The Super Project
Introduction
General Foods (GF) expects Super, a new powdered dessert, to capture 10% share of the total dessert market (2% coming from the erosion of Jell-O sales). The company’s Financial Analyst has issued a memo comparing three alternative techniques for project evaluations, illustrating the problems and limitations inherent in using ROFE (return on funds employed) and payback as evaluation methods. The disparate ROFE results obtained with these methods are due to differences in the allocation of excess capacity from Jell-O equipment and overhead costs.
Problem Statement: How should GF allocate excess capacity and overhead costs in their evaluations of capital investments for profit increasing projects?
Other
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In relation to the Super project, GF must account for the excess capacity that would be use by Super, ignore overhead and sunk costs, and use the incremental cash flow analysis method. Following this criteria, and assuming an interest rate of 10% we recommend that the Super Project be rejected because its NPV is -$438,11 < 1. Super project could only be accepted with a discount of 2.50% or less, where NPV will be positive. Only at this rate could GF deliver value to shareholders for the capital investment in this project.
APPENDIX B - Assumptions
1. All cash flows occur at the end of the year. 2. All periods are equal (one full year). 3. (1) Sales revenue: Based on Net Sales (line 25) of Exhibit 6, assuming Deductions come from purchase/early payment discounts or bad debt adjustments. 4. Equipment: Consists of: $120,000 (Super Project packaging equipment), 2/3 of $200,000 existing Jell-O building and 1/2 of $640,000 existing JellO agglomerator. 5. (2) Operating costs include COGS and Advertising Costs. 6. (3) Opportunity costs are based on Adjustments (line 34) of Exhibit 6, representing erosion of Jell-O profits (this figure was specified as representing the incremental adverse effect of the proposed project on other products). 7. (4) CCA and Depreciation:
CCA used for new equipment and machinery, based on Class 8 rate (20%), assuming CCA classes and rates were the same in 1968 and
Free cash flows of the project for next five years can be calculated by adding depreciation values and subtracting changes in working capital from net income. In 2010, there will be a cash outflow of $2.2 million as capital expenditure. In 2011, there will be an additional one time cash outflow of $300,000 as an advertising expense. Using net free cash flow values for next five years and discount rate for discounting, NPV for the project comes out to be $2907, 100. The rate of return at which net present value becomes zero i.e.
After evaluating the Super Project for General Foods, the two main things that management needed to address were the relevant incremental and non-incremental cash flows discussed below and incorporate the NPV and the net cash flows (yearly) to make a decision on whether to accept or reject the project. The start-up costs were determined by splitting up the costs of $160,000 in 1967 and $40,000 in 1968. To calculate the yearly cash flows, I used year 1 through 10, and the gross profit was calculated by subtracting out relative cash flows and the before tax depreciation. The NPV of $169,530 is positive for the 10% discount rate, which is less than the IRR of 11.4%.
Allocation of charges for the use of excess agglomerator capacity – As this was accounted for already as part of the evaluation criteria for the Jell-o project this should not be included
Super Project will eat into the Jell-O Sales and this must be taken as a cost for the project when making the final decision.
General Foods is a large corporation organized by product lines. They are evaluating Super Project, the manufacture of a new powdered dessert. Crosby Sanberg, a financial analysis manager, must determine the value in accepting the proposal, along with J.C. Kresslin, the Corporate Controller. The Super Project will increase profit with a payback period of less than ten years. The proposed capital investment for the project is $200,000 ($80,000 for building modifications and $120,000 for machinery and equipment) and production would take place
A. The company needs to focus on the free cash flows instead of the accounting profits since these are the funds flow the company will receive and will be able to reinvest. By examining the cash flows they will be adapt to predict the profits and/or expenses timetable. The company’s interests in these cash flows are on an after-tax basis since they are part of the shareholders dividends. Additionally, the additional cash flows are of important, because, after analyzing the project while viewing the company as a whole, the additional cash flows are seen as minimal benefits and will show the elevated value to the company if the decision is made to implement the project.
After analyzing all given information about how GLY Construction allocate their general overhead, it seems that GLY first determines the ratio of general overhead to the total revenue in order to get the required amount of money to operate the corporation smoothly in a year, which is common used method. Furthermore, it depends on how many construction
iii. Can this project be financed with current cash flow from the company? Why or why not?
Sales for the year will be consistent with the previous year (only a small decrease)
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:
The required interest rate which would return an NPV of zero is 9.22%. This is less than the cost of capital of 10%.
In the case of Worldwide Paper Company we performed calculations to decide whether they should accept a new project or not. We calculated their net income and their cash flows for this project (See Table 1.6 and 1.5). We computed WPC’s weighted average cost of capital as 9.87%. We then used the cash flows to calculate the company’s NPV. We first calculated the NPV by using the 15% discount rate; by using that number we calculated a negative NPV of $2,162,760. We determined that the discount rate of 15% was out dated and insufficient. To calculate a more accurate NPV for the project, we decided to use the rate of 9.87% that we computed. Using this number we got the NPV of $577,069. With the NPV of $577,069 our conclusion is to accept this
Given our recommendation to accept the new investment opportunity, this project will impact the forecasted financial statements from 2010 onwards. Please refer to Exhibits 6 and 7 for the revised projections.
The use of an accounting rate of return also underscores a project 's true future profitability because returns are calculated from accounting statements that list items at book or historical values and are, thus, backward-looking. According to the ARR, cash flows are positive due to the way the return has been tabulated with regard to returns on funds employed. The Payback Period technique also reflects that the project is positive and that initial expenses will be retrieved in approximately 7 years. However, the Payback method treats all cash flows as if they are received in the same period, i.e. cash flows in period 2 are treated the same as cash flows received in period 8. Clearly, it ignores the time value of money and is not the best method employed. Conversely, the IRR and NPV methods reflect that The Super Project is unattractive. IRR calculated is less then the 10% cost of capital (tax tabulated was 48%). NPV calculations were also negative. We accept the NPV method as the optimal capital budgeting technique and use its outcome to provide the overall evidence for our final decision on The Super Project. In this case IRR provided the same rejection result; therefore, it too proved its usefulness. Despite that, IRR is not the most favorable method because it can provide false results in the case where multiple negative
period (based on operating schedules and budgets) in terms of materials used, labor cost, and overhead cost, and then determining how much of this production, if any, was used to build up