Jacobs Division 2003

Richard Soderberg, financial analyst for the Jacobs Division of MacFadden Chemical
Company, was reviewing several complex issues relating to possible investment in a new product
for the following year, !!"# $he product was a specialty coating material, which %ualified for
investment according to company guidelines# Mr# Reynolds, however, the Jacobs Division
manager, was fearful that it might be too ris&y# 'hile regarding the pro(ect as an attractive
opportunity, Mr# Soderberg believed that the only practical way to sell the product in the short
run would place it in a wea& competitive position over the long run# )e was also concerned that
the estimates used in the probability analysis were little better than educated guesses#
Company Background
MacFadden Chemical Company was one of the larger chemical firms in the world, with
sales in excess of *+! billion# ,ts volume had grown steadily at the rate of +! percent per year
throughout the +-.!s until +--/0 sales and earnings had grown more rapidly# 1eginning in +--/,
the chemical industry began to experience overcapacity, particularly in basic materials, which led
to price cutting# 2lso, more funds had to be spent in mar&eting and research for firms to remain
competitive# 2s a conse%uence of the industry problems, MacFadden achieved only a modest
growth of " percent in sales in the +--!3s and experienced an overall decline in profits# Certain
shortages began developing in the economy in !!, however, and by !!/, sales had risen 4!
percent and profits over +!! percent as the result of price increases and near5capacity operations#
Most observers believed that the shortage boom would be only a short respite from the
intensely competitive conditions of the last decade#
$he ++ operating divisions of MacFadden were organi6ed into three groups# Most
divisions had a number of products centered on one chemical, such as fluoride, sulphur, or
petroleum# $he Jacobs Division was an exception#
,t was the newest and, with sales of *+!! million, the smallest division# ,ts products were
specialty industrial products with various chemical bases, such as dyes, adhesives, and finishes,
$his case is based on the Jacobs Division prepared by 7rofessors Diana )arrington and Robert 8andell# $he case
has been updated and revised by 7rofessor Robert Conroy# $he case was written as a basis for class discussion
rather than to illustrate effective or ineffective handling of an administrative situation# Copyright !!/ by the
9niversity of 8irginia Darden School Foundation, Charlottesville, 82# 2ll rights reserved# To order copies, send
an e-mail to dardencases:virginia#edu# No part of this publication may be reproduced, stored in a retrieval
system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwise without the permission of the Darden School Foundation#
which were sold in relatively small lots to diverse industrial customers# ;o single product had
sales over *< million, and many had sales of only *<!!,!!!# $here were +<! basic products in the
division, each with several minor variations# Jacobs was one of MacFadden3s more rapidly
growing divisions 55+ percent per year prior to !!/55with a +/ percent return on total net
assets#
Capital Budgeting for New Proects
Corporate5wide guidelines were used for analy6ing new investment opportunities# ,n the
current environment the long5term ris&5free rate was about 4percent# 2t the firm level, the return
criteria were . percent for cost5reduction pro(ects, + percent for expansion of facilities, and +4
percent for new products or processes# Returns were measured in terms of discounted cash flows
after taxes# Mr# Soderberg believed that these rates and methods were typical of those used
throughout the chemical industry#
Mr# Reynolds tended, however, to demand higher returns for pro(ects in his division, even
though its earnings5growth stability in the past mar&ed it as one of MacFadden3s more reliable
operations# Mr# Reynolds had three reasons for wanting better returns than corporate
re%uirements# First, one of the &ey variables used in appraising management performance at
MacFadden was the growth of residual income, although such aspects as mar&et share and profit
margins were also considered#
+
Mr# Reynolds did not li&e the idea of investing in pro(ects that
were close to the target rate of earnings imbedded in the residual5income calculation#
Second, many new pro(ects had high start5up costs# =ven though they might achieve
attractive returns over the long run, such pro(ects hurt earnings performance in the short run#
>Don3t tell me what a pro(ect3s discount rate of return is0 tell me whether we3re going to improve
our return on total net assets within three years,? Mr# Reynolds would say# $hird, Mr# Reynolds
was s&eptical of estimates# >, don3t &now what3s going to happen here on this pro(ect, but ,3ll bet
we overstate returns by to < percent on average,? was a typical comment# )e therefore tended
to loo& for at least " percent more than the company standard before becoming enthusiastic about
a pro(ect# >@ou3ve got to be hard5nosed about ta&ing ris&,? he said# >1y demanding a decent
return for ris&ier opportunities, we have a better chance to grow and prosper#?
