You will use the following case study for this assignment:
Kunz, D., & Dow, B., III. (2010).
Cape Chemical: Capital budgeting issues (Links to an external site.)
. Journal of the International Academy for Case Studies, 16(5), 133-137.
Case Summary:
This case is primarily a capital budgeting expansion project for the company, Cape Chemical, which has done very well in the past in terms of sales and profits growth, and now needs to expand. Furthermore, the sudden withdrawal of one key competitor from the region has opened the opportunity for Cape Chemical to increase its market share. Unfortunately, the company was already operating at its maximum. So, the company needs to expand its work force and storage capacity and acquire more equipment. However, the company has no set process for capital expenditure evaluation in place. The company is unsure whether it should buy used or new equipment. Although the used equipment costs significantly less, it has an economic life of just three years, while the new equipment will last seven years.
Your task is to conduct a cash flow analysis for each alternative and provide recommendations to Cape Chemical. This case study has two sections; the first part looks at the weighted average cost of capital (WACC), and the second extends to capital budgeting. For this week, you are required to answer questions 4-8.
Your well-written draft should answer questions 4-8 and meet the following requirements:
- Be provided in one document in Word or a similar word processing program
- Provide at least one paragraph of supporting explanation in response to each question
- Provide an Excel spreadsheet with solutions to each question on a separate worksheet; formulas in the spreadsheet must be linked; each worksheet should be clearly labeled (e.g. “Question #4,” “Question #5,” etc.); and each spreadsheet should be embedded in the Word document
- Be formatted according to the CSU-Global Guide to Writing and APA (Links to an external site.)
See the Embedding Instructions for instructions on how to embed an Excel spreadsheet into a Word document.
page 20 Allied Academies International Conference
Reno, 2008 Proceedings of the International Academy for Case Studies, Volume 15, Number 2
CAPE CHEMICAL: CAPITAL BUDGETING ISSUES
David A. Kunz, Southeast Missouri State University
Benjamin L. Dow III, Southeast Missouri State University
dkunz@semo.edu
CASE DESCRIPTION
The primary subject matter of this case concerns the issues surrounding evaluation of capital
expenditures. Case provides a systematic approach to evaluating capital expenditures including a
review of alternative capital budgeting methods and the relationship between the cost of capital and
capital budgeting. The case requires students to have an advanced knowledge of accounting,
finance and general business issues thus the case has a difficulty level of four (senior level) or
higher. In particular, an understanding of capital budgeting practices and cost of capital issues is
necessary to solve the case. The case is designed to be taught in one class session of approximately
1.25 hours and is expected to require 3-4 hours of preparation time from the students.
CASE SYNOPSIS
The case tells the story of Ann Stewart, President and primary owner of Cape Chemical. By most
measures, the performance of Cape Chemical has been very good over the last three years.
Double-digit sales growth has been achieved, new product lines have been added and profits have
more than tripled. The growth has required the acquisition of equipment, expansion of storage
capacity and increasing the size of the work force.
The unexpected withdrawal of one of Cape Chemical’s competitors from the region has
provided the opportunity to increase its blended packaged goods sales. However, Cape Chemical’s
blending equipment is already operating at capacity. 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 of 1,400,000 gallons is necessary to meet
projected demand beyond the next three years. The firm has no systematic capital expenditure
evaluation process.
BACKGROUND
Cape Chemical is a relatively new regional distributor of liquid and dry chemicals,
headquartered in Cape Girardeau, Missouri. The company, founded by Ann Stewart, has been
serving southeast Missouri, southern Illinois, northeast Arkansas, western Kentucky and northwest
Tennessee for five years and has developed a reputation as a reliable supplier of industrial
chemicals. Stewart’s previous business experience provided her with a solid understanding of the
chemical industry and the distribution process. As a general manager for a chemical manufacturer,
Allied Academies International Conference page 21
Proceedings of the International Academy for Case Studies, Volume 15, Number 2 Reno, 2008
Stewart had profit and loss (P&L) responsibility, but until beginning Cape Chemical, she had limited
exposure to company accounting and finance decisions.
The company reported small losses during its early years of operation, but performance in
recent years has been very good. Sales have grown at double-digit rates, new product lines have
been added and profits have more than tripled. The growth has required the acquisition of additional
land, equipment, expansion of storage capacity and more than tripling the size of the work force.
Stewart has proven to be an expert marketer, and Cape Chemical has developed a reputation with
its customers of providing quality products and superior service at competitive prices.
