The Baldwin Company
We consider the example of a proposed investment in machinery and related items. Our
example involves the Baldwin Company and colored bowling balls.
The Baldwin Company, originally established in 1965 to make footballs, is now a leading
producer of tennis balls, baseballs, footballs, and golf balls. In 1973 the company
introduced “High Flite”, its first line of high-performance golf balls. The Baldwin
management has sought opportunities in whatever businesses seem to have some
potential for cash flow. In 1999 W.C. Meadows, vice president of the Baldwin Company,
identified another segment of the sports ball market that looked promising and that he felt
was not adequately served by larger manufacturers. That market was for brightly colored
bowling balls, and he believed a large number of bowlers valued appearance and style
above performance. He also believed that it would be difficult for competitors to take
advantage of the opportunity because of Baldwin’s cost advantages and because of its
ability to use its highly developed marketing skills.
As a result, in late 2000 the Baldwin Company decided to evaluate the marketing
potential of brightly colored bowling balls. Baldwin sent a questionnaire to consumers in
three markets: Philadelphia, Los Angeles, and New Haven. The results of the three
questionnaires were much better than expected and supported the conclusion that the
brightly colored bowling ball could achieve a 10- to 15-percent share of the market. Of
course, some people at Baldwin complained about the cost of the test marketing, which
was $250,000. However, Meadows argued that it was a sunk cost and should not be
included in project evaluation.
In any case, the Baldwin Company is now considering investing in a machine to produce
bowling balls. The bowling balls would be produced in a building owned by the firm and
located near Los Angeles. This building, which is vacant, and the land can be sold to net
$150,000 after taxes. The adjusted basis of this property, the original purchase price of
the property less depreciation, is zero.
Working with his staff, Meadows is preparing an analysis of the proposed new product.
He summarizes his assumptions as follows: The cost of the bowling ball machine is
$100,000. The machine has an estimated market value at the end of five years of $30,000.
Production by year during the five-year life of the machine is expected to be as follows:
5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units. The price of bowling
balls in the first year will be $20. The bowling ball market is highly competitive, so
Meadows believes that the price of bowling balls will increase at only 2 percent per year,
as compared to the anticipated general inflation rate of 5 percent. Conversely, the plastic
used to produce bowling balls is rapidly becoming more expensive. Because of this,
production cash outflows are expected to grow at 10 percent per year. First-year
production costs will be $10 per unit. Meadows has determined, based upon Baldwin’s
1
taxable income, that the appropriate incremental corporate tax rate in the bowling ball
project is 34 percent.
Net working capital is defined as the difference between trade receivables and
inventories on the one hand and trade payables and personnel payables on the other hand.
Baldwin finds that it must maintain an investment in working capital. Like any
manufacturing firm, it will purchase raw materials before production and sale, giving rise
to an investment in inventory. It will maintain cash as a buffer against unforeseen
expenditures. Its credit sales will generate accounts receivable. Management believes that
the investment in the different items of working capital totals $10,000 in year 0, rises
somewhat in the early of the project, and falls to $0 by the project’s end. In other words,
the investment in working capital is completely recovered by the end of the project’s life.
Projections based on these assumptions and Meadow’s analysis appear in Tables 7.1 and
7.2. In these tables all cash flows are assumed to occur at the end of the year. Because of
the large amount of data in these tables, it is important to see how the tables are related.
Table 7.1 shows the basic data for depreciation, whereas table 7.2 provides an additional
schedule on net working capital. Our goal is to obtain projections of cash flow.
Table 7.1 – Depreciation for the Baldwin Company
Recovery Period Class
Year 3 Years 5 Years 7 Years
1 $ 33,340 $ 20,000 $14,280
2 44,440 32,000 24,490
3 14,810 19,200 17,490
4 7,410 11,520 12,500
5 11,520 8,920
6 5,760 8,920
7 8,920
8 4,480
Total $100,000 $100,000 $100,000
These schedules are based on the IRS publication Depreciation. Details on depreciation are presented in the
appendix. Three-year depreciation actually carries over four years because the IRS assumes you purchase
in midyear.
Table 7.2 – Net working capital for the Baldwin Company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Net working capital 10 10 16,32 24,97 21,22 0
(in 000$)
Discount rate (WACC) = 10%
Copyright © 2002 by the McGraw-Hill Companies. All rights reserved.