Mr# Soderberg &new that Mr# Reynolds3s views were reflected in decisions throughout the
division# 7ro(ects that did not have promising returns according to Mr# Reynolds3s standards
were often dropped or shelved early in the decision process# Mr# Soderberg guessed that at
Jacobs almost as many pro(ects with returns meeting the company hurdle rates were abandoned as
+Residual income was the division3s profit after allocated taxes minus a +!5percent capital charge on total
assets after depreciation#
$his case is based on the Jacobs Division prepared by 7rofessors Diana )arrington and Robert 8andell# $he case
has been updated and revised by 7rofessor Robert Conroy# $he case was written as a basis for class discussion
rather than to illustrate effective or ineffective handling of an administrative situation# Copyright !!/ by the
9niversity of 8irginia Darden School Foundation, Charlottesville, 82# 2ll rights reserved# To order copies, send
an e-mail to dardencases:virginia#edu# No part of this publication may be reproduced, stored in a retrieval
system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwise without the permission of the Darden School Foundation#
were ultimately approved# ,n fact, the pro(ects that were finally submitted to Mr# Reynolds were
usually so promising that he rarely re(ected them# Capital pro(ects from his division were
accepted virtually unchanged, unless top management happened to be unusually pessimistic about
prospects for business and financing in general#
!"e #ilicone$% Proect
2 new product was often under study for several years after research had developed a
>test tube? idea# $he product had to be evaluated relative to mar&et needs and competition# $he
large number of possible applications of any product complicated this analysis# 2t the same time,
technological studies were underta&en to examine such factors as material sources, plant location,
manufacturing5process alternatives, and economies of scale# 'hile a myriad of feasible
alternatives existed, only a few could be actively explored, and they often re%uired outlays of
several hundred thousand dollars before the potential of the pro(ect could be ascertained# >For
every dollar of new capital approved, , bet we spend *!#/! on the opportunities,? observed Mr#
Soderberg, >and that doesn3t count the money we spend on research#?

$he pro(ect that concerned Mr# Soderberg at the moment was called Silicone5A, a
special5purpose coating that added slipperiness to a surface# $he coating could be used on a
variety of products to reduce friction, particularly where other lubricants might imperfectly
eliminate friction between moving parts# ,ts uni%ueness lay in its hardness, adhesiveness to the
applied surface, and durability# $he product was li&ely to have a large number of buyers, but
most of them could use only small %uantitiesB only a few firms were li&ely to buy amounts greater
than <,!!! pounds per year#
$est5tube batches of Silicone5A had been tested both inside and outside the Jacobs
Division# Comments were universally favorable, although *#!! per pound seemed to be the
maximum price that would be acceptable# Cower prices were considered unli&ely to produce
larger volume# For planning purposes, a price of *+#-! per pound had been used#
Demand was difficult to estimate because of the variety of possible applications# $he
division3s mar&et5research group had estimated a first year demand of + to million pounds with
+# million cited as most li&ely# Mr# Soderberg commented, >$hey could spend another year
studying it and be more confident, but we wouldn3t find them more believable# $he estimates are
educated guesses by smart people# )owever, they are also pretty wild stabs in the dar&# $hey
won3t rule out the possibility of demand as low as <!!,!!! pounds, and million pounds is not
the ceiling#? Mr# Soderberg empathi6ed with the problem facing the mar&et5research group#
$hey tried to do a systematic (ob of loo&ing at the most probable applications, but the data were
not good#
$his case is based on the Jacobs Division prepared by 7rofessors Diana )arrington and Robert 8andell# $he case
has been updated and revised by 7rofessor Robert Conroy# $he case was written as a basis for class discussion
rather than to illustrate effective or ineffective handling of an administrative situation# Copyright !!/ by the
9niversity of 8irginia Darden School Foundation, Charlottesville, 82# 2ll rights reserved# To order copies, send
an e-mail to dardencases:virginia#edu# No part of this publication may be reproduced, stored in a retrieval
system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwise without the permission of the Darden School Foundation#
$he mar&et researchers believed that, once the product became established, average
demand would probably grow at a healthy rate, perhaps +! percent per year# )owever, the
industries served were li&ely to be cyclical with volume re%uirements swinging ! percent
depending on mar&et conditions# $he mar&et researchers concluded, >'e thin& demand should
level off after eight to ten years, but the odds are very much against someone developing a
cheaper or mar&edly superior substitute#?
