted from the existing product lines) Year 1 2 3 4 5 6 7 8 EXHIBIT 2. D&D Laundry Products Company Annual Cash Flows from the Acceptance of Blast (Not including those flows resulting from sales diverted from the existing product lines) Year Cash Flows Year Cash Flows 1 $250,000 9 315,000 2 250,000 10 315,000 3 250,000 11 225,000 4 250,000 12 225,000 5 250,000 13 225,000 6 315,000 14 225,000 7 315,000 15 225,000 8 315,000 Rainey replied that, at the present time, Lift-Offs 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 other than the specialized equipment and packaging facilities previously mentioned need be acquired for the production of the new product line. It was estimated that full production of Blast would require only 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 Cash Flows $280,000 280,000 280,000 280,000 280,000 350,000 350,000 350,000 Year 9 10 11 12 13 14 15 Cash Flows 350,000 350,000 250,000 250,000 250,000 250,000 250,000

project would require $200,000 of additional working capital; however, as this money would never leave the firm and always would be in liquid form, it was not considered an outflow and hence was not included in the calculations.

Donnalley 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 tried to rent this space from D&D, it would be charged somewhere in the neighborhood of $2 million, and since this project would compete with the current projects, it should be treated as an outside project and charged as such; however, he went on to acknowledge that D&D has a strict policy that forbids the renting or leasing out of any of its production facilities. If they didnt 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 questions of what to do about the "lost contribution from other projects," the test marketing costs, and the working capital. QUESTIONS 1. 2. 3. 4. If you were put in the place of Steve Gasper, would you argue for the cost from market testing to be included as a cash outflow? What would your opinion be as to how to deal with the question of working capital? Would you suggest that the product be charged for the use of excess production facilities and building? 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 were a chance of competition introducing a similar product if you do not introduce Blast, would this affect your answer? If debt is used to finance this project, should the interest payments associated with this new debt be considered cash flows? What are the NPV, IRR, and PI of this project, including cash flows resulting from lost sales from existing product lines? What are the NPV, IRR, and PI of this project excluding these flows? Under the assumption that there is a good chance that competition will introduce a similar product if you do not, would you accept or reject this project?

5. 6.

SOLUTIONS TO CASES
DANFORTH AND DONNALLEY LAUNDRY PRODUCTS COMPANY
(Capital Budgeting: Relevant Cash Flows) SOLUTION OBJECTIVE: The purpose of this case is to focus on what types and which cash flows should be included in capital budgeting analysis. The student is forced to decide which cash flows are actually after-tax cash flows incremental to the company as a whole. This case should be introduced toward the beginning of the introduction to capital budgeting and works well as either a homework assignment or as an in-class lecture problem. Relatively Simple

DEGREE OF DIFFICULTY: Question Answers: 1.

No. The cash flows associated with test marketing have already occurred at the time of the case and as such should be considered "sunk costs." Within the capitalbudgeting decision we are only interested in incremental cash flows on an after-tax basis. This flow is clearly not incremental; regardless of the decision with respect to acceptance or rejection of the project, this cash outflow will remain. At an earlier date, prior to the occurrence of this expenditure, it should have been included as a cash outflow in the evaluation of this project, but after its occurrence, it is no longer an incremental cash flow. While major cash outflows for most projects will be associated with plant and equipment expenditures, many times these expenditures will be accompanied by an increase in working capital needs. These increased needs are those associated with funds needed for inventories, payroll, and other cash needs and receivables from customers. As increased working capital needs involve the tying up of funds over the life of the project, they should be considered as cash outflows with the residual working capital being recovered at the termination of operations. In this case, the $200,000 needed for working capital should be considered an initial outflow and also an inflow at the end of the life of the project in year 15. At this point, some students may still feel that the investment and subsequent recovery of funds will balance each other out; here it should be emphasized that the present value equivalents of these flows are far from equal. Since the production of Blast will occupy current excess capacity, no incremental cash flows are incurred; hence, none should be charged against Blast. In a strict sense, cash flows resulting from lost sales to the existing product line should not be included as a cash inflow. These cash flows are not incremental in that if the project is not accepted, they will occur anyway. If it seems likely that a

2.

3. 4.

competitor may introduce a similar product, the approach to market erosion from existing product lines may change. In this case, the market erosion may exist whether or not the new project is introduced; hence, the cash flows may be incremental. In the laundry detergent industry, where the competition is vigorous, this may in fact be a rational assumption. Thus, if cash flows from sales erosion are not considered, it may result in the rejection of a project which would be acceptable to a competitor, resulting in the subsequent introduction of this product by competition. Hence, the sales erosion of the existing product lines may no longer be dependent upon the introduction of Blast. In summary, the question seems to boil down to the ability and likelihood of competition introducing a similar product. 5. No. These flows are taken into consideration within the discounting process and are represented by the opportunity cost or "cost of capital." To include them as cash flows results in double counting these flows. Determining the NPV and PI for this project gives students an excellent chance to work with the annuity tables in determining the value of future annuities (i.e., annuities for years 6-10 and 11-15). Working through the calculations slowly takes students a long way toward understanding the meaning of the annuity tables. Including Flows from From Sales Erosion of Existing Line Year 0 1-5 6-10 3.7908) 11-15 6.1446) 15* -2.2M 280,000 x (3.7908) 350,000 x (6.1446 - 3.7908) 250,000 x (7.6061- 6.1446) 200,000 x (.23939) Sales Erosion of Existing Line -2.2M 250,000 x (3.7908) 315,000 x (6.1446 225,000 x (7.6061 200,000 x (.23939) Excluding Flows

6.

*Recapture of working capital NPV PI IRR = $98,507 = 1.0447 = A little less than 11% NPV PI IRR = -$134,137.50 = .9390 = 9%

If the introduction of a similar product by competition is likely, then cash flows from sales erosion of the existing product line should be included; hence, the project should be accepted as it has a positive NPV, PI > 1.0 and the IRR > opportunity rate.