Academic journal article Journal of the International Academy for Case Studies

Cape Chemical: Capital Budgeting issues.(Instructor's Note)

Academic journal article Journal of the International Academy for Case Studies

Cape Chemical: Capital Budgeting issues.(Instructor's Note)

Article excerpt

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 workforce.

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.

INSTRUCTORS' NOTES

Case Use

The case as written includes discussion questions to aid the student in their analysis of Cape Chemical's current financial position. The case can be made more difficult by omitting the discussion questions. The case can be made easier by including partially completed schedules to aid the students in their calculations.

Case Overview

As the case opened Ann Stewart, the President of the Cape Chemical, a regional chemical distributor, headquartered in Cape Girardeau, Missouri, is considering the opportunity to increase its blended packaged goods sales. The company'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 of 1,400,000 gallons is necessary 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 cost $360,000 to acquire and $60,000 to install and have an economic life of seven years. The new equipment is more efficient thus the cost to blend is less than the blending cost of the used equipment. Stewart asked Kate Clarkson, the newly hired financial officer, to lead the evaluation process. The company does not have a formal evaluation process for capital projects.

Clarkson thinks the used equipment could be obtained without new bank debt. The acquisition of the new equipment would require new bank borrowing. …

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