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Unformatted text preview: ELEMENTS OF MODERN FINANCE - MGCR-641 THE SUPER PROJECT Prepared By: Bogdan Enoiu Chris McLachlin J. Alejandro Noboa February 03, 2006 EXECUTIVE SUMMARY PROBLEMS 1. Is General Foods using the proper capital budgeting methods in evaluating their potential projects? 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 OPTIONS • 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 RECOMMENDATIONS 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 opportunity cost. 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 Sanberg. 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 decisions. 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. Assumptions 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 Building Equipment Total Estimated CCA Year 1 2 3 4 5 6 7 8 9 10 Thousands $ 213.0 440.0 653.0 10% Depreciation and tax shield –Thousands $ UCC beg CCA UCC end 653.0 32.7 620.4 620.4 62.0 558.3 558.3 55.8 502.5 502.5 50.2 452.2 452.2 45.2 407.0 407.0 40.7 366.3 366.3 36.6 329.7 329.7 33.0 296.7 296.7 29.7 267.0 267.0 26.7 240.3 Tax shield 17.0 32.2 29.0 26.1 23.5 21.1 19.0 17.1 15.4 13.9 APPENDIX 3 - Calculation of WACC Source of funds (Thousands $) LT debt & debentures Common Equity Total Balance as of April 1, 1967 Weight k WACC 61 613 674 9% 91% 100% 1.62% 12.5% 0.15% 11.40% 11.55% APPENDIX 4 - Calculation of Tc Year (Thous. $) EBIT Tax paid % 1958 105.0 57.0 54.3% Average Tc 51.94% The Super Project 1959 115.0 61.0 53.0% 1960 130.0 69.0 53.1% 1961 138.0 71.0 51.4% 1962 156.0 84.0 53.8% 1963 170.0 91.0 53.5% 1964 179.0 95.0 53.1% 1965 177.0 91.0 51.4% 1966 185.0 91.0 49.2% 1967 193.0 94.0 48.7% Page 4 1968 1,548.0 804.0 51.9% APPENDIX 5 - Calculation of g Year 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 Average g Dividend 1.00 1.15 1.30 1.40 1.60 1.80 2.00 2.00 2.10 2.20 g 15% 13% 8% 14% 13% 11% 0% 5% 5% 9.3% APPENDIX 6 - Calculation of Po Common stock price (1967) Low $ Mean $ 81.75 65.25 Po High $ 73.50 APPENDIX 7 – Cash Flows and NPV Calculation - Super Project Concept (Thousands$) E0 Investment EBIT Overhead Net EBIT Net Earnings after tax Depreciation tax shield ∆ NWC Terminal FCF ITC Total (653.0) (653.0) NPV IRR ($233.7) 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 90.0 360.0 450.0 90.0 360.0 502.0 90.0 412.0 502.0 90.0 412.0 564.0 90.0 474.0 564.0 90.0 474.0 (136.0) (70.2) (6.7) 80.7 173.0 173.0 198.0 198.0 227.8 227.8 17.0 (329.0) 32.2 55.0 29.0 3.0 26.1 1.0 23.5 29.0 21.1 (1.0) 19.0 (13.0) 17.1 - 15.4 (12.0) 13.9 391.8 1.0 (447.1) 1.0 18.0 1.0 26.3 1.0 108.8 1.0 226.5 1.0 194.2 1.0 205.0 1.0 216.1 231.2 633.5 Page 5 APPENDIX 8 - WACC Sensitivity Analysis Source of funds LT debt & debentures Common Equity WACC NPV (Thousands $) Weight Sensitivity Analysis 9% 91% 11.5% (233.7) 15% 85% 10.9% (200.7) 20% 80% 10.4% (171.5) 25% 75% 9.8% (140.9) 35% 65% 8.7% (75.2) 46% 54% 7.5% - 50% 50% 7.1% 35.8 55% 45% 6.5% 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) (150.0) (200.0) (250.0) (300.0) WACC The Super Project Page 6 APPENDIX 9 - Erosion Sensitivity Analysis Level of erosion NPV (Thousands $) 20% (233.7) Erosion Sensitivity Analysis 18% 16% 14% 12% (173.3) (112.9) (52.4) 8.0 10% 68.4 Erosion simulation 100.0 IRR NPV (Thousands $) 50.0 (50.0) 20% 18% 16% 14% 12% 10% (100.0) (150.0) (200.0) (250.0) (300.0) % of erosion APPENDIX 10 - Overhead Sensitivity Analysis NPV (Thousands $) The Super Project Overhead simulation With overhead Without overhead (233.7) (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 calculations) • 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.

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