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Unformatted text preview: ELEMENTS OF MODERN FINANCE - MGCR-641
THE SUPER PROJECT
J. Alejandro Noboa
February 03, 2006 EXECUTIVE SUMMARY
1. Is General Foods using the proper capital budgeting methods in evaluating their
2. Should General Foods invest in the Super project? In evaluating the Super
Project, what are the relevant cash flows to use? In particular:
• Test market Expenses
• Overhead Expenses
• Erosion of Jell-O contribution margin
• Allocation of charges for the use of excess agglomerator capacity
• Evaluation Methods – NPV, IRR, Payback, Alternative 1, 2, or 3
o Test Market Expenses – Include or Exclude
o Overhead Expenses – Include or Exclude
o Erosion of Jell-O contribution margin – Include or Exclude
o Allocation of charges for the use of excess capacity – Include or Exclude
• Accept or Reject the Super Project
1. NPV is the best capital budgeting method for evaluating projects.
2. Do not include test market expenses as they are sunk costs.
3. Include only incremental overhead expenses specific to the project.
4. General Foods should account for erosion of Jell-O margin as this reflects
incremental costs of the project.
5. Account for allocation of charges for the use of excess capacity as an
6. Reject Super Project as it has a negative NPV. ANALYSIS
Capital Budgeting Techniques
The first issue that General Foods needs to address is their capital budgeting techniques.
General Foods currently uses ROFE and payback (depending on the type of project)
and both methods are flawed, possibly leading to faulty capital budgeting decisions.
We must also address each of the alternative methods as proposed by Crosby
The use of the payback method for evaluating new projects has several flaws. The first is
that it ignores the cash flows that occur after the payback time; second it does not
account for the time value of money and thus is not consistent with the objective of the
firm to maximize value.
Among the 3 proposed alternatives concerning the evaluation of the Super Project,
Alternative 1 (Incremental Basis) is flawed due to the fact that it does not include the
costs associated with the use by the Super Project of the idle capacity from the Jell-O
project (the building space and the processing capacity of the Jell-O agglomeration
machinery). These costs should be included as they are opportunity costs (see below)
so the decision to consider them sunk costs in alternative 1 is incorrect. Moreover,
alternative 1 does not consider any of the incremental overhead costs incurred as a
result of accepting the Super Project, therefore not recognizing all cash flows.
Alternative 2 (Facilities-Used Basis) correctly recognizes the opportunity cost for the idle
capacity, but does not consider the future overhead charges. Again this alternative
fails to consider all cash flows and is not a strong method for making capital budgeting
Alternative 3 (Fully Allocated Basis) is the most complete and correct alternative listed
by Sanberg, as it takes into account both of these elements. However, this alternative
includes the test marketing expenses, which as mentioned above are sunk costs and
should be excluded.
Superior methods used for evaluating the attractiveness of a single new project are the
Net Present Value (NPV) and the Internal Rate of Return (IRR). Based on these
alternatives, NPV should be used for capital budgeting purposes as it recognizes all
relevant cash flows, takes into consideration the time value of money, discounts at the
opportunity cost and is consistent with the objective of the firm for maximizing value.
Cash Flows Discussion
The test market expenses of $360,000 should be considered a sunk cost and not
included in the calculations when evaluating the Super Project. These costs have
already been incurred and cannot be recovered if the project is rejected. Including
sunk costs in capital budgeting leads to faulty decisions. (See Appendix 1 for an
example). The Super Project Page 1 In general, the overhead expenses of the company as a whole should not be allocated
into the capital budgeting decision for the Super Project. If these costs will be incurred
by General Foods regardless of whether the Super Project is accepted or rejected; they
are not incremental and should be treated as sunk costs, similar to the test market
expense above. However, as in this case, if during the project overhead expenses are
expected to increase specifically due to the project, these costs are incremental and
should be included in the capital budgeting decision. This is the case for the expected
increases in overhead in years 5 through 10 for the Super Project.
The erosion of the Jell-O contribution margin needs to be considered when General
Foods are making their capital budgeting decision for the Super Project. When
evaluating a project a firm must take into consideration how the firm will be affected as
a whole, and in this case although the Super Project is expected to bring in revenues
(increasing cash flows), it is also expected to negatively affect the revenues of the JellO product line (decreasing cash flows). Therefore, the erosion must be considered in
the analysis as an incremental cost related to the Super Project.
The allocation of charges for the use of excess capacity must also be considered in the
capital budgeting calculations when evaluating the Super Project. In order to reflect
the true cost of this project General Foods must consider what other options exist for
utilizing the excess capacity. They must consider the cost of the next best alternative
and treat it as an opportunity cost that is lost if the Super Project is accepted.
All of the assumptions we have used in making our analysis are listed in Appendix 11.
Accept or Reject Super Project Using NPV
Based on the previous discussion regarding relevant cash flows the cash flow analysis
provides a NPV of -$ 233.7 (thousands of dollars), therefore the project should be
rejected as it has a negative NPV. In addition, the IRR has a value of 7.58% which is
lower than the WACC of the project (11.55%). (Appendix 7 Cash Flow and NPV analysis)
Finally, 3 separate sensitivity analyses have been made to measure the impact of key
variables on the NPV of the project:
• WACC: We have simulated different weights for the sourcing of funds for the
project (Appendix 8). The current weight of 9% LT debt & debentures and 91%
Equity has to change to 46% and 54% in order to make the NPV equal to 0.
• Level of erosion: We have analyzed different levels of erosion of Jell-O sales by
the Super Project (Appendix 9). The current erosion would need to be reduced
from 20% to 12% in order to achieve an NPV of 0.
