Eric Griffey, manager of the Celebes Products Division of the Dudley Company is trying to decide whether to launch a new model of food blender,
Erin Griff, manager of the Cal Division of the N Corp is trying to decide whether to launch a new model of blender, BF87.
Griff is particularly excited about this proposal because it calls for producing the product in the company’s old plant at St. Franc, Griff’s home town.
During the last recession, N Corp had to shut down this plant and lay off its workers, many of whom had grown up with Griff and were his friends.
Griff had been very upset when the plant was closed down.
If BF87 were produced in the new plant, most of the laid-off workers would be rehired.
Griff asks Ann Chan, the management accountant of the Cal Division to analyze the BF87 proposal.
Through the years the company has found that its products have a useful life of 6 years, after which the product is dropped and replaced by another new product.
Chan gathers the following data:
a. BF87 will require new special-purpose equipment costing $900,000.
The useful life of the equipment is 6 years, with a $140,000 estimated terminal disposal price at that time.
However, the income tax authorities will not allow a write-off based on a life shorter than 9 years.
Therefore, the new equipment would be written off over 9 years for tax purposes, using the straight-line depreciation method and assuming a zero terminal disposal price.
b. The old plant has a book value of $250,000 and is being depreciated on a straight-line basis at $25,000 annually.
The plant is currently being leased to another company.
This lease has 6 years remaining at an annual rental of $45,000.
The lease contains a cancellation clause whereby the landlord can obtain immediate possession of the premises upon payment of $30,000 cash (fully deductible for income tax purposes).
c. Certain nonrecurring market-research studies and sales-promotion activities will amount to a cost of $300,000 at the end of year 1.
The entire amount is deductible in full for income tax purposes in the year of expenditure.
d. Additions to working capital will require $200,000 at the outset and an additional $200,000 at the end of 2 years.
This total is fully recoverable at the end of 6 years.
e. Net cash inflow from operations before depreciation and income taxes are expected to be $400,000 in years 1 and 2, $600,000 in years 3-5, and $100,000 in year 6.
The after-tax required rate of return is 12%.
The income tax rate is 36%.
REQUIRED DISCUSSION QUESTIONS:
1. Use a net present-value analysis to determine whether Chan should recommend launching BF87.
2. Chan learns that the working capital required will be twice the amounts estimated in the preceding analysis.
All other data remain unchanged.
She revises her analysis and presents it to Griff.
Griff is very unhappy with what he sees.
He tells Chan “Try different assumptions and redo your analysis. I have no doubt that this project should be worth pursuing on financial grounds.”
Chan is aware of Griff’s interest in supporting his home-town community.
There is also the possibility that Griff may be hired as a consultant by the new plant management after he retires next year.
Why is Griff unhappy with Chan’s revised analysis?
How should Chan respond to Griff’s suggestions?
Identify the specific steps that Chan should take to resolve this situation.