Net Present Value and Cash
Need to consider what types and which cash flows should be included in capital budgeting analysis. D&D was producing and marketing two major product lines: 1. Lift-Off: Low –suds, concentrated powder. 2. Wave: Traditional powder detergent. Questions & Answers: . If you were in Steve Gasper’s place, would you argue to include the cost from market testing as a cash outflow? If I’m Steven Gasper’s I would not include the cost from market testing as a cash outflow. The reason is because the cost from market testing was considered as sunk costs. A sunk cost is an outlay that has already occurred, hence by decision under consideration would not been affected by the costs. Since sunk costs are not incremental cost they should not be included in the analysis.
In this case initial cost for Blast, $500,000 for test marketing, which was conducted in the Detroit area and completed in the previous June was consider as a sunk cost and it will not affect Danforth & Donnalley Laundry future cash flows regardless of whether or not the new branch is built.
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2. What would your opinion be as to how to deal with the question of working capital? Working capital management deals with the management of current assets which are inventories, payroll, and other cash needs and receivables from customers, account receivable, and also procedures financing these assets.
In our opinion, have two basic questions involves in working capital policy: (i) What is the appropriate amount of current assets for the firm to carry both in total and for each specific account and (ii) How should current asset be financed. Therefore, the most important element in best buys working capital policy is its inventory management. Refer to the Danforth & Donnalley laundry, McDonald suggest to add another $200,000 in working capital, because they estimate this money would never leave the firm and would always be in liquid form, for the first time; it consider outflow but hence inflow.
In our opinion, some additional cash is required to conduct operations in D&D laundry because additional some cash is needed in order to reserve for some contingency, or as a “parking place” for funds prior to an acquisition, a major capital investment program, or the like. That concept has been applied to more complex businesses, where it is used to analyze the effectiveness of a firm’s working capital management. Under relaxed current assets policy, D&D laundry would hold relatively large amounts of each type of current asset and under a restricted current assets policy; company would hold minimal amounts of these items.
Current assets are necessary, but there are costs associated with holding them. Therefore, if D&D can manage its current assets more efficiently and thereby operate with smaller investment in working capital; this will increase D&D laundry profitability. 3. Would you suggest that the product be charged for the use of excess production facilities and building? Would this opinion change under the hypothetical assumption that needed production facilities for the current line of powdered detergents were at 55 percent of capacity and expected to grow at a rate 20 percent a year and maximum production capacity was 100 percent?
What would be the present value of this cash flow given the fact that the currently proposed new plant would involve cash outflows of $5 million in three years (assuming that acceptance of the Blast project would not affect the size of the proposed outlay, only the timing, and that the new plant and facilities would be operable indefinitely). (Hint: Assume that the introduction of Blast would only move the need for a new plant ahead by one year, that the cash outflow would remain at $5 million regardless of when incurred, and that the plant would operate indefinitely. In our opinion, the excess usage of production facilities and building would not be charge into Blast.
The reasons of this are:- a) When the machine was bought for Lift-Off productions the cost has been calculated; and b) In obtaining the machine and building for Blast productions no cash payment has been made. Since the production of Blast will occupy current excess capacity, no incremental cash flows are incurred; hence, none should be charged against Blast.
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 that competition would introduce a similar product were D&D to fail to introduce Blast, would this affect your answer? Yes, it should be treat as an incremental cash flow for the reduction in the sales of the Lift-Off and Wave, referred to as erosion. These lost sales are included because it a cost (a revenue reduction) that the company must bear if it choose to produce the new product (Blast).
It will not affect our answer if there was a chance that competition would introduce a similar product at time D&D fail to introduce Blast. This happen due to the fact that for constructs cash flow we ignore the competitor effect. 5. If debt is used to finance this project, should the interest payments associated with this new debt be considered cash flows? No. We discount project cash flows with a cost of capital that is the rate of return required by all investors (not just debt holders or stockholders), and so we should discount the total amount of cash flow available to all investors.