The Xavier Motor Company makes outdoor power equipment including lawn mowers and garden tractors and is considering two diversification ventures. The first involves manufacturing a larger, more powerful tractor than the firm has made up until now. Market research indicates a substantial demand for more powerful equipment, and some competitors are already moving in that direction. The second opportunity involves building snowblowers.
The manufacturing and engineering technology required for making snowblowers is essentially the same as that for building garden equipment, but Xavier has never made snowblowers before. Management wants to make a decision based on only five years of projected cash flows, because it feels the future beyond that time is too vague to form a basis for current decisions. In other words, if a project isn’t expected to earn enough to justify itself in five years, management considers it too risky.
Working with representatives from the marketing, engineering, and manufacturing departments, a financial analyst has put together a set of projected incremental cash flows for each project. Xavier’s cost of capital is 9%.
A financial analysis of the project situation should provide answers to the following questions.
a. If these projects were being considered on a stand-alone basis, would either or both be acceptable?
b. If Xavier can raise no more than $5 million for new projects, which of these projects should be chosen?
c. If Xavier’s management is willing to consider two more years of projected cash flow, and the contributions continued at the level of the last two years, which project would be chosen?
d. Are any risk considerations relevant beyond the numbers in this situation?