• Overhead costs: Two options have been considered, with or without the increase
in overheads starting in year 5. Even without the overhead, the NPV of the
project is negative, so the decision of rejecting the project does not change.
(Appendix 10) The Super Project Page 2 APPENDIX 1 - Sunk Costs (Test Market Expenses)
To illustrate the reason for excluding sunk costs from the capital budgeting decision,
consider the following scenarios related to the Super Project (NPV numbers have been
made up to help reinforce the reason to exclude sunk costs):
Scenario 1 – including the sunk costs in NPV analysis
NPV = - $100,000
In this scenario, the project would be rejected; however the firm would be losing value
as they have already incurred the cost of $360,000. In effect their value would be
decreased by the full amount of $360,000.
Scenario 2 – excluding the sunk costs in NPV analysis
Sunk Costs = $360,000
NPV = $260,000
In this scenario, the project would be accepted, with $260,000 going towards
recovering the sunk costs already incurred. Overall the firm is still losing value, in this
case $100,000, but they are better off by $160,000 by accepting the project.
This example shows that if they include the sunk costs in the NPV analysis and reject the
project; the firm would make a faulty decision and destroy more value than if they
excluded the sunk costs and accepted the project.
However, in the long term the firm must consider sunk costs. If they continually accept
projects with positive NPV’s but do not help recover the costs already incurred (sunk
costs related to the project) they will not be adding value. This is where the firm must
conduct second stage analyses to ensure that they are indeed accepting projects that
help to recover sunk costs.
Firms should also ensure they consider possible sunk costs like test marketing expenses
BEFORE they actually incur them. This can be achieved through the use of decision
trees and NPV analysis to decide whether to proceed with such test marketing and
eventually projects from the very beginning. The Super Project Page 3 APPENDIX 2 - Calculation of depreciation and tax shield
Type of investment
Estimated CCA Year
10 Thousands $
10% Depreciation and tax shield –Thousands $
240.3 Tax shield
13.9 APPENDIX 3 - Calculation of WACC
Source of funds
LT debt &
Total Balance as of
April 1, 1967 Weight k WACC 61
11.55% APPENDIX 4 - Calculation of Tc
Tc 51.94% The Super Project 1959
48.7% Page 4 1968
51.9% APPENDIX 5 - Calculation of g
Average g Dividend
9.3% APPENDIX 6 - Calculation of Po
price (1967) Low
$ 81.75 65.25 Po High
$ 73.50 APPENDIX 7 – Cash Flows and NPV Calculation - Super Project
(Thousands$) E0 Investment
Total (653.0) (653.0) NPV
7.58% The Super Project E1 E2 E3 E4 E5 E6 E7 E8 E9 E10 (283.0) (146.0) (14.0) 168.0 (283.0) (146.0) (14.0) 168.0 450.0
474.0 (136.0) (70.2) (6.7) 80.7 173.0 173.0 198.0 198.0 227.8 227.8 17.0
216.1 231.2 633.5 Page 5 APPENDIX 8 - WACC Sensitivity Analysis
Source of funds
LT debt & debentures
NPV (Thousands $) Weight Sensitivity Analysis
76.5 WACC simulation
100.0 IRR NPV (Thousands $) 50.0
(50.0) 11.5% 10.9% 10.4% 9.8% 8.7% 7.5% 7.1% 6.5% (100.0)
WACC The Super Project Page 6 APPENDIX 9 - Erosion Sensitivity Analysis Level of erosion
NPV (Thousands $) 20%
(233.7) Erosion Sensitivity Analysis
(173.3) (112.9) (52.4)
68.4 Erosion simulation
100.0 IRR NPV (Thousands $) 50.0
(50.0) 20% 18% 16% 14% 12% 10% (100.0)
% of erosion APPENDIX 10 - Overhead Sensitivity Analysis NPV (Thousands $) The Super Project Overhead simulation
With overhead Without overhead
(117.4) Page 7 APPENDIX 11 – Assumptions
Note: our calculations and analysis are based on several assumptions:
• For calculating the weighted average cost of capital (WACC):
o First assumed that the project will be financed using a combination of
debt and equity identical to the current capital structure of the company
as a whole. (Appendix 3)
o Second, we estimated the growth rate (g) as an average of the historic
dividend payout data. (Appendix 5)
o Next, the current price of common stock was calculated as the average
of the low and high price for 1967. Finally, for the sake of simplicity, we
considered the floating cost rate (f%) to be 0%, for issuing both debt and
common stock for financing the project. (See Appendix 6 for Po
• In calculating the NPV of the project, we assumed that the WACC is constant
throughout the lifetime of the project. • Because the case does not list relevant information for calculating the WACC for
the project, we are assuming the risk of the project is the same as the risk of the
company and therefore use the WACC of the company as the discount factor. • For depreciation calculations, we used a CCA rate of 10% for both building and
equipment. In addition, we assumed that the salvage value of the capital assets
at the end of 10 years is equal to its book value. (Appendix 2 for CCA and tax
shield calculations) • In estimating the earnings generated by the project, we considered several data
presented in the case to be sound. We included the marketing estimates of
erosion of profits from the Jell-O project and the volume sales as such. Also, we
added the investment tax credit (ITC) rate of 4% (calculated as 8,000/200,000,
from exhibit 6) following the same policy used by the company in the case
(spread over 8 years as per notes from Exhibit 6). • In all of our calculations, the corporate tax rate (Tc) applied to this project is an
average of the company’s historical tax rates. (Appendix 4) • Following the analysis from Alternative 3, we included the incremental overhead
costs beginning in year 5 through to year 10. The Super Project Page 8 ...
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This note was uploaded on 05/02/2010 for the course MGRL MGRL442 taught by Professor Smithwick during the Spring '10 term at Academy of Art University.
- Spring '10