Chapter 17 Does Debt Policy Matter? 447
bre44380_ch17_436-459.indd 447 10/05/15 12:52 PM
Reeby Sports is considering launch of a carbon-fiber Bocce shoe. The product will require
investment of $500,000 in up-front marketing expenses and $500,000 for new equipment.
George Reeby prepares a simple spreadsheet for the new product’s expected five-year life and
discounts at Reeby Sports’ normal 10% cost of capital.^5
EXAMPLE 17.2 ● Reeby Sports’ Bocce Project
(^5) Reeby Sports has massive tax losses carried forward from the disastrous recession of 2020. Therefore George’s cash-flow projections
assume no taxes and ignore depreciation tax shields.
Bocce Shoe Proposal
Cash Flow ($1,000s)
Investment ($1,000s)^12345
Marketing – 500 + 270 + 270 + 270 + 270 + 270
Equipment – 500
Total –1,000
NPV at 10% = +24, or $24,000
IRR = 10.9%
A NPV of $24,000 on a $1 million investment is okay but no great shakes. George hesitates,
then calls the equipment salesperson to cancel Reeby Sports’ order. The salesperson, anxious
to keep her sale, offers to let Reeby Sports buy the equipment now and pay later. She asks
whether George will commit to five fixed payments of $122,000 per year. She argues that this
will reduce the up-front investment and improve profitability. George revises his spreadsheet:
Now George is inclined to go ahead—the NPV and IRR look much better—but Jenny, his
investment-banker daughter, points out that the manufacturer is really just lending $500,000
to Reeby Sports at the same 7% interest rate that Reeby Sports would pay to a bank. She
explains that the manufacturer would advance $500,000 now in exchange for later fixed pay-
ments totaling 5 × 122,000 = $610,000 undiscounted. The payments are obligatory, just like
debt service on a bank loan. The effective interest rate is 7%. (You can check that the IRR to
the manufacturer from agreeing to payment by installments is 7%.)
Jenny chides her father for mixing up investment and financing decisions. She upbraids
him for forgetting about the financial risk created by a debt-financed equipment purchase. She
berates him for discounting the cash flows of $148,000 per year (after installment payments)
Bocce Shoe Proposal (Revised)
Cash Flow ($1,000s)
(Fixed payments of $122,000 per year subtracted)
Investment ($1,000s)^12345
Marketing – 500 + 270 + 270 + 270 + 270 + 270
Equipment 0 – 122 – 122 – 122 – 122 – 122
Total – 500 + 148 + 148 + 148 + 148 + 148
NPV at 10% = +61, or $61,000
IRR = 14.7%