Despite its business success, Cape Chemical is still a “large” small business with Stewart
making all important decisions. She recognized the need to develop a professional managerial staff,
particularly in the area of finance. Recently, she hired Kate Clarkson as the company’s first finance
professional and placed her in charge of the company’s accounting and finance activities. Cape
Chemical’s board of directors is composed of Stewart, her brother and the company’s attorney. The
board’s existence satisfies state regulatory requirements for corporations but provides no input to
business operations.
CHEMICAL DISTRIBUTION
A chemical distributor is a wholesaler. Operations may vary but a typical distributor
purchases chemicals in large quantities (bulk – barge, rail or truckloads) from a number of
manufacturers. They store bulk chemicals in “tank farms”, a number of tanks surrounded by dikes
to prevent pollution in the event of a tank failure. Tanks can receive and ship materials from all
modes of transportation. Packaged chemicals are stored in a warehouse. Other distributor activities
include blending, repackaging, and shipping in smaller quantities (less than truckload, tote tanks,
55-gallon drums, and other smaller package sizes) to meet the needs of a variety of industrial users.
THE SITUATION
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
page 22 Allied Academies International Conference
Reno, 2008 Proceedings of the International Academy for Case Studies, Volume 15, Number 2
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.
PROJECT EVALUATION PROCESS
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.
Weighted Average Cost of Capital (WACC)
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 equipment at an annual interest rate of 12% (before tax cost of debt). The bank would require
the loan 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.
Used Equipment
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 cost to 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).
Allied Academies International Conference page 23
Proceedings of the International Academy for Case Studies, Volume 15, Number 2 Reno, 2008
New Equipment
The acquisition of new equipment with the capacity to blend 1,600,000 gallons annually is
the second alternative. The new equipment would cost $360,000 to acquire with an installation cost
of $60,000 and have an economic life of seven years and a salvage value of $60,000. The new
equipment can be operated more efficiently than the used equipment. The cost to blend a gallon of
material is estimated to be $.17. The equipment will be depreciated under the MACRS 7-year class.
Under the current tax law, the depreciation allowances are 0.14, 0.25, 0.17, 0.13, 0.09, 0.09, 0.09
and 0.04 in years 1 through 8, 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).
REQUIREMENTS
Assume the role of a consultant, and assist Clarkson to answer the following questions.
1) Calculate Cape Chemical’s weighted average cost of capital (WACC). Note: round to the
nearest whole number. Discuss the theory used by Clarkson to determine Cape Chemical’s
optimum target capital structure (30% debt and 70% equity).
2) Since the used equipment will be financed with internal capital and the new equipment with
a bank loan, should the same discount rate be used to evaluate each alternative? Explain.
3) Explain why an accurate WACC is important to a firm’s long-term success.
4) Evaluate the strengths and weaknesses of the Cash Payback Period, Discounted Cash
Payback Period, NPV, IRR and MIRR capital expenditure budgeting methods. Prepare a
recommendation for Stewart regarding the capital budgeting method or methods to use in
evaluating the expansion alternatives. Support your answer.
5) Calculate the Cash Payback Period, Discounted Cash Payback Period, NPV, IRR and MIRR
for each alternative. For these calculations, assume a WACC of 15%. Based strictly on the
results of these methods, should either option be selected? Why? Solution requires
preparation of a spreadsheet.
6) Stewart is concerned that the projected annual sales growth rate of 15% for incremental
blended material may be optimistic. Recalculate the Cash Payback Period, Discounted Cash
Payback Period, NPV, IRR and MIRR for each alternative assuming the annual sales growth
rates of 10% and 5%. Assume a WACC of 15%. Does the change in growth rate alter the
recommendation made in question 5? Solution requires preparation of spreadsheets.
Explain.
7) The projected cash flow benefits of both projects did not include the effects of inflation.
Future cash flows were determined using a constant selling price and operating costs (real
cash flows). The cash flows were then discounted using a WACC that included the impact
of inflation (nominal WACC). Discuss the problem with using real cash flows and a
nominal WACC when calculating a project’s Discounted Payback Period, NPV, IRR and
MIRR.
page 24 Allied Academies International Conference
Reno, 2008 Proceedings of the International Academy for Case Studies, Volume 15, Number 2
8) What other issues should Stewart and Clarkson considered before a final decision regarding
the expansion alternatives is made?
REFERENCES
Brigham, Eugene and Joel Houston, “Fundamentals of Financial Management,” Concise 5th edition,
Thomson South-Western, a part of the Thomson Corporation, 2007.
Brigham, Eugene, and Michael Ehrhardt, “Financial Management: Theory and Practice,” 12th
edition, Thomson South-Western, a part of the Thomson Corporation, 2008.