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MINICASE
Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company
confidential envelope. It contained a draft of a competitive bid for a
contract to supply duffel canvas to the U.S. Navy. The cover memo
from Sheetbend's CEO asked Mr. Tar to review the bid before it
was submitted.
The bid and its supporting documents had been prepared by
Sheetbend's sales staff. It called for Sheetbend to supply 100,000
yards of duffel canvas per year for 5 years. The proposed selling
price was fixed at $30 per yard.
Mr. Tar was not usually involved in sales, but this bid was
unusual in at least two respects. First, if accepted by the navy, it
would commit Sheetbend to a fixed-price, long-term contract. Sec-
ond, producing the duffel canvas would require an investment of
$1.5 million to purchase machinery and to refurbish Sheetbend's
plant in Pleasantboro, Maine.
Mr. Tar set to work and by the end of the week had collected the
following facts and assumptions:

The plant in Pleasantboro had been built in the early 1900s and is

now idle. The plant was fully depreciated on Sheetbend's books,
except for the purchase cost of the land (in 1947) of $10,000.

Now that the land was valuable shorefront property, Mr. Tar
thought the land and the idle plant could be sold, immediately
or in the near future, for $600,000.

Refurbishing the plant would cost $500,000. This investment
would be depreciated for tax purposes on the 10-year MACRS
schedule.

The new machinery would cost $1 million. This investment
could be depreciated on the 5-year MACRS schedule.

The refurbished plant and new machinery would last for many
years. However, the remaining market for duffel canvas was
small, and it was not clear that additional orders could be
obtained once the navy contract was finished. The machinery
was custom-built and could be used only for duffel canvas. Its
secondhand value at the end of 5 years was probably zero.

Table 9-4 shows the sales staff's forecasts of income from the
navy contract. Mr. Tar reviewed this forecast and decided that
its assumptions were reasonable, except that the forecast used
book, not tax, depreciation.

But the forecast income statement contained no mention of
working capital. Mr. Tar thought that working capital would
average about 10% of sales.
Armed with this information, Mr. Tar constructed a spreadsheet
to calculate the NPV of the duffel canvas project, assuming that
Sheetbend's bid would be accepted by the navy.
He had just finished debugging the spreadsheet when another
confidential envelope arrived from Sheetbend's CEO. It con-
tained a firm offer from a Maine real estate developer to pur-
chase Sheetbend's Pleasantboro land and plant for $1.5 million
in cash.
Should Mr. Tar recommend submitting the bid to the navy at
the proposed price of $30 per yard? The discount rate for this proj-
ect is 12%.

Year: 1 2 3 4 5
1. Yards sold 100.00 100.00 100.00 100.00 100.00
2. Price per yard 30.00 30.00 30.00 30.00 30.00
3. Revenue (1 ?? 2) 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00
4. Cost of goods sold 2,100.00 2,184.00 2,271.36 2,362.21 2,456.70
5. Operating cash flow (3 ?? 4) 900.00 816.00 728.64 637.79 543.30
6. Depreciation 250.00 250.00 250.00 250.00 250.00
7. Income (5 ?? 6) 650.00 566.00 478.64 387.79 293.30
8. Tax at 35% 227.50 198.10 167.52 135.72 102.65
9. Net income (7 ?? 8) $422.50 $367.90 $311.12 $252.07 $190.65
TABLE 9-4 Forecast income statement for the U.S. Navy duffel canvas project (dollar
figures in thousands, except price per yard)
Notes:
1. Yards sold and price per yard would be fixed by contract.
2.
Cost of goods includes fixed cost of $300,000 per year plus variable costs of $18 per yard. Costs
are expected to
increase at the inflation rate of 4% per year.
3.
Depreciation: A $1 million investment in machinery is depreciated straight-line over 5 years
($200,000 per year).
The $500,000 cost of refurbishing the Pleasantboro plant is depreciated straight-line over 10
years ($50,000
per year).
(Breasley. Fundamentals of Corporate Finance + Standard and Poor's Educational Version of
Market Insight, 6th Edition. Irwin/McGraw-Hill/MBS, 092008. 294).


