The Super Project case mainly deals with the efficiency of project tool analysis in capital budgeting process. The three techniques that General Foods management used to determine whether Super Project was a worthwhile project were: •Incremental basis •Facilities-used basis •Fully allocated facilities and costs basis The three techniques mentioned above will be discussed in more details in question 4 below.
What are the relevant cash flows for General Foods to use in evaluating the Super project? In particular, how should management deal with issues such as: )Test-market expenses? b)Overhead expenses? c)Erosion of Jell-O contribution margin? d)Allocation of charges for the use of excess agglomerator capacity? Typically, when using Net Present Value (NPV) method to determine whether a project adds value to the organization, free cash flow is taken into consideration. Depreciation expense, a non-cash item, is to be added back to the operating profit after tax to give operating cash flow. Other expenses such as SG&A and fixed costs are to be included in operating cash flow calculation.
Change in net working capital (current assets – current liabilities) and capital expenditure are added to the operating cash flow to calculate free cash flow. Test-market expenses are usually considered as sunk costs, and thus, should not be included in the expenses category. Overhead expenses refer to ongoing expenses of operating a business and are fixed costs. We can see from Exhibit 3 that there was a substantial increase in the SG&A expenses from 1958 to 1967 of more than 100% increase. Therefore, overhead expenses should be counted towards expenses when calculating the free cash flow.
Twenty percent of the 10% expected Super volume would come from the erosion of Jell-O sales. Although we do not have any data indicating the impact of Super on Jell-O contribution margin, it is safe to assume that as in any new product launches, when cannibalization kicks in, the impact on existing product’s contribution margin should be quite substantial. In addition, Super fell into a profit-increasing project. The increase in Jell-O volume was 40% between August and September 1966. Coupled with the high growth expected for the Super project, excess agglomerator capacity might be needed sooner than later.
So, the allocation of charges for excess agglomerator capacity should be included. 2. How attractive is the investment as measured by various capital budgeting techniques (i. e. , ARR, Payback, IRR, NPV)? How useful are each of these measures of investment attractiveness? Accounting Rate of Return (ARR) is one of the methods used internally in an organization to select projects. The rate of return is simply calculated by dividing average operating profit by average investment. Its biggest advantage is that it is very easy to calculate.
In addition, with the operating profit numbers coming from the balance sheet of the company, ARR method adds credibility to the market because market follows accounting numbers closely. However, with balance sheet also comes the problem of accounting manipulation. The biggest drawback in ARR is that it does not account for time value of money. Longer term forecasts are not adjusted properly with the level of risks involved. As a result, it tends to favour higher risk decisions. Payback period is a method used to determine how much time is needed to recover initial investment of a project.
It is calculated by dividing the cost of the project by annual cash inflows. The shorter the payback period, the better the project is. Similar with ARR, the method is easy to use. However, the method does not adjust for the risks involved and also ignores time value of money. The Internal Rate of Return (IRR) of a project is the interest rate that will yield net present value of zero. In other words, it is the discount rate at which the present value of a series of investments is equal to the present value of the returns of those investments.
When IRR of a project is higher than WACC (weighted cost of capital) of the organization, the project should be financially viable and thus, accepted. A project may have more than one IRR, especially when returns of an investment yield negative cash flows following positive cash flows. Net Present Value (NPV) calculates the sum of discounted future cash flows and subtracting that amount with the initial investment of the project. If the NPV of a project results in a positive number, the project should be undertaken.
It is the most widely used method of capital budgeting. While discount rate used in NPV is typically the organization’s WACC, higher risk projects would not be factored in into the calculation. In this case, higher discount rate should be used. An example of this is when the project to be undertaken happens to be an international project where the country risk is high. Therefore, NPV is usually used to determine if a project will add value to the company. Another disadvantage of NPV method is that it is fairly complex compared to the other methods discussed earlier.
While NPV method may be a more accurate way in capital budgeting process, it is worthwhile to note that because of the longer time it takes to generate the data (using the proper discount rate, for example), other easier and simpler methods like payback and ARR can be used as initial rough guides in the process. 3. How attractive is the Super project in strategic and competitive terms? What potential risks and benefits does General Foods incur by either accepting or rejecting the project? Super project is expected to capture 10% share in the total dessert market.
From Table A, it can be seen that the powder market, which Super is properly categorized into, grew at around 62% between August and September 1966. With projected 10% market share in a fast-growing powder market, Super project strategically is very attractive for General Foods Corporation. In addition, Super project is a profit-increasing initiative, which would indicate that Super is definitely very competitive in the market. The profit-generating Super project may come from the incremental cost of the excess agglomerator capacity.
Currently, the capacity is under-utilized and Super project may take advantage of the excess capacity to generate sales and profits. However, when business picks up both in the Jell-O and powder markets (growths of 40% and 62% respectively), General Foods will need to invest in more capital in the long-run. Nevertheless, Super project is still an attractive project to undertake for General Foods Corporation. 4. Should General Foods proceed with the project? It was General Foods’ policy that new projects should be evaluated based on two criteria, payback and ROFE (Return on Funds Employed).
The general rule of thumb is that the project should have payback period of up to 10 years and minimum ROFE of 20%. General Foods management used three different techniques in determining whether they should invest in the Super Project. The simplest is incremental basis, where the project is evaluated based on incremental revenue and investment. However, Super project would extensively utilize the existing facilities that could otherwise be used for alternative uses. As a result, incremental basis would overestimate the ROFE.
It was estimated that the ROFE would yield 63% under this method. Since Super project would utilize half of the existing agglomerator capacity and two-thirds of the existing building, facilities-used basis method would involve adding these costs to Super accordingly. This method yielded ROFE of 34%. Fully allocated basis added more overhead expenses and capital to Super project, on the basis that after year 5 of the whole 10-year evaluation period, more fixed costs and facilities would have to be incurred.
This was more of a conservative approach for General Foods upper management to see how much returns, if at all, they would reap from a project. This method would give 25% ROFE. It is clear that from the three techniques briefly discussed above, General Foods management should proceed with Super project. At the end of the day, the three techniques, each with its own limitations, served as sensitivity analysis to upper management regarding the Super Project. In this case, the ‘worst’ case scenario from Super project would yield the company 25% ROFE, which was still higher than the company policy of 20%.
However, the downside to these three techniques is that they ignore time value of money. The case was written in 1960s, where the concept of NPV was still unknown at the time. Therefore, it would be interesting to see how Super would perform using the NPV method. A challenge, in this case, is determining the proper discount rate for General Foods because of limited information in the case. Nevertheless, another sensitivity analysis can be done with different discount rates to find out if Super project is indeed profitable.
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