The Super Project case mainly deals with the efficiency of project tool analysis in capital budgeting process. The three techniques that General Foods management used to determine whether Super Project was a worthwhile project were: •Incremental basis
•Fully allocated facilities and costs basis
The three techniques mentioned above will be discussed in more details in question 4 below.
1.What are the relevant cash flows for General Foods to use in evaluating the Super project? In particular, how should management deal with issues such as:
c)Erosion of Jell-O contribution margin?
d)Allocation of charges for the use of excess agglomerator capacity?
Typically, when using Net Present Value (NPV) method to determine whether a project adds value to the organization, free cash flow is taken into consideration. Depreciation expense, a non-cash item, is to be added back to the operating profit after tax to give operating cash flow. Other expenses such as SG&A and fixed costs are to be included in operating cash flow calculation. Change in net working capital (current assets – current liabilities) and capital expenditure are added to the operating cash flow to calculate free cash flow.
Test-market expenses are usually considered as sunk costs, and thus, should not be included in the expenses category. Overhead expenses refer to ongoing expenses of operating a business and are fixed costs. We can see from Exhibit 3 that there was a substantial increase in the SG&A expenses from 1958 to 1967 of more than 100% increase. Therefore, overhead expenses should be counted towards expenses when calculating the free cash flow.
Twenty percent of the 10% expected Super volume would come from the erosion of Jell-O sales. Although we do not have any data indicating the impact of Super on Jell-O contribution margin, it is safe to assume that as in any new product launches, when cannibalization kicks in, the impact on existing product’s contribution margin should be quite substantial. In addition, Super fell into a profit-increasing project.
The increase in Jell-O volume was 40% between August and September 1966. Coupled with the high growth expected for the Super project, excess agglomerator capacity might be needed sooner than later. So, the allocation of charges for excess agglomerator capacity should be included.
2.How attractive is the investment as measured by various capital budgeting techniques (i.e., ARR, Payback, IRR, NPV)? How useful are each of these measures of investment attractiveness?
Accounting Rate of Return (ARR) is one of the methods used internally in an organization to select projects. The rate of return is simply calculated by dividing average operating profit by average investment. Its biggest advantage is that it is very easy to calculate. In addition, with the operating profit numbers coming from the balance sheet of the company, ARR method adds credibility to the market because market follows accounting numbers closely. However, with balance sheet also comes the problem of accounting manipulation. The biggest drawback in ARR is that it does not account for time value of money. Longer term forecasts are not adjusted properly with the level of risks involved. As a result, it tends to favour higher risk decisions.
Payback period is a method used to determine how much time is needed to recover initial investment of a project. It is calculated by dividing the cost of the project by annual cash inflows. The shorter the payback period, the better the project is. Similar with ARR, the method is easy to use. However, the method does not adjust for the risks involved and also ignores time value of money.
The Internal Rate of Return (IRR) of a project is the interest rate that will yield net present value of zero. In other words, it is the discount rate at which the present value...