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General Foods - Project Super

Essay by   •  June 28, 2011  •  1,333 Words (6 Pages)  •  1,456 Views

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Summary

Depending on a company’s specific situation, different methods for evaluating project returns are appropriate. If we were evaluating a choice of (A, B, C, D) and there is unlimited investment resources, then the answer is to simply pick out all of the positive NPV projects. However, if there are limited resources, then the right answer is to optimize based on cashflows. The current situation is similar. General Foods needs to develop a method of evaluating projects that takes into consideration the potential limitation of resources, now and in the future, and generate the highest ROE for equity investors. Neither the incremental analysis nor the fully allocated analysis presented in the case is quite the optimal method. An alternative method that combines the attractive elements of both would give us a more optimal solution, and would probably satisfy the proponents of both.

Company Discussion

General Foods has been steady growing over the last ten years. The average sales growth is 5.7%. Average net income growth is 8.4%. The average sales growth is 8.4%. Everything considered, General Foods is a well run, conservatively financed, and cash rich company.

Return on equity has held steady for the last ten years between 16% and 17%. Return on sales has improved during the same period, rising from 4.8% to 6.0%, perhaps on the basis of the innovative product offerings. However, the return on sales had not translated to higher ROE because it is dragged down by lower asset turnover. This is perhaps due to higher capital investments, or less efficient use of existing assets. Leverage ratio has barely changed over the ten year period.

The powdered deserts segment is a hot area in a relatively sleepy industry. General Foods best positioned with Jell-O, taking 19% market share of all deserts, with sales volume growth of 40% over one single year. This growth is supported by a heavy investment in manufacturing facility, as inferred by the case’s discussion of available capacity. On the back of success of Jell-O, this is a great time to offer a complimentary powdered desert product code named Project Super. Project Super can use some of the facilities that Jell-O is currently under-utilizing. Can Super be evaluated on the same basis as other projects, i.e. using incremental analysis?

Project Evaluation Methodology Discussion

Analyzing projects on incremental basis reflects the true economic value of those projects if 1) the resources that the project is getting for “free” is truly unconstraint and underutilized 2) there is no clear optional projects which would take up those facilities in the future 3) the project will truly be incremental in terms of SG&A and corporate overhead. This methodology will penalize the projects that need large initial upfront investments in new facilities, and promote investments which piggy-backs off of existing fixed resources. In the short run, this methodology will promote the most efficient use of existing facilities, since new projects will attempt to squeeze every last available resource since those resources are “free”. Over the long run this methodology might deter innovation, and limit the top-line growth of the company since project that needs fixed investment upfront will look relatively less attractive.

Fully allocated project evaluation goes 180 degrees in the opposite direction. It hugely penalizes them upfront for the optional value of the facility they are using, even if those facilities are underutilized at the moment. This methodology might be applicable if 1) the company is growing quickly 2) all product lines is certain to expand into their existing facilities 3) there are numerous new projects to choose from which all have positive NPV and not all of them can be pursued using existing resources. Over the long run, this methodology promotes only the projects that have potential to be blockbusters and makes the projects that will bring in incremental projects by making efficient use of company resources less attractive. A food company like General Foods can not survive by just waiting for blockbuster new products.

The best methodology is likely somewhere in between. Going back to Dupont Analysis (always handy!), we should develop a method that targets growth in both the ROS and the AT. ROS can be increased by offing innovate product that can command a market premium (i.e. Jell-O) and by controlling basic costs (i.e. Coca-cola). AT can be increased by efficiently using the existing facilities. How can we promote incremental projects while at the same time encourage capital investment and new product development?

Recommendation

Starting with incremental analysis, the cost of fixed asset should be free up to the point when new capital expenditures are necessary. When new capital investments are made to expand, improve, replace, or purchase new copies

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