Dn the other hand, there was no patent protection on Silicone5A, and the technological
&now5how involved in the manufacturing process could be duplicated by others in perhaps as little
as + months# >$his product is essentially a commodity, and someone is certainly going to get
interested in it when sales volume reaches */ million,? observed Mr# Soderberg#
$he cost estimates loo&ed solid# Mr# Soderberg continued, >1asic chemicals, of course,
fluctuate in purchase price, but we have a captive source with stable manufacturing costs# 'e can
probably negotiate a long5term transfer price with 'ilson Eanother MacFadden divisionF, although
this is not the time to do so#?
Proect &nalysis
,n his preliminary analysis, Mr# Soderberg used a discount rate of ! percent and a pro(ect
life of +< years, because most e%uipment for the pro(ect was li&ely to wear out and need
replacement during that time frame#
'e also wor& with most li&ely estimates# 9ntil we get down to the bitter end, there are
too many alternatives to consider, and we can3t afford probabilistic measures or fancy simulations#
2 conservative definition of most li&ely values is good enough for most of the subsidiary analyses#
'e3ve probably made over !! present5value calculations using our computer programs (ust to
get to this decision point, and heaven &nows how many %uic&5and5dirty paybac&s,? observed Mr#
Soderberg# >'e3ve made a raft of important decisions that affect the attractiveness of this
pro(ect# Some of them are bound to be wrong , hope not critically so# ,n any case, these
decisions are behind us# $hey3re buried so deep in the assumptions, no one can find them, and
top management wouldn3t have time to loo& at them anyway#?

'ith Silicone5A, Mr# Soderberg was down to a labor5intensive, limited5capacity approach
and a capital5intensive method# >$he analyses all point in one direction,? he said, >but , have the
feeling it3s going to be the worst one for the long run#?

$his case is based on the Jacobs Division prepared by 7rofessors Diana )arrington and Robert 8andell# $he case
has been updated and revised by 7rofessor Robert Conroy# $he case was written as a basis for class discussion
rather than to illustrate effective or ineffective handling of an administrative situation# Copyright !!/ by the
9niversity of 8irginia Darden School Foundation, Charlottesville, 82# 2ll rights reserved# To order copies, send
an e-mail to dardencases:virginia#edu# No part of this publication may be reproduced, stored in a retrieval
system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwise without the permission of the Darden School Foundation#
$he labor5intensive method involved an initial plant and e%uipment outlay of *-!!,!!!# ,t
could produce +#< million pounds per year# >=ven if the pro(ect bombs out, we won3t lose much#
$he e%uipment is very adaptable# 'e could find uses for about half of it# 'e could probably sell
the balance for *!!,!!!, and let our tax write5offs cover most of the rest# 'e should salvage the
wor&ing5capital part without any trouble# $he start5up costs and losses are our real ris&s,?
summari6ed Mr# Soderberg# >'e3ll spend *<!,!!! debugging the process, and we3ll be luc&y to
satisfy half the possible demand# )owever, , believe we can get this pro(ect on stream in one
year3s time#?
'("ibit ) shows Mr# Soderberg3s analysis of the labor5intensive alternative# )is
calculations showed a small net present value when discounted at ! percent and a si6able net
present value at . percent# 'hen the positive present values were compared with the negative
present values, the pro(ect loo&ed particularly attractive#
$he capital5intensive method involved a much larger outlay for plant and e%uipmentB */#/
million# Manufacturing costs would, however, be reduced by *!#/< per unit and fixed costs by
*+!!,!!!, excluding depreciation# $he capital5intensive plant was designed to handle #! million
pounds, the lowest volume for which appropriate e%uipment could be ac%uired# Since the
e%uipment was more speciali6ed, only *"!!,!!! of this machinery could be used in other company
activities# $he balance probably had a salvage value of *.!!,!!!# ,t would ta&e two years to get
the plant on stream, and the first year3s operating volume was li&ely to be low55perhaps G!!,!!!
