CF Assignment Case Study

PRACTICE CASE.
ERIE CHEMICAL COMPANY
Dr. Christian Larson, Chief of Research at Erie Chemical Company, was contemplating a proposal
submitted to him by Dr. Francesca Michaels, head of the Garden Products Lab. Her request was to
purchase some new equipment to perform operations currently being performed on different, less
efficient equipment. The purchase price was $300,000 delivered and installed.
Background
Erie Chemical Company was a diversified conglomerate, specializing in consumer products. It was
located on the shores of Lake Erie in Cleveland, Ohio, and had been in existence for some 40 years.
Although it manufactured a variety of products for homeowners, its distinguishing specialty was
garden products, where it prided itself on having the latest in technology and up-to-date facilities, and
where it conducted state-of-the-art research. Because of the rapid changes taking place in the field of
garden products, maintaining the company’s cutting-edge position required constant upgrading of its
facilities and equipment. In recent years, with the advent of environmental regulation, there had been
increasing pressures on the company’s profits. Because of this, the company’s senior management
was taking an increasingly hard look at all capital equipment proposals.
The Request
Dr. Michaels had worked closely with the equipment manufacturer to determine the potential
benefits of the new equipment. She estimated that it would result in annual savings of $60,000 in
labor and other direct costs, as compared with the present equipment. She also estimated that the new
equipment’s economic life would be 10 years, with zero salvage value.
The company had recently borrowed long-term to finance another project. Paul Hershey, Erie’s Chief
Financial Officer, had informed Dr. Larson that, because of this, he was certain the company could
obtain additional funds at 12 percent, although he would not plan to negotiate a loan specifically for
the purchase of Dr. Michaels’ equipment. He did feel, however, that an investment of the type Dr.
Michaels was proposing should have a return of at least 20 percent.
Complicating Factors
There were three complications associated with the proposed investment. First, the present
equipment was in good working order and probably would last, physically, for at least 8 more years.
Second, the request was for what Dr. Michaels called “even better equipment,” to replace some
equipment purchased two years ago involving the same projected economic life and dollar amounts.
Dr. Michaels had informed Dr. Larson that the new equipment would render the existing equipment
completely obsolete with no resale value. The third complicating factor had arisen at a recent board
meeting, when the chairman of the board’s finance committee had discussed some inconsistencies
between Erie’s capital structure and the 20 percent rate of return that Mr. Hershey was
recommending. The finance committee chairman had pointed out that Erie’s shareholder equity and
retained earnings had no interest charges. As a result, he thought the proper discount rate to use for
capital investment proposals was not 20 percent, but only about 5 percent, as shown below:
The Decision
Although funds were available to finance Dr. Michaels’ proposed new equipment purchase, Dr.
Larson and Mr. Hershey were both concerned about the mistake made two years ago, and wanted to
be sure that a similar mistake would not be made again.
Assignment
1. What is the proposal’s net present value, using a discount rate of 20 percent? 5 percent?
2. What is the proposal’s internal rate of return?
3. What is the appropriate discount rate to use? Why?
4. If the company decides to purchase the new equipment for Dr. Larson, a mistake has been made somewhere,
because good equipment bought only two years ago is being scrapped. How did this mistake come about?
5. What non-quantitative factors should the company consider in making this decision? How important are
they? Would it make a difference if the proposal were for new technology rather than replacement of existing
technology? If it were for new technology with the same dollar amounts, but in the Maintenance Department?
Why?

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PRACTICE CASE.

ERIE CHEMICAL COMPANY

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