If The Coat Fits, Wear It

The Innovative Sporting Goods Company (ISGC) was founded in 1975 in Cambridge, MA. Its Founder, Andy Pratt, a
mechanical engineers had developed a sound technique of making baseball bats. Under his leadership, the
company had gained national reputation. Recently, however, a new machine had been developed in the industry,
which would allow manufacturers to coat aluminum baseball bats with a compound giving them a satin finish and
making them more durable and powerful. The prototype had been presented to the respective regulatory
authorities and had been approved. Upon Andys request, Douglas Adams, the Head of design group, had tested
the new product and researched the relevant cost and production process issues that a machine replacement
would entail.
Dough Reported that besides the initial price tag of $ 350.000 for one of these machines, users would have to
incur shipping, handling, and installation costs of $ 4500 and annual fixed operating costs of about $20,000 per
machine. Currently, the company incurs fixed operating costs of $ 28,000 for its coating and finishing process.
Initial marketing survey results indicated that the company would be able to increase sales of its newly designed
baseball bats by about 15 % in the first year of introduction and there after at a rate of 5 % per year compared
with forecasted sales growth of 2 % per year for the current type of baseball bats. During the most recent year,
ISGC sold 220,000 baseball bats at an average price $ 12,50 per unit. The newly designed bat was expected to sell
for $ 13 per unit.
Material, labor, general, and administration costs were expected to remain constant at $ 10 per unit. The increased
sales and production requirement would entail an increase in accounts receivable of $ 54,000, an increase in
accounts payable of $ 30,000, and increase in inventory of $ 20,000. It was assumed that any increase in net
working capital would be recovered at the end of useful life of the machine, which was estimated to be 10 years.
The existing machine was purchased 5 years ago for $ 225,000. Currently, it could be sold for $ 100,000, with the
price expected to decline to about $ 10,000 after 10 more years of use. Depreciation on the existing machine was
calculated using a 15-year straight-line schedule with assumption of no residual salvage value. The new machine
was expected to last for ten years--the same as the remaining life of the old machine. The new machine would
qualify as a 5-year class life asset under MACRS depreciation rates ( see table 1) and was expected to have a
market value of approximately $ 20,000 at the end of its economic life. ISGC marginal tax rate was 34 %. And its
weighted average cost of capital was estimated at 15 %. Part of the cost of replacing the existing machine would
be financed by a bank loan that would require an annual interest expense of 10 % in the outstanding balance.Andy
knows that the new technology is the way to go. However, being cautious and conservative by nature, he does not
want to implement changes that would be financially detrimental to his company. After all, he has worked too hard
to let it all slip away by making lousy financial decisions. Andy has long believed in the age-old saving, If the coat
fits wear it

1. Your Supervisor, Vie Gonzales, has asked you to prepare a capital budgeting report indicating wheter ISGC
should replace the existing machine or not. Indicate how you would proceed ( without making any calculations).
Capital Budgeting is evaluated future cash flows in relation to cash put out today. One of the most important tasks
in capital budgeting is estimating future cash flows for a project. This case project stress that wheter should
replace the existing machine or not. . The firm will analyze in order to receiving cash return greater ammount
.consideration to capital budgeting according to Incremental basis. Because of cash flows, so that we expect from
a project in terms of cash flows rather the incomeI would to estimated from The difference Cash Inflows deduct to
cash outflows between using the existing machine with the new machine. The cash inflows obtained from ( Sales
price x volume of Sales ), in which price of the current product is $ 12.5 and new product is $ 13.00 and the
increase sales of its newly designed baseball bats by about 15 % in the first year of introduction and there after at
a rate of 5 % per year compared with forecasted sales growth of 2 % per year for the current type of baseball bats.
For the Cash Outflows obtained from all of cost associated from replacement, Material, labor, general, and
administration costs, and net working capital.
2. Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the context of this case.
Incremental Cash flows is cash flows incur regarding to situation with and without the new investment. The
Relevance of incremental cash flows is incremental cash inflows from diffence of sales price ( $ 13.00 per unit with
$ 12.5 per unit) and growth of sales ( thereafter at rate 5 % which call the difference of total Amount of sales and
Incremental cash outflows from cost of NWC (Net Working Capital), from the costs of new Machine and
maintenance with the existing machine.
3. As is often the case, the marketing department has overestimated the annual sales growth. How can more
conservative and realistic estimates be generated? How can these estimates be incorporated into the analysis so
as to arrive at a good and well-justified decision?
The marketing departments sales forecast is a good place to start. However, it is better for managers to consider