pounds at the most# Debugging costs were estimated to be *+!!,!!!#
'("ibit 2 presents Mr# Soderberg3s analysis of the capital5intensive method# 2t a
!5percent discount rate, the capital5intensive pro(ect had a large negative present value and thus
appeared much worse than the labor5intensive alternative# )owever, at an .5percent discount
rate, it loo&ed significantly better than the labor5intensive alternative#
Problems in t"e &nalysis
Several things concerned Mr# Soderberg about the analysis# Mr# Reynolds would only loo&
at the total return# $hus the capital5intensive pro(ect would not be acceptable# @et, on the basis
of the brea&even analysis, the capital5intensive alternative seemed the safest way to start# ,t
needed sales of (ust /<,-!! pounds to brea& even, while the labor5intensive method re%uired
<"!,!!! pounds Hsee '("ibit 3I#
Mr# Soderberg was concerned that future competition might result in price cutting# ,f the
price per pound fell by *!#!, the labor5intensive method would not brea& even unless -!!,!!!
pounds were sold# Competitors could, once the mar&et was established, build a capital5intensive
$his case is based on the Jacobs Division prepared by 7rofessors Diana )arrington and Robert 8andell# $he case
has been updated and revised by 7rofessor Robert Conroy# $he case was written as a basis for class discussion
rather than to illustrate effective or ineffective handling of an administrative situation# Copyright !!/ by the
9niversity of 8irginia Darden School Foundation, Charlottesville, 82# 2ll rights reserved# To order copies, send
an e-mail to dardencases:virginia#edu# No part of this publication may be reproduced, stored in a retrieval
system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwise without the permission of the Darden School Foundation#
plant that would put them in a good position to cut prices by *!#! or more# ,n short, there was a
ris&, given the labor5intensive solution, that Silicone5A might not remain competitive# $he better
the demand proved to be, the more serious this ris& would become# Df course, once the mar&et
was established, Jacobs could build a capital5intensive facility, but almost none of the
labor5intensive e%uipment would be useful in such a new plant# $he new plant would still cost
*/#/ million, and Jacobs would have to write off losses on the labor5intensive facility#
$he labor5intensive facility would be difficult to expand economically# ,t would cost
*<!,!!! for each +!!,!!! pounds of additional capacity Honly practical in <!,!!!5pound
incrementsI# ,n contrast, an additional +!!,!!! pounds of capacity in the capital5intensive unit
could be added for *<,!!!#
$he need to expand, however, would depend on sales# ,f demand remained low, the
pro(ect would probably return a higher rate under the labor5intensive method# ,f demand
developed, the capital5intensive method would clearly be superior# $his analysis led Mr#
Soderberg to believe that his brea&even calculations were somehow wrong#
7ricing strategy was another important element in the analysis# 2t *+#-! per pound,
Jacobs could be inviting competition# Competitors would be satisfied with a low rate of return,
perhaps + percent, in an established mar&et# 2t a price lower than *+#-!, Jacobs might
discourage competition# =ven the labor5intensive alternative would not provide a rate of return of
! percent at any lower price# ,t began to appear to Mr# Soderberg that using a high discount
rate was forcing the company to ma&e a ris&ier decision than would a lower rate and was
increasing the chance of reali6ing a lower rate of return than had been forecast#
Mr# Soderberg was not sure how to incorporate pricing into his analysis# )e &new he
could determine what level of demand would be necessary to encourage a competitor, expecting a
<!5percent share and needing a + percent return on a capital5intensive investment, to enter the
mar&et at a price of *+#G!, or *+#-!, but this analysis did not seem to be enough#

Finally, Mr# Soderberg was concerned about the volatility of demand estimates on which
he had based the analysis# )e reviewed some analysts3 reports and found some information on
firms that were in businesses similar to SiliconeJA# 1ased on these firms3 stoc& mar&et returns he
estimated that the volatility of returns for this line of business was around #/<#
Mr# Soderberg3s (ob was to analy6e the alternatives fully and recommend one of them to
Mr# Reynolds# Dn the simplest analysis, the labor5intensive approach seemed best# =ven at !
percent, its present value was positive# $hat analysis, however, did not ta&e other factors into
consideration#
$his case is based on the Jacobs Division prepared by 7rofessors Diana )arrington and Robert 8andell# $he case
has been updated and revised by 7rofessor Robert Conroy# $he case was written as a basis for class discussion
rather than to illustrate effective or ineffective handling of an administrative situation# Copyright !!/ by the
9niversity of 8irginia Darden School Foundation, Charlottesville, 82# 2ll rights reserved# To order copies, send
an e-mail to dardencases:virginia#edu# No part of this publication may be reproduced, stored in a retrieval
system, used in a spreadsheet, or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwise without the permission of the Darden School Foundation#
=xhibit +
!*' J&C+B# D,-,#,+N 2003
2nalysis of Cabor5,ntensive 2lternative for Silicone5A
Hdollars in thousands, except per5unit dataI
@ear
! + / " < 5+<
,nvestments
7lant and e%uipment * -!!
