As you can tell General Foods uses some unique methods in determining if the investment is worth implementing or not. General Foods has given us three different options of the basis they will use. One, an Incremental basis, two, a Facilities-Used basis, and three, a fully allocated basis, all of which we will go into more detail about. We have come up with another option to value the expected profitability, the Net Present Value Method. Once we figure out which of these options we are going to use we must figure out if we will include the test market expenses, which are the sunk costs, the overhead expenses, the Erosion of Jell-O, and the allocation of charges for the use of excess capacity. So the problems are which one of our four options do we use to value the Super Project and do we accept or reject the Super Project.
Alternatives
The first three alternatives used were, Incremental Basis, Facilities-Used Basis, and Fully Allocated Basis. These alternatives were set up by General Foods and would be selected using the company’s Return on Fund Employed (ROFE) method along with payback period. The company had different requirements as far as ROFE and payback period. They were set up for every new project, and if the project met these requirements they would be implemented. The only problem with these methods is that ROFE and payback period are very inefficient ways of determining the quality of a project. Both ROFE and payback period don't take into account the time value of money, making some projects more attractive because without time value of money, projects will appear as good investments in the short term but actually be bad in the long term.
Besides the inefficient ways of determining the projects in ROFE and payback period, General Foods alternatives were also not the greatest ways to determine a projects worth. First off, there was Alternative 1, Incremental Basis. This alternative was passed on an ROFE and payback period basis, with an ROFE of 63% and a payback period of 7 years. Unfortunately, these numbers do not show all the facts incorporated with alternative 1. One of the major problems with Alternative 1 is that it does not take into effect opportunity cost by using Jell-O machinery and facilities on Super instead of Jell-O. Alternative 1 also incorporates the original marketing cost of super into the project costs. These marketing costs should not be included because they should actually be considered as sunk costs.
Alternative 2, facilities used basis, is slightly better than Alternative 1. In alternative 2, opportunity cost is incorporated by allocating the Super Project some facilities costs prorate with Jell-O. This increases the amount of capital used to $453 from $200 million to cover the costs of losing production of Jell-O. However, though opportunity cost is included for alternative 2, the sunk costs of pre-marketing efforts of Super are still included, when they should not be.
Alternative 3, fully allocated basis, is the most complete and correct alternative listed by Sanberg. It takes into account both the Incremental and Facilities-Used basis. However, this alternative includes the test marketing expenses, which as mentioned above are sunk costs and should be excluded from the valuation.
The corporate controllers’ memo is a reply about the Super Project. The controller questions whether we will be better off in the aggregate. He also doubts some different ROFE figure of the Super project is irrelevant. He thinks the way of allocated production is not very clear to describe the total situation of Super Project. He says that he sees very little value in looking at the Super Project.
The last alternative that General Foods could use to value the Super Project is the Net Present Value Method (NPV) and it will be discussed below.
Recommendation
We chose to use the NPV method because it is the best method for capital budgeting and valuing a project or alternative. The NPV takes into account all of the relevant cash flows and the time value of money. When calculating NPV, we do not need to include the test market expenses, as they are sunk costs. We need to include any relevant overhead expenses, erosion costs from the Jell-O product line and the excess capacity used. When determining whether to accept or reject a project based on a NPV, as long as the NPV is positive the project or alternative should be accepted. Just the opposite, if the NPV is negative, the project or alternative should be rejected.
In terms of a SWOT analysis for the project in general, one strength would be the strong market share that General Foods already has with their other strong products, jell-O for example. Another strength would be their knowledge of powdered desserts and similar products. One weakness that is prominent in this case is the fact that the new Super Product is taking away from the production of Jell-O, an already strong product. In terms of the opportunities, the product may flop, taking away possible gains General Foods could gain from developing a new different product. A threat to this case and General Foods is that of competitors. Competitors may try and copy the product or create a better alternative to General Foods’ Super Product.
Analysis
The Super Project has an initial investment of $200 and a pro rata share of facilities of $453 giving us a $653 total investment. This total investment will depreciate over the next ten periods. The first period only depreciates by 5% while the next nine will depreciate by 10%. After all the depreciation has occurred there will just be the salvage value remaining for the capital asset. With depreciation being paid each year there is a tax shield created. A tax shield is a deduction in income taxes that result from taking an allowable deduction from taxable income. To find out how much the tax shield the Super Project has, just take the amount of depreciation for that period and multiple it by the tax rate (52%). The tax rate used was the average tax rate over the past 10 years.
Cost of Debt and cost of equity help get different rates that are an important factor in figuring out the weighted average cost of capital (WACC). Cost of debt gives the interest rate General Foods would pay for all the current debts. While the cost of equity is the minimum rate of return that they must offer shareholders to keep them investing in their company. The Super Project has cost of debt of 1.57% and cost of equity of 13%. This helps figure out the WACC which is the rate we expect to pay on average to all security holders to finance our assets. The WACC for the super project is 11.77% which is less than the 13% rate of return that the shareholders are looking for. This tells us that the Super Project might not be the best idea. NPV is still the best measure for capital budgeting so we went ahead and did the calculations for it.
To figure out the net present value we have to first figure out the cash flow. In 1968 we get earnings before income taxes of $283. This is the $643 total investment minus the $360 cost for test markets that we see as a sunk cost and are not including it as part of the Super Project. The cash flow generates positive revenue for the Super Project but we still have to factor in that the Super Project is eroding 20% of Jell-O causing their revenues to decrease along with their cash flow. After cash flow is figured out we are finally able to see what the NPV is. When calculating NPV you have to get the sum of discounted cash flows and add it to the initial investment. For the Super Project we get $298.4 discounted cash flow + (653) fixed investment = (354.6) NPV. With the NPV being a negative number, we know to reject the super project.
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