When Crosby Sandberg stated in the opening paragraph of the case, “What I learned about incremental analysis at the Business School doesn’t always work.” He came to the conclusion that sunk costs were relevant to capital project evaluations. In this case though, he could not have been more wrong. The sunk costs are lost once they are spent, and should definitely not be used to evaluate the Super Project.
General Foods is a large company with various divisions in both domestic and foreign operations. One account executive states that they want to grow more rapidly than the GDP, and develop projects accordingly. The Super Project will allow them to reach that goal. The NPV in the base is $2,196.30, with an IRR of 25.6%. Even in the worst case scenario, which includes change in net working capital as well as after tax erosion, the NPV is $232.70 with an IRR of 10.3%, far outpacing national GDP growth.
General Foods enjoys a significantly large market share in the food business. They face many risks from competitors, and they actively seek the opportunity to fill out their product line whenever possible. As of the moment the company lacks a large share of the dessert market. Super would offer the company a chance to develop a larger share of that market, and even with the serious risk of erosion present, the larger risk is losing leadership throughout the food industry.
P.D.C. Consulting highly recommends that management actively seeks to develop the Super Project.
The relevant cash flows for General Foods used in evaluating the Super Project (SP) are overhead expenses, erosion of Jell-O-Contribution margin and the opportunity costs from allocation of charges for the use of excess agglomerator. We can also include the sales, cost of goods sold, capital expenditures, general expenses, income taxes, and the increases in the net working capital.
The Test-Market Expenses are sunk costs, costs that are already incurred and cannot be recovered regardless of future events, so therefore cannot be combined in our calculation of cash flows. These expenses and cash flows may include various items as Research and Development, Product plan, Market Testing, Manufacturing Investment, and Working Capital. Since these costs may have been included with other product line we will not include them in or analysis of SP Cash Flow.
Overhead expenses- As we know from the information given General Mills will use the same building and machinery to produce the SP. There is opportunity cost of using the building and machinery since the company could have put it up for rent or sold the unused portion of the business.
The erosion of Jell-O Contribution Margin is justifiable as we consider cost profitability, expansion of market growth, company improvement, the development of new customer tastes , and company innovation. In our analysis we assume that Jell-O will suffer erosion of sales and profits from the introduction of this new product, therefore our analysis includes the erosion as a negative cash flow. Thus, this causes us to predict that other companies will follow the increasing market growth and produce similar products to capture a piece of the market share. Reviewing our calculations in the attached Exhibits I through IV P.D.C. Consultants see that erosion causes the overall NPV to decrease. However, the NPV is greater than zero in all cases, therefore P.D.C. Consultants conclude General Foods should go ahead with Super Project.
Allocation of charges for the use of excess agglomerator- which is defined as the opportunity cost. The $453M for facilities is our opportunity cost for the Super Project. In our case we depreciate it over 10 years using straight line depreciation. This excess agglomerator could be used for other products and or for the expansion of the Jell-O product.
Super Project has been reviewed under four scenarios and the results have been summarized in the following table.
Changes in net working capital and the erosion of Jell-O profitability do not impact the accounting rate of return (ARR) it stays constant at 17.2%. However, the performance of the project declines dramatically when a more complete analysis is conducted by including the ongoing investment in the changes in NWC, along with the erosion of Jell-O profitability; each measured separately and then combined.
As can be seen from the table above, under all scenarios the payback period is lengthened, net present value declines (NPV) dramatically (although the NPV remains positive) and the internal rate of return (IRR) declines sharply.
However, because the project remains positive from an NPV perspective, General Foods should undertake this project.
While the ARR, Payback, NPV and IRR all may have some level of merit in measuring the attractiveness of the Super Project, only the NPV is truly useful in measuring the project. The NPV takes into account the weighted average cost of capital (10.0%) in measuring the time value of money and is not impacted by sign changes on the cash flows.
The relevant cash flows of the project are provided on Exhibits I through IV. In each of our scenarios, the NOPAT cash flow was the base to which depreciation was added back and the investment tax credit was added in the year it was received, year-one. The base year has no erosion or NWC calculations included. Other adjustments were made for the addition of changes in net working capital, and the erosion to the profitability to Jell-O. In the second scenario, Exhibit II includes and adjusts to the cash flow from changes to net working capital. In the third scenario, Exhibit III, the erosion to the profitability of Jell-O is added to the base case. In the fourth scenario, Exhibit IV, both the changes to net working capital and the erosion to the profitability of Jell-O are added to the base case.
The NPV for the base case is $2,196.3, for the second scenario the NPV is $718.3, in the third scenario the NPV is $159.8 and in the fourth scenario the NPV drops down to $232.7, which is only marginally positive.
The Super Project is attractive in strategic terms. In the best case, the IRR 25.6% and in the worse case the IRR is 10.3%. The NPV, a stated in the previous paragraph, varies $1,963.60 from the base case to the fourth scenario. The market for Super is growing, and Jell-O’s sales seem to have flattened over the last few years, so preserving General Foods’ dominant market share in the powdered foods market is vital. The obvious risk in not going forward with the project is that competitors could take that potential market share, and even a marginal NPV of $232.70 is much more beneficial than losing their market share.
Another large concern is that of General Foods’ competition creating a product similar to Super Project. If this were the case, then Super’s projected sales could be significantly weaker than anticipated, causing a much less lucrative project. We assume that General made this assumption when they made the sales of the project slow in further years, leading us to believe that this was due to the competition taking more of Super’s market share.
The largest risk is the accuracy of Jell-O’s erosion. If the erosion is predominantly higher than anticipated, it could eat into the profitability very quickly. Erosion is a rather weak projection, and firms have much difficulty attempting to forecast these numbers. Erosion should not be ignored because of its inaccurate nature, but should be monitored carefully by General Foods. As stated in the last paragraph, the potential for General Foods competition creating a product similar to Super is great, so as long as erosion stays within the company then it is preferable to lost market share.
Jell-O faces the distinct possibility that the agglomerator machines will develop wear and tear more quickly than their deprecation schedule shows, having to deal with both Jell-O and Super Projects powdered products. This more demanding work schedule could increase maintenance costs as well, driving down the actual profits.
While there is risk that Super Project will erode a portion of Jell-O sales, there is no less risk that failing to execute this brand extension will prevent competitors from taking Jell-O’s market share. Staying ahead of competition is the most important aspect ofthe project, and becoming a customer brand of choice is equally as important.
Let see what the calculations have to say:
Looking at all the calculations it is safe to say that the Super project would be a good investment project for General Foods. P.D.C. Consultants see positive NPV and ARR and an IRR higher then 10%. Payback period is an average of 7.0 years. Also, since General Food does not have many products in the dessert market, therefore it is definitely a good idea to expand on their current product line. The Super Project does just that. It would use the current facilities to create a product that will follow the rapidly growing powdered dessert market. Thus, they will increase company profit, follow the trendy market, and stay one step ahead of their competition.