We chose to use the NPV method because it is the best method for capital budgeting and valuing a project or alternative. The NPV takes into account all of the relevant cash flows and the time value of money. When calculating NPV, we do not need to include the test market expenses, as they are sunk costs. We need to include any relevant overhead expenses, erosion costs from the Jell-O product line and the excess capacity used. When determining whether to accept or reject a project based on a NPV, as long as the NPV is positive the project or alternative should be accepted.
Just the opposite, if the NPV is negative, the project or alternative should be rejected. In terms of a SWOT analysis for the project in general, one strength would be the strong market share that General Foods already has with their other strong products, jell-O for example. Another strength would be their knowledge of powdered desserts and similar products.
One weakness that is prominent in this case is the fact that the new Super Product is taking away from the production of Jell-O, an already strong product.
In terms of the opportunities, the product may flop, taking away possible gains General Foods could gain from developing a new different product. A threat to this case and General Foods is that of competitors. Competitors may try and copy the product or create a better alternative to General Foods’ Super Product. Analysis The Super Project has an initial investment of $200 and a pro rata share of facilities of $453 giving us a 3 total investment.
This total investment will depreciate over the next ten periods.
The first period only depreciates by 5% while the next nine will depreciate by 10%. After all the depreciation has occurred there will just be the salvage value remaining for the capital asset. With depreciation being paid each year there is a tax shield created. A tax shield is a deduction in income taxes that result from taking an allowable deduction from taxable income. To find out how much the tax shield the Super Project has, just take the amount of depreciation for that period and multiple it by the tax rate (52%). The tax rate used was the average tax rate over the past 10 years.
Cost of Debt and cost of equity help get different rates that are an important factor in figuring out the weighted average cost of capital (WACC). Cost of debt gives the interest rate General Foods would pay for all the current debts. While the cost of equity is the minimum rate of return that they must offer shareholders to keep them investing in their company. The Super Project has cost of debt of 1. 57% and cost of equity of 13%. This helps figure out the WACC which is the rate we expect to pay on average to all security holders to finance our assets.
The WACC for the super project is 11. 77% which is less than the 13% rate of return that the shareholders are looking for. This tells us that the Super Project might not be the best idea. NPV is still the best measure for capital budgeting so we went ahead and did the calculations for it. To figure out the net present value we have to first figure out the cash flow. In 1968 we get earnings before income taxes of $283. This is the $643 total investment minus the $360 cost for test markets that we see as a sunk cost and are not including it as part of the Super Project.
The cash flow generates positive revenue for the Super Project but we still have to factor in that the Super Project is eroding 20% of Jell-O causing their revenues to decrease along with their cash flow. After cash flow is figured out we are finally able to see what the NPV is. When calculating NPV you have to get the sum of discounted cash flows and add it to the initial investment. For the Super Project we get $298. 4 discounted cash flow + (653) fixed investment = (354. 6) NPV. With the NPV being a negative number, we know to reject the super project.