The Super Project

By Lekan Ajirotutu

A US Based company with foreign operations put under a separate division. The company is organized along Product Lines

Major U.S divisions included Post, Kool-Aid, Maxwell House, Jell-O and Birds Eye

Has consistently been profitable over the years

The company has 25,127,000 common stock-shares outstanding at the end of 1967.

Annual dividend payments were consistent features of the company and the payment has been on the increase since 1958 up till date (1967). Net Earnings per share has consistently increased since 1958. There had been a decline in the highest value of the stock price since 1962 till date.

The company sets basic criteria for evaluation of capital investment proposals. The Purpose of the Project and the Payback and ROFE (Return on Funds employed) .The purpose of the project is evaluated along 4 categories

I. safety and convenience II. Quality III. Increase in profit IV. Other

Estimates of payback and return of on funds employed were required for each such project requiring $50,000 or more of new capital funds and expense before taxes.

According to a General Foods accounting Executive, The Food industry should show a continuous growth

About General Foods Corporation

Super is a new project initiation of General foods corporation

It was a new instant dessert, based on flavored, water soluble, agglomerated powder

It Would come in 4 flavors, chocolate would account for 80% of total sales

Requires $200k in capital budget, $80k for building and $120k for machinery and equipment.

Will use the available excess capacity of the Jell-o agglomerator. No cost of the agglomerator was factored into the project.

On the basis of test market experience, General Foods expected super to capture 10% of the total Dessert market share

80% of this expected Super volume would come from growth in the total market share or growth in the powders segment and 20% will come from erosion of Jell-o sales.

The Super Project

According to a General Foods accounting Executive,

“The Food industry should show a continuous growth . We want to expand faster than the gross national product. The key to our capital budgeting is to integrate the plans of our eight divisions into a balanced company plan which meets our overall growth objectives”

Objective

Whether or not to go ahead with the Super Project

Decision Question

Positivity of the NPV

Whether or Not the IRR Rate is greater than the Hurdle rate.

Decision Criteria

Go ahead with the Super project

Don’t Go Ahead.

Decision Alternatives:

The capital budgeting policy of the company is based on the ability of the project to meet a range of values for the Return on Funds Employed (ROFE) within a pay back period of 10 years. 20% for low risk projects and 40% for high risk projects.

There are problems associated with basing a capital budget decision on ROFE.1. It Ignores the timing of the cash flows2. It ignores the size of the cash flows3. It also ignores the span of the project

NPV and IRR based analysis provides a more objective conclusion on the viability of a project because they address the issues that ROFE does not address.

Key Issues

The Super project is faced with a decision on whether to consider the excess capacity (space and machinery) available on the Jell-O as sunk cost or as opportunity cost.

◦ Sunk Cost by definition is a cost we have already paid or have already incurred the liability to pay. Such a cost cannot be changed by the decision to accept or reject a project.

◦ Opportunity is slightly different. It requires us to give up a benefit. A common situation arises in which a firm already owns some of the assets a proposed project will be using.

It is also faced with a decision on whether to consider long term fixed costs associated with the super project as variable costs based on the argument that all fixed costs becomes variable in the long run

Since a definitive hurdle rate does not exist for the company, an estimate has to be derived based on the available information about the current return on equity, the risk associated with the project, the cost of capital and the growth expectations in share value and dividend pay-out.

Key Issues Continued

If 2 investments, x and y are mutually exclusive, then taking one of them means that we cannot take the other. Two projects that are not mutually exclusive are said to be independent. For example if we own a corner lot, then we can build a gas station or an apartment building, but not both. These are mutually exclusive alternatives.

A quick question to ask is if the super project is mutually exclusive of the jell-o project or if they are independent.

There seem to be some element of mutual exclusivity and independence here.

If the agglomerator operates at below capacity, then the 2 project can be viewed as mutually exclusive, however at full capacity, a decision has to be made on which production to reduce, doing this will mean not being able to meet the desired level of production of the other project. this will introduce some degree of mutual exclusivity.

Mutually Exclusive versus Independent Projects

Analysis A- Sunk Cost Assumption

  Scenario 1  

Actual Year Year Investment Outflows Inflows Netflow NPV

            10%  0 (200)     (200) (200)

1968 1   (329) (308) (637) (579)

1969 2   55 (69) (14) (12)

1970 3   3 (6) (3) (2)

1971 4   7 82 89 61

1972 5   23 217 240 149

1973 6   (1) 217 216 122

1974 7   (13) 242 229 118

1975 8   - 242 242 113

1976 9   (12) 271 259 110

1977 10   - 271 271 104

            (16) IRR = 9.63%

Analysis B – Opportunity Cost

  Scenario 2  

Actual Year Year Investment Outflows Inflows Netflow NPV

            10%

  -

(653)     (653)

(653)

1968 1   (329) (308)

(637)

(579)

1969 2   55

(69)

(14)

(12)

1970 3   3 (6) (3) (2)

1971 4  

7

82 89

61

1972 5  

23 217 240 149

1973 6  

(1) 217 216 122

1974 7  

(13) 242 229 118

1975 8  

- 242 242 113

1976 9  

(12) 271 259 110

1977 10  

- 271 271 104 (267)

(469)

Analysis C  Scenario 3  

Actual Year Year Investment Outflows Inflows Netflow NPV

10%

         -                (672)              (672)          (672)

1968      1             (329)          (308)          (637)          (579)

1969      2                  55             (69)            (14)            (12)

1970      3                    3                (6)              (3)               (2)

1971      4                    7                82               89                61 

1972      5                  23             217             240             149 

1973      6                  (1)            217             216             122 

1974      7               (13)            242             229             118 

1975      8                     -             242             242             113 

1976      9               (12)            271             259             110 

1977    10                     -             271             271             104 

         (267)          (488)