4- 1

The Super Project

Cash Flow Estimation for Capital Budgeting

4- 2

Investment Criteria

Project ranking according to Payback period Accounting rate of return

Are certain costs being ignored? What are the relevant project costs and cash

flows? Test-market expenses Use of excess agglomerator and building capacity Overhead costs Lost contribution margin on Jell-O

4- 3

Test Market Expense

R&D ProductDesign

MarketTesting

ManufacturingInvestment

WorkingCapital

4- 4 Allocated Charges for Capacity Utilization

Charge for excess agglomerator and building capacity Jell-O sales for August to September 1966

increased by 40% over previous year In two years you would have to increase capacity

anyway Super project will require earlier and even greater

increase Reasonable to include use as costs

Risk of investment?

4- 5

Allocated Overhead Charges

Overhead costs are not fixed (see last 10 yrs in Exhibit 3) SGA/Sales: 17.9% (1958) to 27.2% (1967)

Reasonable to include an increase from years 5 to 10 How much?

Costs increase by $54,000/year for 10 years Total of $540,000 Yearly cost from years 5-10 = $540,000/6 $90,000

• Graduated scale?

4- 6

Charge for Lost Contribution

Questionable charge Assume that Jell-O would hold volume if

Super is not introduced What if a competitor introduces a product like

Super? Erosion is inevitable?

4- 7

Assumptions and setup

Exclude: test market expense (sunk cost) erosion (inevitable)

Include: agglomerator and building use (opportunity cost) overhead costs (side effect)

cash flow identity cash (project) = OCF - additions to NWC - NCS Assume r=10%

4- 8

Cash Flow from Operations

Year 1 2 3 4 5 6 7 8 9 10Net sales $2,112 $2,304 $2,496 $2,688 $2,880 $2,880 $3,072 $3,072 $3,264 $3,264COGS $1,100 $1,200 $1,300 $1,400 $1,500 $1,500 $1,600 $1,600 $1,700 $1,700Gross profit 1,012 1,104 1,196 1,288 1,380 1,380 1,472 1,472 1,564 1,564Advertising expense 1,100 1,050 1,000 900 700 700 730 730 750 750Increased overhead 90 90 90 90 90 90Depreciation 46 43 41 38 35 33 30 26 24 21Start-up costs 15

Profit before taxes ($149) $11 $155 $350 $555 $557 $622 $626 $700 $703Taxes (@52%) (77) 6 81 182 289 290 323 326 364 366

Net Profit (72) 5 74 168 266 267 299 300 336 337Depreciation 65 61 58 54 50 46 42 37 34 30

Cash flow (7) $66 $132 $222 $316 $313 $341 $337 $370 $367

Depreciation for Jell-O facilities: Sum-of-year digits; 40/15 year lives; $133/320

4- 9

Cash Flows for Super

Year New P&E Jell-O Facilities Working Capital CF Operations Total Cash Flows0 ($200) ($453) $8 ($645)1 ($329) (7) (336)2 55 66 1213 3 132 1354 7 222 2295 23 316 3396 (1) 313 3127 (13) 341 3288 0 337 3379 (12) 370 358

10 0 367 36711 31 60 267 358

Investment tax credit of $8 in year 0; Tax shield on write-off of equip. in yr 11

4- 10

DCF Calculation

Year Cash Flow Discount PV

0 $645 1/(1.1)0=1 $6451 $336 0.909 $3052 $121 0.826 100

3 $135 0.751 101

4 $229 0.683 156

5 $339 0.621 211

6 $312 0.564 176

7 $328 0.513 168

8 $337 0.467 157

9 $358 0.424 152

10 $367 0.386 142

11 $358 0.350 125

NPV = $538 = accept

4- 11

NPV Profile of Project

-500

0

500

1000

1500

2000

2500

0 5 10 15 20 25

Discount rate

NP

V IRR = 18.5%

4- 12 Sensitivity Analysis Use of Jell-O Facilities

Depreciation Tax PV ofExpense Shelter Cash Flow

Year Foregone Foregone at 10%0 $4531 $46 $24 (22)2 43 22 (18)3 41 21 (16)4 38 20 (13)5 35 18 (11)6 33 17 (10)7 30 16 (8)8 26 14 (6)9 24 12 (5)

10 21 11 (4)11 60 (21)

Total $317

4- 13 Sensitivity AnalysisOverhead

After PV ofOverhead Tax Cash Flow

Year Savings CF at 10%01 02 03 04 05 $90 $43 $276 90 43 247 90 43 228 90 43 209 90 43 18

10 90 43 1711

Total $129

4- 14 Sensitivity Analysis Erosion

Contribution PV ofLoss from After tax Cash Flow

Year Erosion Cash Flow at 10%01 $180 ($86) (79)2 200 ($96) (79)3 210 ($101) (76)4 220 ($106) (72)5 230 ($110) (69)6 230 ($110) (62)7 240 ($115) (59)8 240 ($115) (54)9 250 ($120) (51)

10 250 ($120) (46)11

Total ($647)

4- 15

NPV Sensitivity Analysis

538

(109)

538

yes

no

EROSION

208

(109)

538

855

JELLO FACILITIES

no

yes

no

yes

OVERHEAD

(109)

20

208

337

538

667

855

984

yes

no

yes

yes

yes

no

no

no