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 ProductsCompany (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 productswere 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 linebrought with it considerable brand loyalty; and, by 2010, sales from the two detergent lines had increased ten-fold from 1993levels, 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 concentratedliquid 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 consumerbenefits 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 possiblymatch. 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 1and 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

I           $280,000           9          $350,000

2          280,000             10         350,000

3          280,000             I I         250,000

4          280,000             12         250,000

5          280,000             13         250,000

6          35 0,000            14         250,000

7          350,000             15         250,000

8          350,000

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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

I           $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.

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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 includingcash 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?