Should Mr. Tar recommend submitting the bid to the navy at the proposed price of $30 per year?
Or should Mr.Tar recommend the company pursue it's next best alternative? Please prepare a
memo to Sheetbend's CEO with a recommendation providing supporting information on all
aspects of your analysis.


The spreadsheet on the next page shows the cash flows associated with the project.
Rows 1 10 replicate the data in Table 9-4, with the exception of the substitution of MACRS
depreciation for straight-line depreciation.
Row 12 (capital investment) shows the initial investment of $1.5 million in refurbishing the plant
and buying the new machinery.
When the project is shut down after five years, the machinery and plant will be worthless. But
they will not be fully depreciated. The tax loss on each will equal the book value since the
market price of each asset is zero. Therefore, tax savings in year 5 (rows 14 and 15) equals:
0.35 book value (i.e., original investment minus accumulated depreciation)
The investment in working capital (row 13) is initially equal to $300,000, but in year 5, when the
project is shut down, the investment in working capital is recouped.
If the project goes ahead, the land cannot be sold until the end of year 5. If the land is sold for
$600,000 (as Mr. Tar assumes it can be), the taxable gain on the sale is $590,000, since the land
is carried on the books at $10,000. Therefore, the cash flow from the sale of the land, net of tax
at 35%, is $393,500.
The total cash flow from the project is given in row 17. The present value of the cash flows, at a
12% discount rate, is $716,400.
If the land can be sold for $1.5 million immediately, the after-tax proceeds will be:
$1,500,000 [0.35 ($1,500,000 $10,000)] = $978,500
So it appears that immediate sale is the better option.
However, Mr. Tar may want to reconsider the estimate of the selling price of the land five years
from now. If the land can be sold today for $1,500,000 and the inflation rate is 4%, then perhaps it
makes more sense to assume it can be sold in 5 years for:
$1,500,000 1.04
5
= $1,825,000
In that case, the forecasted after-tax proceeds of the sale of the land in five years increases to
$1,190,000, which is $796,500 higher than the original estimate of $393,500; the present value of
the proceeds from the sale of the land increases by:
$796,500/1.12
5
= $452,000
Therefore, under this assumption, the present value of the project increases from the original
estimate of $716,400 to a new value of $1,168,400, and in this case the project is more valuable
than the proceeds from selling the land immediately.

Year 0 1 2 3 4 5
1. Yards sold 100.00 100.00 100.00 100.00 100.00
2. Price per yard 30.00 30.00 30.00 30.00 30.00
3. Revenue 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00
4. Cost of goods sold 2,100.00 2,184.00 2,271.36 2,362.21 2,456.70
5. Operating cash flow 900.00 816.00 728.64 637.79 543.30
6. Depreciation on machine* 200.00 320.00 192.00 115.20 115.20
7. Depreciation on Plant** 50.00 90.00 72.00 57.60 46.10
8. Income (5 6 7) 650.00 406.00 464.64 464.99 382.00
9. Tax at 35% 227.50 142.10 162.62 162.75 133.70
10. Net Income 422.50 263.90 302.02 302.24 248.30
11. Cash flow from operations 672.50 673.90 566.02 475.04 409.60

12. Capital investment 1,500.00
13. Investment in wk cap 300.00 300.00
14. Tax savings on machine 20.16
15. Tax savings on plant 64.51
16. Sale of land (after tax) 393.50
17. TOTAL CASH FLOW 1,800.00 672.50 673.90 566.02 475.04 1,187.77

*5-yr MACRS depreciation 0.2000 0.3200 0.1920 0.1152 0.1152
**10-yr MACRS depreciation 0.1000 0.1800 0.1440 0.1152 0.0922
We compare the NPV of the project to the value of an immediate sale of the land. This treats the
problem as two competing mutually exclusive investments: sell the land now versus pursue the
project. The investment with higher NPV is selected. Alternatively, we could treat the after-tax
cash flow that can be realized from the sale of the land as an opportunity cost at year 0 if the
project is pursued. In that case, the NPV of the project would be reduced by the initial cash flow
given up by not selling the land. Under this approach, the decision rule is to pursue the project if
the NPV is positive, accounting for that opportunity cost. This approach would result in the
same decision as the one we have presented.