Prairie Winds Pasta – Capital Budgeting Methods & Cash Flow Estimation
Summary of Case
Prairie Winds Pasta is experiencing a high demand for pasta from its customers. The customers demand delivery with in one week with a maximum allowance of 10 days. The facility is running at full capacity - 24 hours a day.
Define the term “incremental cash flow.” Since the project will be financed in part by debt, should the cash flow statement include interest expense? Explain. Response:
Incremental cash flows is the difference between the cash flows a company will have if it implements the new project versus the cash flows the company will have if they choose not to embark on the project. Cash flows not attributable to the new project are irrelevant to the investment decision making process. Comparing the two cash flows will show how much better or worse off the company may be by implementing the new project. Even though the project will be financed partially by debt, the cash flow statement should exclude interest expense. Interest expense is related to the cost of financing the project. It is the general principle of capital budgeting analysis to separate the investment or capital budgeting and financing decisions so that the capital budgeting evaluation of a project can be made independently of the financing costs.
Questions 2 through 11 relate to the initial decision of adding the second pasta machine: Question 2
What is Prairie Winds Pasta’s Year 0 net investment outlay for the new pasta equipment expansion project? (Hint: Use Table 1 as a guide) Response:
|Net Investment | | | |Outlay: | | | |Equipment cost |$40,000,000 | |Freight | |250,000 | |Installation |115,000 | |Change in NWC |2,000 | | | |$40,367,000 |
The initial investment is $ 40,365,000, which is the total of the equipment cost, freight, and installation. The $2,000 change in NWC is the cost of the spare parts, that is not part of the initial cost of investment but is inventory held in case of maintenance/break down.
Since Prairie Winds already owns space in the production facility, is this space “free” or “costless” from the standpoint of the additional pasta machine? Explain how the $100,000 in annual rent the company currently receives for space in the facility should be included in the analysis. Response:
The $100,000 a year would be an opportunity cost should Prairie Winds decide to use its space. This cost should be considered in the analysis of the new expansion because Prairie Winds will forgo rental income of $100,000 to pursue expansion.
The addition of competing product lines with a cheaper grade of pasta has been raised. What additional concerns about the high-grade pasta machine must be considered if the company decides to introduce a competitive pasta product to its existing offerings? What if it were believed that if Prairie Winds did not introduce the cheaper product, a competing firm would develop a very similar product? How would Prairie Winds’ decision to purchase the new high-grade pasta machine be affected? Response:
The company needs to be concerned about the possible effects (both positive and negative) if the cheaper grade of pasta is introduced to the current product line. If Prairie Winds decides to introduce the cheaper grade of pasta, this new product line would be competing against their current high grade pasta. If the introduction of the cheaper grade pasta reduces the sales of the high grade pasta, this reduction ins...
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