Executive Summary

General Foods is a large corporation organized by Product lines. Corporation was planning to introduce a new
product Super – a new instant dessert, based on flavored, water-soluble, agglomerated powder. Super would be
offered in four flavors although chocolate was estimated to account for 80% of total sales. The requested capital
investment for Super was $200,000, and its production would take place after modifying an existing building, where
Jell-O was manufactured and by using available capacity of Jell-O agglomerator. Cost for the key machine was not
included in the project. On the basis of test market experience, once the product is introduced, it was expected to
capture a 10% of dessert market share, 80% of which would come from growth in total dessert market share and
20% of which would come from erosion of Jell-O sales.
There are basically four categories of capital investment project proposals at General Foods corporation: (1) safety
and convenience; (2) quality; (3) increase profit; and other. Super project was considered into third category, as a
profit-increasing project. Crosby Sanberg, a manager of financial analysis at General Food Corporation calculated
return on investment in three different ways of on Super Project. The first technique was Incremental basis, which
projected Super project would have an attractive return of 63% in 7 years, which in-turn could directly identify with
the decision to product Super. The second technique was Facilities-Used Basis, which consider after using half of an
existing agglomerator and two-thirds of an existing building, pre-existing Jell-O equipment. It projected Super
project would have a return of 34%. The third technique was Fully Allocated Basis, which accounted by increasing
the cost and investment base developed in second technique with overhead expenses and overhead capital. This
method projected Super Project would have a return of 25%. General Food Corporation’s dilemma was to identify
the best technique for evaluating the Super project, as the return on investment produced was significantly different.

Problem Statement

Questions- will focus the problem statement on question 1.

1.Is General Food Corporation is using the proper capital investment methods in evaluating the projects?

What are the relevant cash flows for General Foods to use in evaluating the Super project? In particular, how
should management deal with issues such as?
a) Test-market expenses?
b) Overhead expenses?
c) Erosion of Jell-O contribution margin?
d) Allocation of charges for the use of excess agglomerator capacity?

*I kept the additional Questions for reference only

2. How attractive is the investment as measured by various capital budgeting techniques (e.g., accounting rate of
return, payback period, internal rate of return, net present value)? How useful are each of these measures of
investment attractiveness? Use WACC = 10 percent.

3. How attractive is the Super Project in strategic and competitive terms? What potential risks and benefits does
General Foods incur by either accepting or rejecting the project?

4. Should General Foods proceed with the Super Project? Why or why not
 Analysis

Capital budgeting is the decision-making process with respect to investment in fixed-assets. It includes measuring
the additional cash flows associated with investment proposals and evaluating the viability of those proposed
investment. General Food Corporation uses Return on Fund Employed (ROFE) and payback to evaluate viability of
capital investment projects. ROFE for Super Project was calculated by dividing 10-year average profit before taxes
by the 10-year average funds employed. The payback period was calculated as the length of time required for the
project to repay the investment from the date the project became operational. The Payback method only accounts for
incremental income and expenses related the project. It completely ignores the cash flows that occur after the
payback time. As these both techniques had flawed, it was possibly leading to incorrect capital investment decisions.

Additional observations to include:

 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.

Thus, Crosby Sanberg presented three alternative techniques to calculate a payback and ROFE, starting with
incremental revenues and investment.
Alternative 1: Incremental Basis: This technique considered only incremental revenue, expenditure and investments.
The technique projected incremental fixed capital will be $200K, payback period in 7 years with ROFE of 63%.
This technique had flaws as it includes sunk costs and does not include the associated cost of not using a portion of
agglomerate and building space from the Jell-O project. These costs should be included as they are opportunity loss
costs. Hence, the decision to consider it as sunk costs is incorrect. Also, it fails to account for any incremental
overhead costs and income-tax-reducing depreciation on the income statement; therefore, it doesn’t recognize all
cash flows.
Alternative 2: Facilities-Used Basis: This technique will consider alternative 1 plus Opportunity cost. It correctly
accounts the opportunity cost for not used capacity, but also excludes the future overhead charges. As Super Project
will only use half of an existing agglomerator and two-thirds of an existing building from Jell-O project, super’s pro
rata share of $453 is added to the incremental capital.
Alternative 3: Fully Allocated Basis: This technique accounts the increased costs and investment base developed in
Alternative 2 by adding overhead expenses and overhead capital. Overhead expenses include manufacturing costs,
plus selling, general and administrative costs on a per unit basis equivalent to Jell-O. Overhead Capital includes a
share of the distribution system assets ($40M). Such costs cannot be considered for evaluation of the Super Project.
Only additional costs related to project could be considered. The technique projects ROFE of 25% which is slightly
greater than return of 24% to compensate for the greater risk involved.

To evaluate the Super Project, we would use Net Present Value (NPV) and the Internal Rate of Return (IRR)
methodology, applied to incremental cash flows. Based on all the alternative, NPV should be used for evaluating
Super Project and capital budgeting as it accounts all relevant cash flows, discounts opportunity cost and excludes
additional overhead costs not related to the project.
Cash Flow Analysis:
1) Test-market expenses: The test-market expenses, included in the first period, should be considered a sunk cost, as
they are already included while evaluating the Super Project. It cannot be recovered even if the project is rejected.
Therefore, test-market expenses should not be included in calculating cash flows otherwise leads to incorrect capital
budgeting decision.

2) Overhead expenses: Overhead expenses were only included in Alternative 3. As overhead expenses are not
accounted for a particular project, it should not be included. However, as Super Project is estimated to capture 80%
of the dessert market, during the project overhead expenses are expected to increase incrementally and should be
considered in capital budgeting evaluation. Also, the case is expected to increase in overhead in years 5 through 10
for the Super Project.

3) Erosion of Jell-O Contribution Margin: The erosion of Jell-O contribution margin should be accounted for capital
budgeting decision for the Super Project. Although, the Super Project is expected to increase cash flow, it is
expected to decrease in cash flow due to erosion of Jell-O product lines. Hence, it should be accounted in
incremental cost analysis.

4) Allocation of charges for the use of excess agglomerator capacity: General Food Corporation is planning to use
existing facilities; it should not include Opportunity loss cost. The corporation needs to consider other options of
utilizing the excess facility by leasing or renting.

Recommendations (draft ONLY)

General Foods should utilize a true Incremental Analysis to evaluate the Super project.
GF can do this by:

 Taking into account incremental cash flows,

 Modifying their income statement to deduct depreciation before calculating tax,
 Ignore sunk costs (marketing test, Jell-O facilities, etc.),
 Remove depreciation from capital assets for purposes of evaluation,
 Accept overhead from growth/doubling powdered dessert line