NewsWire--OCTOBER 8, 1996

TOPIC : Capital Budgeting

SOURCE : "Pricing for Growth," Forbes, October 7, 1996, 50.

SYNOPSIS : This brief article describes the basic elements in a capital budgeting decision. A firm has the opportunity to take over production of a component used by one of its major customers. The customer currently makes this component itself. The article makes two interesting points and allows for development of a third. First, the analysis of this decision to produce a high gross profit margin product must reflect capital costs as well as operating costs (i.e., This is a capital budgeting decision, not an operating profit decision). Second, there is a pricing issue here. Your bid for the exclusive rights to this component has a lower bound based on the direct costs to manufacture and an upper bound based on the direct costs of other potential suppliers. finally, the article provides a simple ROE based analysis of the decision. This can easily be extended to a discounted cash flow approach.

DISCUSSION QUESTIONS:

1. The author makes a big point regarding the difference between margin analysis and a capital investment decision. What's the difference? How can an NPV or an IRR approach address his concerns regarding margin analysis?

2. How might you classify the risk of the future cash flows for a project such as this? (High? Low? Average?) Suppose the firm attached a required return, or hurdle rate, of 20% on this project and that it has a 20 year life and no expected salvage value. Given the other cash flow information in the article, what would the NPV and IRR for the project be? How do these analyses compare with the author's "return on capital" and "return on equity" assessments?

3. The analysis in the article and in the solution to question 2 includes some assumptions regarding the bid that the firm ultimately made for the production rights. Use your knowledge regarding the interpretation of NPV and other information in the article to explain the upper and lower boundaries for the bid.