Nagornov Alexander (5812437)
Lvov Sergey (5758637)
Sohail Ahmed (5813018)
Super Project Case
1.
The relevant cash flows for General Foods are the following: sales and cost of goods sold for the Super
project, erosion of Jell-O contribution margin, selling expenses, income tax, capital expenditures,
opportunity costs for using excess agglomerator capacity, and increases in the net working capital.
a. Test-market expenses, which were included in the first period, are sunk costs because they had
been already expensed for feasibility of the Super project. Therefore, the management should not
include the test-market expenses into calculation of the cash flows.
b. The management did not include the overhead costs into the calculations, but the manager-
financial analysis proposed to embrace the costs in Alternative 3. However, the management
should not include overhead expenses because overhead expenses affect many areas of the
business and are not attributable to a particular business activity. Only additional overhead
expenses that arise of the decision to take a project should be added.
c. As sales of the Super project displace sales of Jell-O, the management should add, and it actually
added, the erosion of Jell-O contribution margin to the cash flows.
d. As the firm plans to use the existing facilities for launching the Super project, it should deduct
from the cash flows the opportunity cost of using the facilities because the management might
have used the facilities in a best alternative way. For example, the management might have
rented or sold the existing unused facilities or it might have produced the existing or new product
using the facilities.
2.
There are three evaluation approaches suggested to evaluating capital investment decisions.
a. Incremental Basis:
In the first approach, the management considered only the incremental revenue and fixed capital
investment. Though the approach is termed as incremental basis, in reality it is not fulfilling all the
factors, considered into the incremental earnings approach. The loss associated with the best alternative
use, i.e., opportunity cost of utilizing the building and agglomerate capacity for Jell-O has not been
taken into account. Moreover, the cannibalization effect on the sales of Jell-O should also be taken into
account when calculating incremental revenues.
b. Facilities-Used Basis:
The proportion on the pro rata share basis of the cost of building and agglomerate ($453Mn) has also
been considered in incremental capital. All costs which are already incurred and don’t affect the decision
of taking a project or not, don’t need to be taken into account for evaluation of project.
Therefore, instead of considering the costs of building and agglomerate on pro rata basis, the
opportunity cost of using these facilities should be considered for calculation of incremental earnings.
Moreover, the overhead costs directly related to the existing facilities don’t need to be subtracted from
incremental earnings. This will underestimate the incremental earnings since these costs in either case
will be incurred.
c. Fully Allocated Basis:
The overhead costs represent the cost associated with the business activities which are not directly
related to the super project. Such costs can not be fully allocated to the evaluation of the super project.
Only the additional costs related to project could be considered.
3.
To evaluate the project we would use NPV and IRR methodology, applied to incremental cash flows.
To get these cash flow we could follow several steps:
Indicatior Comment
= Forecasted sales We take the forecasted volume of sales
- Deductions
= Net Sales
- COGS Deduct the cost of goods sold
= Gross Profit
- Depreciation Deduct depreciation
- Selling expense Deduct selling expenses, as well as advertising and
administrative costs if they appear because of the
project
- Start-up costs Deduct start-up costs, needed to launch the project.*
- Adjustments to erosion Deduct the effect of cannibalization
= EBIT
- Tax
= Unlevered Income After deducting taxes from EBIT we get the unlevered
income associated with the project.**
- Initial Investment Then we start moving towards the actual cash flows
from the project. First we adjust for initial investment
in year 0.
+ Depreciation Then we add depreciation, as it is non-cash expense
- Change in NWC We also deduct the change in NWC, which is
calculated as the increase in Cash, Inventory and
Accounts receivable less the increase in Accounts
payable
= FCF from the project w/o opp. This way we receive the free cash flow from the
Сosts project
- opportunity costs Then we should take into account the opportunity costs
of using the free capacity and currently unused
equipment (it should be the largest amount of various
possibilities: selling the assets, rent, alternative project
in terms of CFs)
= FCF Thus we receive the final FCF to be used in further
calculations.
* But we don’t take into account the market research expenses incurred before the project was
operational, because they are actually the sunk costs
** We don’t deduct any interest expenses, as we try to analyze the project separately from the
financing decision.
The approach described above we apply to the number of year, we expect the project to exist (if it is
possible to forecast all components more or less precise). If the project is expected to run for infinity we
could add the PV of all future cash flows.
After getting the FCF from the project, we can calculate NPV, if we know the discount rate for the
projects with this level of risk. Alternatively we could calculate the IRR (as we have negative cash flows
only in the beginning of the project period it is possible to get the one and only value of it) and compare
it with the return on projects with similar risk characteristics.
So if we assume the project to run and bring benefits for 10 periods we will get something similar to
the following estimation:
0 1 2 3 4 5 6 7 8 9 10
= Forecasted sales 2200 2400 2600 2800 3000 3000 3200 3200 3400 3400
- Deductions 88 96 104 112 120 120 128 128 136 136
= Net Sales 2112 2304 2496 2688 2880 2880 3072 3072 3264 3264
- COGS 1100 1200 1300 1400 1500 1500 1600 1600 1700 1700
= Gross Profit 1012 1104 1196 1288 1380 1380 1472 1472 1564 1564
- Depreciation 19 18 17 16 15 13 12 11 10 9
- Selling expense 1100 1050 1000 900 700 700 730 730 750 750
- Start-up costs 15
- Adjustments to erosion 180 200 210 220 230 230 240 240 250 250
= EBIT -302 -164 -31 152 435 437 490 491 554 555
- Tax -157 -85 -16 79 226 227 255 255 288 288
= Unlevered Income -145 -79 -15 73 209 210 235 236 266 267
- Initial Investment 200
+ Depreciation 19 18 17 16 15 13 12 11 10 9
- Change in NWC 329 -55 -3 -7 -23 1 18 0 12 -272
+ Change in Cash 124 10 8 9 9 0 9 0 9 -178
+ Change in Inventories 207 15 15 14 15 0 15 0 15 -296
- Change in Accounts payable 2 80 26 30 47 -1 6 0 12 -202
= CF from the project w/o opp. сosts -200 -455.1 -5.8 5.1 96.0 247.0 222.0 229.4 246.9 264.2 547.7
- opportunity costs (e.g. rent 15%) 67.95 67.95 67.95 67.95 67.95 67.95 67.95 67.95 67.95 67.95
= CF -200 -523 -74 -63 28 179 154 161 179 196 480
IRR = 7%
It seems to be below a discount rate, which could apply for this project. But here we should be careful
and probably check the sensitivity to key assumptions of the model.
