Super Project
Essay by 24 • June 15, 2011 • 1,146 Words (5 Pages) • 2,106 Views
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 managerfinancial
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
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