Danforth & Donnalley Laundry Products Company
Determining Relevant Cash Flows
At 3:00 p.m. on April 14, 2010, 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 1993 with the merger of Danforth
Chemical Company (producer of Lift-Off detergent, the leading
laundry detergent on the West Coast) and Donnalley Home Products
Company (maker 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 powder detergent. Each line
brought with it considerable brand loyalty; and, by 2010, sales
from the two detergent lines had increased ten-fold from 1993
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 4 years researching and developing a new, highly concentrated
liquid laundry detergent. D&D’s new detergent, which they
call Blast, had many obvious advantages over the conventional
powdered products. The company felt that Blast offered the consumer
benefits 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 participants included James Danforth, president
of D&D; Jim Donnalley, director of the board; Guy Rainey,
vice-president in charge of new products; Urban McDonald,
controller; and Steve Gasper, a newcomer to the D&D 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 insights
Exhibit 1: D&D Laundry Products Company Forecast of Annual
Cash Flows from the Blast Product (Including cash flows
resulting from sales diverted from the existing product lines.)
Year Cash flows Year Cash flows
1 $280,000 9 $350,000
2 280,000 10 350,000
3 280,000 11 250,000
4 280,000 12 250,000
5 280,000 13 250,000
6 350,000 14 250,000
7 350,000 15 250,000
8 350,000
| Capital Budgeting
Exhibit 2 D&D Laundry Products Company Forecast of Annual
Cash Flows from the Blast Product (Excluding cash 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
as to how these calculations were determined. Rainey proposed
that the initial cost for Blast include $500,000 for the test marketing,
which was conducted in the Detroit area and completed in
June of the previous year, 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 would be a result of sales that had been diverted
from Lift-Off and Wave. For this reason, Rainey also produced
the estimated 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 was 10%. Gasper then questioned the fact that no costs
were included in the proposed cash budget for plant facilities that
would be needed to produce the new product.
Rainey replied that, at the present time, Lift-Off’s 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 would need to be acquired for the
production of the new product line. It was estimated that full production
of Blast would only require 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 project would
require $200,000 of additional working capital; however, as this
money would never leave the firm and would always be in liquid
form, it was not considered an outflow and hence not included in
the calculations.
Donnalley argued that this project should be charged something
for its use of current excess plant facilities. His reasoning
was that if another firm had space like this and was willing to rent
it out, it could charge somewhere in the neighborhood of $2 million.
However, he went on to acknowledge that D&D had a strict
policy that prohibits renting or leasing any of its production facilities
to any party from outside the firm. If they didn’t 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 question
of what to do about the lost contribution from other projects,
the test marketing costs, and the working capital.
Questions
1. If you were put in the place of Steve Gasper, would you argue
for the cost from market testing to be included in a cash
outflow?
2. What would your opinion be as to how to deal with the question
of working capital?
3. Would you suggest that the product be charged for the use
of excess production facilities and building space?
4. 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 was a chance of
competitors introducing a similar product if you did not introduce
Blast, would this affect your answer?
5. If debt were used to finance this project, should the interest
payments associated with this new debt be considered
cash flows?
6. What are the NPV, IRR, and PI of this project, both including
cash flows resulting from sales diverted from the existing
product lines (Exhibit 1) and excluding cash flows resulting
from sales diverted from the existing product lines (Exhibit 2)?
Under the assumption that there is a good chance that competition
will introduce a similar product if you don’t, would you
accept or reject this project?
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