Case 1 Solved
A Capital Budgeting Decision — Gillette
Prepared by
Ray Kerlagon
The following capital budgeting situation is up for review. Things to consider include:
Identification of incremental cash flows.
Any working capital requirements and/or sunk costs.
What is the appropriate capital budgeting technique?
How should we address risk?
What is the cost of capital?
What is the project’s IRR?
PROJECT DEFINITION:
A market research study was conducted in 1997 at a cost of $1,500,000 that indicates a high receptivity among the 30,000,000 American males for a new Gillette shaving razor. Research indicates that between 5% - 12% of the target market would purchase the razor. Marketing has stated that your analysis should assume that only 10% of the target market is penetrated. The research also indicated that out of every 10 new razors sold, only 3 of the purchasers (30% of sales) would have purchased an existing Gillette razor if the new razor had not been available. The cost of the study was expensed in 1997. The new razor will require the purchase of some manufacturing equipment this year, 1998, at a cost of $9,000,000, and it will be straight-line depreciated over 3 years beginning next year - 1999; no other new equipment is required. If authorized, Gillette would introduce the razor in 1998 and sales are projected to grow as follows:
2000 would have an increase of 5% over 1999
2001 would have an increase of 10% over 2000
2002 would have an increase of 15% over 2001
Through numerous meetings with Marketing, Engineering, Treasury, and Accounting departments, you have determined the following information:
New razor
Price - $8.00 - will be constant over life of study
Fixed costs per year (excluding depreciation) - $1,000,000
Variable cost per razor - $3.50
Existing razor
Price - $5.00 - will be constant over life of study
Variable cost per razor - $1.75
Tax bracket 35%
Capital structure:
Debt $60,000,000 @ 10% coupon
Equity $40,000,000 @ 14% cost
Total
Prepared by
Ray Kerlagon
The following capital budgeting situation is up for review. Things to consider include:
Identification of incremental cash flows.
Any working capital requirements and/or sunk costs.
What is the appropriate capital budgeting technique?
How should we address risk?
What is the cost of capital?
What is the project’s IRR?
PROJECT DEFINITION:
A market research study was conducted in 1997 at a cost of $1,500,000 that indicates a high receptivity among the 30,000,000 American males for a new Gillette shaving razor. Research indicates that between 5% - 12% of the target market would purchase the razor. Marketing has stated that your analysis should assume that only 10% of the target market is penetrated. The research also indicated that out of every 10 new razors sold, only 3 of the purchasers (30% of sales) would have purchased an existing Gillette razor if the new razor had not been available. The cost of the study was expensed in 1997. The new razor will require the purchase of some manufacturing equipment this year, 1998, at a cost of $9,000,000, and it will be straight-line depreciated over 3 years beginning next year - 1999; no other new equipment is required. If authorized, Gillette would introduce the razor in 1998 and sales are projected to grow as follows:
2000 would have an increase of 5% over 1999
2001 would have an increase of 10% over 2000
2002 would have an increase of 15% over 2001
Through numerous meetings with Marketing, Engineering, Treasury, and Accounting departments, you have determined the following information:
New razor
Price - $8.00 - will be constant over life of study
Fixed costs per year (excluding depreciation) - $1,000,000
Variable cost per razor - $3.50
Existing razor
Price - $5.00 - will be constant over life of study
Variable cost per razor - $1.75
Tax bracket 35%
Capital structure:
Debt $60,000,000 @ 10% coupon
Equity $40,000,000 @ 14% cost
Total