Question

Crispy Snacks produces a variety of salty snack foods. Its main competitor, Chips Inc., has just introduced a new product that threatens several of Crispy’s big sellers. A product manager at Crispy has just proposed a new product to protect those sales. The new product – code name Pirate Chow – will use excess capacity on existing production lines. Some new packaging equipment will be purchased, largely financed with an 8% bank loan. Here is how Crispy’s financial team plans to evaluate the project.

“Cash flows for Pirate Chow must include an overhead allocation for the use of the equipment and the interest expense on the 8% loan. Since Pirate Chow will erode sales of existing product lines, we will reduce Pirate Chow revenues by 10% when computing cash flows. The wear-and-tear of the existing equipment requires that Pirate Chow be assigned some portion of the equipment’s depreciation expense. The risk of this project seems moderate so we will set a 4-year payback acceptance criterion for it.”

There are five errors about capital budgeting in the preceding paragraph. Identify these five mistakes and explain in a sentence or two either why they are wrong and/or what the correct approach should be.

Answer 1

Error 1 :

Cash flows analysis should not include overhead allocation because such allocation is not incremental to the acceptance of the project (as the excess capacity is being used).

Error 2 :

Interest expense should not be included in the cash flow analysis because interest is a financing cash flow and not an operating cash flow. The effect of interest expense is considered when calculating the cost of capital.

Error 3 :

Reducing revenues by 10% is incomplete. The reduction in cash flows due to erosion of existing sales should be calculated, and not simply the reduction in revenues.

Error 4 :

Excess capacity is being used, hence the depreciation and the depreciation tax shield should not be considered.

Error 5 :

To incorporate the effects of risk, the cost of capital should be adjusted. Payback period does not consider the risk of the project.