Essay Instructions: Intermediate Accounting I – Case Study ACC404 (2009A)
CASE STUDY Instruction : Please answer all questions. All questions carry equal marks. Please note that the layout of your answer to the questions should be in the form of long essays.
DANFORTH & DONNALLEY LAUNDRY PRODUCTS COMPANY
On April 14, 1993, at 3:00 p.m., 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 1968 with the merger of Danforth Chemical Company, headquartered in Seattle, Washington, producers of Lift-Off detergent, the leading laundry detergent on the West Coast, and Donnalley Home Products Company, headquartered in Detroit, Michigan, makers 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 products were in direct competition, they were not without product differentiation: Lift-Off was a low-suds, concentrated powder, and Wave was a more traditional powdered detergent. Each line brought with it considerable brand loyalty, and by 1993, sales from the two detergent lines had increased tenfold from 1968 levels, 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 four years researching and developing a new, highly concentrated liquid laundry detergent. D&D’s new detergent, which they called Blast, had many obvious advantages over the conventional powdered products. It was felt that with Blast the consumer would benefit 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 possibly match. 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 was attended by James Danforth; Jim Donnalley, director of the board; Guy Rainey, vice-president in charge of new products; Urban McDonald, controller; and Steve Gasper, a newcomer to D&D’s 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 1 and 2). In support of this information, he provided some insight as to how these calculations were determined. Rainey proposed that the initial cost for Blast included $500,000 for the test marketing, which was conducted in the Detroit area and completed in the previous June, and $2 million for new specialized equipment and packaging facilities.
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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 are a result of sales that had been diverted from Lift-Off and Wave. For this reason, Rainey also produced the 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 is 10%. Gasper then questioned the fact that no costs were included in the proposed cash budget for plant facilities, which would be needed to produce the new product.
EXHIBIT 1.
D&D Laundry Products Company Annual Cash Flows from the Acceptance of Blast (Including flows resulting from sales diverted from the existing product lines)
Year Cash Flows Year Cash Flows
1 $280,000 9 350,000
2 280,000 10 350,000
3 280,000 11 250,000
4 280,000 12 250,000
5 280,000 13 250,000
6 350,000 14 250,000
7 350,000 15 250,000
8 350,000
EXHIBIT 2.
D&D Laundry Products Company Annual Cash Flows from the Acceptance of Blast (Not including those flows resulting from sales diverted from the existing product lines)
Year Cash Flows Year Cash Flows
1 $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
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 other than the specialized equipment and packaging facilities
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previously mentioned need be acquired for the production of the new product line. It was estimated that full production of Blast would require only 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 always would be in liquid form, it was not considered an outflow and hence was not included in the calculations.
Donnalley argued that this project should be charged something for its use of the current excess plant facilities. His reasoning was that, if an outside firm tried to rent this space from D&D, it would be charged somewhere in the neighborhood of $2 million, and since this project would compete with the current projects, it should be treated as an outside project and charged as such; however, he went on to acknowledge that D&D has a strict policy that forbids the renting or leasing out of any of its production facilities. 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 questions of what to do about the "lost contribution from other projects," the test marketing costs, and the working capital.
QUESTIONS
1. If you were put in the place of Steve Gasper, would you argue for the cost from market testing to be included as a cash outflow?
2. Would you suggest that the product be charged for the use of excess production facilities and building?
3. 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 were chances of competition introducing a similar product if you do not introduce Blast, would this affect your answer?
