The Super Project
• Case Summary • Problem Statement • ROFE & Capital Budgeting • Incredible Incremental • Analysis Options • Cash Flows • Recommendations
• General Foods is a large corporation organized by Product Lines. • Super is a proposed new instant desert, based on a “flavored, water-soluble, agglomerated powder.” • General Foods has numerous projects with strict criteria to judge worthiness. • There are basically three types of Capital Investment proposals at General Foods: Safety, Quality, Increased Profit • Increased Profit: Cost Reduction, Capacity, New Product • Max 10 years payback: as low as 20% PBT • … if expected to be permanent product addition • … if facilities highly reconfigurable • Three analysis types: Incremental, Facilities-based and Fully Allocated.
• Above all, Super’s worthiness as a capital investment must be evaluated according to General Foods’ accepted criteria. • Memos indicate that General Foods’ finance personnel are questioning the same criteria’s ability to accurately reflect the value of the Super project. • This is not an accounting exercise. In accounting, one tries to track and attribute all sources of costs. Also, one alters transaction timings to match expenses with income. • This is a capital budgeting exercise. We’re interested in cash flows to judge the value of a project, and when those cash flows occur. • Therefore, our team must 1) evaluate the pertinence of each of the analysis types to Super; and 2) evaluate the worthiness of the Super project.
General Foods – 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. • What is ROFE? ROFE = EBIT / Capital Invested (book value) •A financial performance metric, ROFE captures a simple relationship •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, has flaws.
In Capital Budgeting you do not evaluate earnings, you evaluate cash flows. Why?
“You can’t spend out of earnings, you can’t eat out of earnings, and you can’t pay dividends out of earnings. You can do these things only out of cash flow.” - Ross, Westerfield, Jaffe To evaluate cash flows, we must account for the time-value of money: Discount future cash flows for interest and inflation. How?
NPV Which Cash Flows?
Capital Budgeting is specifically about Incremental Cash Flows “[Incremental cash flows are] the changes in the firm’s cash flows that occur as a direct consequence of accepting the project” - Ross, Westerfield, Jaffe
•Capital budgeting decisions about Super contain externalities •Cost of the market study •Facilities used from the Jell-O project •SG&A overhead for GF corporate •Confusion about how to make these decisions •The GF Accounting and Financial Manual specifies, “capital project requests be prepared on an incremental basis.” •“What I learned about incremental analysis at the Business School doesn’t always work.” - Crosby Sanberg, GF •“Although the existing facilities utilized by Super are not incremental to this project, they are relevant.” - Crosby
•If you add non-incremental items to Super, shouldn’t you balance the equation and account for changes to the Jell-O project? •Where do you draw the line? Should not be arbitrary. •To make good decisions, a well defined framework is required to reliably apply rules to decision making
It is important to determine which cash flows are incremental and which are not because non-incremental cash flows are not relevant to the project. How do we know which cash flows are incremental cash flows? Incremental Cash Flow = total firm cash flow WITH the project total firm cash flow WITHOUT the project
Source: Professor Tim Thompson, Kellogg School of Management http://www.kellogg.northwestern.edu/faculty/thompsnt/htm/emp/Investment%20Evaluation%20Abridged.ppt
Examine cash flows decisions • • • • • • • • • Changes in net working capital Capital Expenditures for fixed assets Depreciation is not cash flow, but must be factored into taxation Ignore sunk costs Include effects of the project on the rest of the firm: erosion or enhancement Include Overhead costs Account for opportunity costs Recaptured working capital recovered after shutdown Net proceeds (after taxes) from salvage value due to the sale of capital assets after shutdown
Summary Option 1
• This evaluation method for Super considers only the “directly identified” incremental revenue, expenditure and investment. • Incremental fixed capital is $200K • Project payback period 7 years • ROFE 63%
Analysis Option 1
• This execution of Incremental Basis is flawed because it: • Includes sunk costs (the marketing study) •Fails to account for relevant increasing overhead •Fails to take into account income-tax-reducing depreciation on the income statement. • Utilizes ROFE. Again, ROFE is no good for capital budgeting
Summary Option 2 Facilities-used Basis
• Option 1 + Opportunity cost. • 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). • ROFE 34%
Analysis Option 2 Facilities-used Basis
• Facilities Basis is the WRONG choice for Super because: • Option 2 shifts costs ($453K in facilities) to Super, which is an accounting maneuver and pointless for cashflow • It’s a “net zero” method since it just moves costs • Useful for accounting; for capital budgeting, irrelevant.
Summary Option 3 Fully Allocated Basis
• Option 1 +Option 2+ OH • OH expenses: • Manufacturing costs, • Selling, general and administrative costs • OH Capital: Distribution system Assets • ROFE 25%
Analysis Option 3 Fully Allocated Basis
• Fully-Allocated is the WRONG choice for Super because: • Gives the most inclusive analysis of existing cash flow • Adds overhead correctly • But, includes Option 1 + Option 2
• General Foods should utilize a true Incremental Analysis to evaluate 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
• General Foods should conclude that the NPV of Super is $51K (10 years, no shutdown) and $71K (10 yrs, with shutdown) • This is a worthwhile (profitable) project in the following circumstances: 1) It goes at least 10 years in its current facilities; 2) If General Foods moves production, we must be willing to absorb sunk costs of that year’s NPV value. • There are additional cashflows to be considered if the project is shut down before 10 yrs (Jell-O expands into the space)
$300 $200 $100 $0
($100) ($200) ($300) ($400) ($500)
$20 $0 9% 10% 11% 11% 11.2% 11.4% 12% 13% ($20)
Discount rate (%)
The NPV is positive for 10 % discount rate