Reference no: EM131942992

The unexpected withdrawal of one of Cape Chemical’s competitors from the region has provided the opportunity to increase its blended packaged goods sales. That's the good news. The bad news is Cape Chemical’s blending equipment is operating at capacity, thus to take advantage of this opportunity, additional equipment must be obtained, requiring a major capital investment. It is estimated that Cape Chemical must increase its annual blending capacity by 800,000 gallons to meet expected demand for the next three years Annual capacity must increase by 1,400,000 gallons to meet projected demand beyond the next three years.Stewart is considering two alternatives proposed by the company’s engineer. The first is the acquisition and installation of used equipment that will provide the capacity to blend an additional 800,000 gallons annually. The used equipment will cost $105,000 to acquire and $15,000 to install. The equipment is projected to have an estimated life of three years. The second option is the acquisition and installation of new equipment with the capacity to blend 1,600,000 gallons annually. The new equipment would have a substantially higher cost of $360,000 to acquire and $60,000 to install, but have a higher capacity and an economic life of seven years. The new equipment is also more efficient thus the cost of blending is less than the blending cost of the used equipment. Stewart asked Clarkson to lead the evaluation process.Stewart thinks the used equipment could be obtained without a new bank loan. The acquisition of the new equipment would require new bank borrowing.The evaluation of each alternative will require an estimate of the financial benefits associated with each. The marketing and sales staff estimated incremental sales of blended package material will be 600,000 gallons the first year and increase by 15% each year thereafter.During the last year, the average selling price for blended material has been near $4.05 per gallon and material cost (not including a cost for blending the material) has been approximately $3.53. The marketing staff anticipates no significant change in either future selling prices or product costs; however they do estimate variable selling and administrative expenses associated with the increased blended material sales to be $.20 per gallon.The company has no formal process for evaluating capital expenditure projects. In the past Stewart had reviewed investment alternatives and made the decision based on her “informal” evaluation. Clarkson plans to develop a formal capital budgeting process using the Cash Payback Period, Discounted Cash Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR) evaluation methods. She will need to educate Stewart on the superiority of a formal evaluation process using these methods.Using input from an investment banking firm, Clarkson estimates the company's cost of equity to be 18%. Their bank has indicated a long-term bank loan can be arranged to finance the new equipmentatanannualinterestrateof12%(beforetaxcostofdebt). Thebankwouldrequiretheloan to be secured with the new equipment. The loan agreement would also include a number of restrictive covenants, including a limitation of dividends while the loans are outstanding. While long-term debt is not included in the firm's current capital structure, Clarkson believes a 30% debt, 70% equity capital mix would be appropriate for Cape Chemical. Last year, the company's federal-plus-state income tax rate was 30%. Clarkson does not expect the income tax rate to change in the foreseeable future.The used equipment will cost $105,000 with another $15,000 required to install the equipment. The equipment is projected to have an economic life of three years with a salvage value of $9,000. The equipment will provide the capacity to blend an additional 800,000 gallons annually. The variable blending cost is estimated to be $.20 per gallon. The equipment will be depreciated under the Modified Accelerate Cost Recovery System (MACRS) 3-year class. Under the current tax law, the depreciation allowances are 0.33, 0.45, 0.15, and 0.07 in years 1 through 4, respectively. The increased sales volume will require an additional investment in working capital of 2% of sales (to be on hand at the beginning of the year).

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