Financial Management

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Chapter 7

Fundamentals of Capital Budgeting
7-1. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $20 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 40% will come from customers who switch to the new, healthier pizza instead of buying the original version. a. b. Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new pizza? Suppose that 50% of the customers who will switch from Pisa Pizza’s original pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this case? Sales of new pizza – lost sales of original = 20 – 0.40(20) = $12 million Sales of new pizza – lost sales of original pizza from customers who would not have switched brands = 20 – 0.50(0.40)(20) = $16 million

a. b.

7-2.

Kokomochi is considering the launch of an advertising campaign for its latest dessert product, the Mini Mochi Munch. Kokomochi plans to spend $5 million on TV, radio, and print advertising this year for the campaign. The ads are expected to boost sales of the Mini Mochi Munch by $9 million this year and by $7 million next year. In addition, the company expects that new consumers who try the Mini Mochi Munch will be more likely to try Kokomochi’s other products. As a result, sales of other products are expected to rise by $2 million each year. Kokomochi’s gross profit margin for the Mini Mochi Munch is 35%, and its gross profit margin averages 25% for all other products. The company’s marginal corporate tax rate is 35% both this year and next year. What are the incremental earnings associated with the advertising campaign?

A B C 1 Year 2 Incremental Earnings Forecast ($000s) 3 1 Sales of Mini Mochi Munch 4 2 Other Sales 5 3 Cost of Goods Sold 6 4 Gross Profit 7 5 Selling, General & Admin. 8 6 Depreciation 9 7 EBIT 10 8 Income tax at 35% 11 9 Unlevered Net Income

D
1 9,000 2,000 (7,350) 3,650 (5,000) (1,350) 473 (878)
$300

E
2 7,000 2,000 (6,050) 2,950 2,950 (1,033) 1,918

$250

©2011 Pearson Education, Inc. Publishing as Prentice Hall
$200 70 80 90 100 110 120 130 140 150

90

Berk/DeMarzo • Corporate Finance, Second Edition

7-3.

Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store. Which of the following should be included as part of the incremental earnings for the proposed new retail store? a. b. c. d. e. f. g. a. b. c. d. e. f. The cost of the land where the store will be located. The cost of demolishing the abandoned warehouse and clearing the lot. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead. The $10,000 in market research spent to evaluate customer demand. Construction costs for the new store. The value of the land if sold. Interest expense on the debt borrowed to pay the construction costs. No, this is a sunk cost and will not be included directly. (But see (f) below.) Yes, this is a cost of opening the new store. Yes, this loss of sales at the existing store should be deducted from the sales at the new store to determine the incremental increase in sales that...
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