'or&ing capital * +"! * +" * +< * +G * !
Demand Hthousands of poundsI +,!! +,/! +,"< +,<-G ;#2#
Capacity Hthousands of poundsI 4!! +,<!! +,<!! +,<!! +,<!!
Sales Hthousands of poundsI 4!! +,/! +,"< +,<!! +,<!!
Sales priceKunit *+#-! *+#-! *+#-! *+#-! *+#-!
8ariable costsKunit
Manufacturing +#/! +#/! +#/! +#/! +#/!
Mar&eting !#+! !#+! !#+! !#+! !#+!
$otal variable costsKunit +#"! +#"! +#"! +#"! +#"!
ContributionKunit !#<! !#<! !#<! !#<! !#<!
Contribution in dollars /!! 44! G4 G<! G<!
Fixed costs
Dverhead +! +! +! +! +!
Depreciation 4! 4! 4! 4! 4!
Start5up costs <! ! ! ! !
$otal fixed costs /! G! G! G! G!
7rofit before taxes H!I /-! "<4 ".! ".!
7rofit after taxes Htaxes :<!LI H+!I +-< . "! "!
Cash flow from operations
H7rofit after taxes M depreciationI <! << .. /!! /!!
$otal cash flow *H-!!I * H-!I * "+ * G/ * ./ .!
$erminal value Hyear +<I * /.+
;#2# N not available#
=xhibit
!*' J&C+B# D,-,#,+N 2003
2nalysis of Capital5,ntensive 2lternative for Silicone5A
Hdollars in thousands, except per5unit dataI
@ear
! + / " < 4 G 5+<

,nvestments
7lant and e%uipment * +,-!! * +,"!!
'or&ing capital * +4! * ++ * +G * ! * " * /!
Demand Hthousands of
poundsI +,/! +,"< +,<-G +,G<G +,-// ,+<
Capacity Hthousands of
poundsI G!! ,!!! ,!!! ,!!! ,!!! ,!!!
Sales Hthousands of poundsI G!! +,"< +,<-G +,G<G +,-// ,!!!
Sales priceKunit *+#-! *+#-! *+#-! *+#-! *+#-! *+#-!
8ariable costsKunit
Manufacturing !#-< !#-< !#-< !#-< !#-< !#-<
Selling !#+! !#+! !#+! !#+! !#+! !#+!
$otal variable costsKunit +#!< +#!< +#!< +#!< +#!< +#!<
ContributionKunit !#.< !#.< !#.< !#.< !#.< !#.<
Contribution in dollars <-< +,/" +,/<G +,"-/ +,4"/ +,G!!
Fixed costs
Dverhead ++! ++! ++! ++! ++! ++!
Depreciation +4G +4G +4G +4G +4G +4G
Start5up costs +!! ! ! ! ! !
$otal fixed costs /GG GG GG GG GG GG
7rofit before taxes +. -<G +,!.+ +,+G +,/44 +,"/
7rofit after taxes
Htaxes :<!LI +!- "G- <"! 4!. 4./ G+
Cash flow from operations
H7rofit after taxes M
depreciationI G4 4"4 G!G GG< .<! .G-
$otal cash flow *H+,-!!I *H+,"!!I * ++4 * 4/< * 4-! G<< * .4 ."-
$erminal value Hyear +<I *+,/."
=xhibit /
!*' J&C+B# D,-,#,+N 2003
1rea&even 2nalysis for Silicone5A
Cabor Capital
,ntensive ,ntensive
;ormal H*+#-! priceI
Fixed costs
Dperations *+!,!!! *++!,!!!
Depreciation 4!,!!! +4G,!!!
$otal *G!,!!! *GG,!!!
Contribution per unit *!#<! *!#.<
9nits to brea&even <"!,!!! /<,..
7rice Competitive H*+# G! priceI
Contribution per unit *!#/ *!#4<
9nits to brea&even -!!,!!! "4,+<"