the overall market for baseball bats and accordingly estimate their niche. Also, various scenarios of growth (best
case, worst case, and most likely case) could be used to estimate the pro forma financial statements and analyze
them using the various evaluation techniques.
4. What are the relevant factors and items to be considered when estimating the initial outlay? Calculate the initial
outlay for this replacement project.
Relevant factors to be considered when estimating the initial outlay :
Purchasing price : $ 350,000
Shipping, handling, and installation cost of $ 4500
Sold existing machine price : $ 100,000
increase in accounts receivable of $ 54,000, an increase in accounts payable of $ 30,000, and increase in
inventory of $ 20,000.
(Net Working Capital)Calculating Initial Outlay: $ 350,000+4500+54,000-30,000+20,000-100,000 = $ 298,500

5. As a shrewd financial analyst you observe that the net working capital of the firm has typically been about 20%
of the annual revenues. How would you incorporate this observation into the analysis?
Net working capital (NWC) is the difference between firms current assets and its current liabilities. It reflects the
firms cushion available to meet short term obligations relative to annual sales. The NWC-to-sales ratio indicates
funds flowing in and flowing out of its current assets. When a firm has NWC of 20% of its annual revenues, it
means that for every dollar of annual sales, the firm has 20 cents of NWC to support it. A low rate of NWC-to-sales
ratio indicates the efficient use of current assets. However, a low rate of NWC-to-sales ratio can also indicate risk
arising from possibility inadequate short-term liquidity because. The economy and most industries are subject to
some degree of cyclicality in economic activity and liquidity that do not necessarily run exactly in tandem. In order
to assess the companys ability to meet peak needs, the analyst should consider the highest reasonable level of
sales that might be anticipated, couple it with the largest accounts receivable and longest inventory turnover
periods that might occur and assess the adequacy of the working capital under that scenario.
6. How should the annual interest expenses on the bank loan be handled? Explain.

The annual interest expenses should be ignored. This is done to avoid double counting the interest expense. The
after-tax cost of borrowing is included in the weighted average cost of capital or discount rate. By discounting the
cash flows to calculate the Net Present Value, interest costs are factored in.
7. What is the relevance of the terminal year cash flow? Which factors must be considered when estimating the
terminal year cash flow?
Relevant terminal year cash flows is residual values (salvage values) recovered from the project at the end of its
useful life. Factors that must be considered in estimating terminal year value is marginal tax rate,
8. After looking at the data provided by Vic, you realize that the revenue and cost figures have not been adjusted
for inflation. If inflation were expected to be at least 3% per year, what effect would this have on your analysis?
Adjust the data and recalculate the relevant cash flows.
If revenues and costs are adjusted upwards by the 3% inflation rate, the Net Present Value will typically increase
and the IRR will get larger. It is imperative that either nominal cash flows (adjusted upwards for inflation) be
discounted at the nominal discount rate (15%) or that the discount rate be adjusted downwards (into the real rate)
and then used to calculate the NPV of the unadjusted cash flows.
9. What recommendation would you make to Vic regarding the replacement of the old coating machine? Explain.
The costs is become lower and the demand will increase because customers will realize the competitive
advantages of the new product. Operationally, company may increase its sales through a good marketing mix or to
find the chance to make costs more efficient.
10. If the new machine has an economic life of 15 years while the current machine has a life of only 10 years, how
would the capital budgeting analysis have to be adjusted?
In effect, the interim cash flows would last for 5 additional years. The after-tax market value of the new machine
would have to be accounted for at the end of the 15th year, and the loss of market value of the old machine would
be a cash outflow in year 10. The recovery of net working capital would also be deferred until the 15th year. With
an economic life of 15 years, the NPV is still positive and IRR exceed the discount rate of 15%. Therefore, the
decision would remain unchanged.