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Valuation of the Super Project

Group Members:
XXX XXXXX
XXX XXXXX
Gordon Schwabe
XXX XXXXX 27.01.2013

AGENDA

1. Case summary
2. Problem statement
3. Clarifying problems & solutions
4. Comments on the 3 evaluation approaches
5. Recommendations on evaluation
6. Cash flow statement
7. Conclusion

Valuation of the Super Project 27.01.2013
Fachhochschule Brandenburg · University of Applied Sciences · Fachbereich Wirtschaft Page 2

Case Summary

• General Foods is a large corporation organized by productl
• Super is a proposed new instant desert, based on a “flavored, water-
soluble, agglomerated powder.”
• General Foods has numerous projects with a strict criteria to judge their value
for the company
• There are basically three types of capital investment proposals at General
Foods:
• Safety
• Quality
• Increased profit


Problem Statement

• 3 methods, each passes with advantages and disadvantages
• Incremental / Facilities used / Fully allocated
• Memos indicate that General Foods’ finance personnel are questioning the same
criteria’s ability to accurately reflect the value of the Super project
• No precise estimation of company value, because of the high variance in the
evaluation methods


Problem Statement – What is ROFE?
GF uses Return On Funds Employed (ROFE) to evaluate the viability of capital
projects, and to weigh one project against another to determine prioritization.

ROFE = EBIT / Capital Invested (book value)
 Ratio of EARNINGS created from the book value of capital invested
• Using EBIT, does not capture net operating cash flow
• Uses book value (depreciated value) of capital investments
• If capital assets are depreciated, they appear to create a cash flow
• Depreciation is an accounting expense not a cash flow
• Artificially biases long-term asset-intensive projects, as they have bigger
apparent depreciation cash flows
• Does not capture the time value of money; interest and inflation
ROFE is not a tool to evaluate capital projects. Even used as a
metric to compare capital earnings performance, it has flaws.


Problem Statement - How we should deal with…

• Test-market expenses
• Erosion of Jell-O contribution margin
• Allocation of charges for the use of excess agglomerator capacity
• Overhead expenses


Test-market expenses

• Should only be taken into account if they can be attributed to the particular
project
• In the Super case these expenses had been made before the Super project had
started

 Will not be taken into account in the FCF


Erosion of Jell-O contribution margin

• Super will displace part of Jell-O´s market share

 Erosion of Jell-O contribution margin should be taken into account


Allocation of charges for the use of excess agglomerator capacity

• Not counted in the FCF of the Super Project
• Charges represent opportunity costs for the Jell-O devision or future projects

 Take costs into account on a corporate level


Erosion of Jell-O contribution margin

• Should be taken into account if they can be attributed to the particular project

 General Foods Corp. already counted theses costs in the CF of Jell-O


Overhead Expenses

• Should be taken into account if these expenses can be attributed to Super
• Overhead expenses for the Super Project are not clearly defined

 Overhead expenses will be taken into account in the FCF


Incremental Basis

• This evaluation approach uses only directly identified cash flows
 Only incremental approaches has been taken into account

 Jell-O facilities and production capacity are not relevant for Super because they
have already been counted in the CF.

This execution of Incremental Basis is flawed because it:
• Includes sunk costs (the marketing study)
• Fails to account for relevant increasing overhead costs.
• Fails to take into account income-tax-reducing depreciation.
• Utilizes ROFE. Again, ROFE is no good for capital budgeting


Facilities-Used Basis

• Super will use 1/2 of Jell-O’s agglomerator
• Super will use 2/3 of Jell-O’s building
• Super “pro-rata” share is $453 K
• Charges Super with the facility overhead ($28k p/y).
 This approach
• In the capital budgeting process only incremental cash flows are taken into
account.
• Only shifts costs ($453K in facilities) to Super, which is an accounting
maneuver and does not effect the cashflow
• It’s a “net zero” method, it just moves costs
 Useful for accounting, not for capital budgeting


Fully Allocated Basis

Facilities-Used Basis + overhead expenses

• Overhead expenses:
• Selling, general and administrative costs

 This approach
• Gives the most inclusive analysis of existing cash flow
• Adds overhead costs correctly


Evaluation of the Super Project

GF can do this by:
1. Taking into account incremental cash flows
2. Modifying their income statement to deduct depreciation before calculating tax
3. Ignore sunk costs (marketing test, Jell-O facilities, etc.)
4. Remove depreciation from capital assets for purposes of evaluation
5. Accept overhead from growth/doubling powdered dessert line


Recommendations evaluation of the Super Project

• $200k for high speed filling/packaging equipment, finish packing room
• $360k market test – irrelevant
• Opportunity cost for Jell-O’s facilities and equipment
• Not relevant – same opportunity for any project using this building
• From corporate POV, hard to sell to move in some business to utilize
temporarily excess Jell-O facilities, low feasibility
• Capital depreciation – non-cash expense – irrelevant
• Capital depreciation expense tax deduction – relevant to operating cash flow
• Shift $453k pro-rata share of Jell-O facilities and agglomerator – Incremental
test – irrelevant


Recommendations Evaluation of the Super Project

• $28k avg. yearly depreciation of Jell-O facilities – Incremental test – irrelevant
• $19k business expansion capital for distribution system – Incremental test –
relevant
• Expansion capital depreciation expense tax deduction – relevant to operating
cash flow
• $90k additional yearly overhead expense for business expansion – Incremental
test – relevant


Free Cash Flow
400.00

200.00

0.00
Amount

-200.00

-400.00

-600.00

-800.00
1 2 3 4 5 6 7 8 9 10 11
FCF Incremental -200 -518 -5.4 5.17 86.1 246. 221. 233. 245. 263. 303.
FCF Facility used -453 -518 6.42 16.3 96.7 256. 229. 241. 253. 269. 345.
FCF Fully Allocated -672 -518 6.42 16.3 96.7 212. 186. 198. 210. 226. 333.


Free Cash Flow

Net Sales Net Earnings
Discount rate 4,66% 7,69%
NPV 447,59 248,64
IRR 13% 13%

NPV 280,38 67,31
IRR 9% 9%

NPV -102,79 -286,13
IRR 3% 3%

Conclusion

- An expansion or broadening of market capture by appealing to somewhat
parallel consumer needs
- Take advantage of short term availability of Jell-O facilities - in the long term it
is not a better project just because it fits a facility that is temporarily unused

Main Points:
- NPV is in 2 approaches positive
- IRR is in 2 approaches higher than discount rate (decision premise)
- Payback after the 6th year (shorter than normal payback period)

 Do the investment


Fachbereich Wirtschaft

Thank you for your attention

Appendix – Incremental CF


Appendix – Facility Used CF


Appendix – Fully Allocated CF


Appendix – Excel File

Excel File


Appendix - Depreciation


Appendix – Opportunity costs


Appendix – Erosion of Jell-O


Appendix – Tax rate


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