Statement of Facts
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 in an already existing building in which Jell-O is manufactured using the available capacity of a pre-existing Jell-O agglomerator. Sandberg has analyzed the different investment proposals based on three different capital allocation techniques. The three different cash flow evaluation alternatives (Incremental, Facilities-Used, and Fully Allocated) differ in the way that the cost of existing facilities and future increases in overhead are allocated.
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The acceptance or rejection of the project relies on the project’s costs. As Sanberg looks to compare Super Project with current profit criteria, recent discussion has brought about what the proper evaluation technique is for their cash flows; specifically, in concern to the relevancy of sunk costs. The problem for General Foods is to decide what the best method for evaluating the Super Project was since each method produced drastically different returns. Issues General Foods has quite a few factors to consider when determining relevant cash flows in their analysis of the project.
Multiple factors for consideration are whether or not to account for test market expense, the allocation of overhead expense, the allocation of charges for agglomerator and capacity use, and erosion of Jell-O sales. Under the analysis of an incremental basis, management included the incremental fixed capital of $200,000, which included packaging equipment. Sanberg also advocates that Super should be charged with the “opportunity loss” of agglomerating capacity and building space that could be used for future production of Jell-O or other products.
Management also analyzed the project based on the amount of facilities-used. Recognizing that Super will use half of an exisiting agglomerator and two thirds of an existing building, Sanberg added Super’s pro rata shares of these facilities to the incremental capital. Overhead costs directly related to these existing facilities were also subtracted from incremental revenue on a shared basis. Sanberg felt this analysis was a useful was of putting various projects on a common ground for purposes of relative evaluation.
Lastly, management included a fully allocated basis of the project in their projections. They recognized that individual decisions to expand inevitably add to a higher overhead base and therefore an increase to the costs and investment base were added. Overhead expenses included manufacturing costs plus selling and general and administrative costs on a per unit basis equivalent to Jell-O. Overhead capital also included a share of the distribution system assets. Analysis
Upon review of management’s case, we broke down the relevant cash flows separately according to test-market expenses, overhead expenses, erosion of Jell-O contribution margin and allocation of charges for the use of excess agglomerator capacity. The four capital budgeting techniques appropriate for review are NPV, IRR, ARR and payback period. After review of the independent costs, we found that each one produces a positive NPV, an IRR above the discount rate and a payback period within the required ten years. However, it is unrealistic to consider these on an independent basis. For our realistic case, we included overhead expenses and the excess cost of capacity for the agglomerator. We did not include the erosion of Jell-O sales and the test market expense, as this is a sunk cost.
Under these circumstances we produced the following results: In this analysis, we included the overhead expense for 1972-1977 because as the project begins to gain a foothold in the market it will acquire a larger market share and will become a larger portion of General Foods’ overall dessert sales. Also, the agglomerator and excess capacity was charged as an incremental investment, which brought the initial investment to $653,000.
Since 70% of the initial $200,000 was depreciated over the 10-year period, we applied the straight-line depreciation method to compute 70% of $453,000 that added an extra $32,000 of depreciation to each year. We did not include the erosion of Jell-O sales because an external competitor could easily acquire the 20% of market share currently held by Jell-O in the future. This would take away profit that would hinder Jell-O regardless of whether it is internal or external. Since we also believe this a mature market, it is a cost that seems to be irrelevant in this analysis.
We did not include the test market expense as well since this was a sunk cost. It did not seem logical to include, because it was almost double the value of the initial investment of $200,000 and roughly half of our adjusted initial investment of $653,000. Since General Foods has a limited amount of product lines in the dessert market, the test market expense should not be accounted for. Conclusion Under our assumptions, we conclude that General Foods should accept the project due to its positive NPV, IRR above discount rate and the attractive payback period within six years (exhibit 6).
When compared to Crosby Sanberg’s view (exhibit 5), which resulted in a negative NPV of -$575. 32, IRR of . 28% and a payback period of just about 10 years, our assumptions lead to a more accurate portrayal of the Super Project. Although we do recommend that General Foods take on the Project, they must be cognizant of increasing test expenses and the initial impact that the addition of Super will have on Jell-O sales. The benefits will be an increase in overall sales for the company, and the chance for General Foods to become a leading producer in the dessert market.
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Super Project. (2017, May 05). Retrieved from https://phdessay.com/super-project/
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