Cash Flow Estimation for Capital Budgeting The Super Project Cash Flow Estimation for Capital Budgeting

Investment Criteria Project ranking according to Payback period Accounting rate of return Are certain costs being ignored? What are the relevant project costs and cash flows? Test-market expenses Use of excess agglomerator and building capacity Overhead costs Lost contribution margin on Jell-O

Test Market Expense Product Design R&D Market Testing Manufacturing Investment Working Capital

Allocated Charges for Capacity Utilization Charge for excess agglomerator and building capacity Jell-O sales for August to September 1966 increased by 40% over previous year In two years you would have to increase capacity anyway Super project will require earlier and even greater increase Reasonable to include use as costs Risk of investment?

Allocated Overhead Charges Overhead costs are not fixed (see last 10 yrs in Exhibit 3) SGA/Sales: 17.9% (1958) to 27.2% (1967) Reasonable to include an increase from years 5 to 10 How much? Costs increase by $54,000/year for 10 years Total of $540,000 Yearly cost from years 5-10 = $540,000/6 $90,000 Graduated scale?

Charge for Lost Contribution Questionable charge Assume that Jell-O would hold volume if Super is not introduced What if a competitor introduces a product like Super? Erosion is inevitable?

Assumptions and setup Exclude: Include: cash flow identity test market expense (sunk cost) erosion (inevitable) Include: agglomerator and building use (opportunity cost) overhead costs (side effect) cash flow identity cash (project) = OCF - additions to NWC - NCS Assume r=10%

Cash Flow from Operations Depreciation for Jell-O facilities: Sum-of-year digits; 40/15 year lives; $133/320

Cash Flows for Super Investment tax credit of $8 in year 0; Tax shield on write-off of equip. in yr 11

DCF Calculation NPV = $538 = accept

NPV Profile of Project IRR = 18.5%

Sensitivity Analysis Use of Jell-O Facilities

Sensitivity Analysis Overhead

Sensitivity Analysis Erosion

NPV Sensitivity Analysis OVERHEAD JELLO FACILITIES yes (109) EROSION yes (109) 20 no yes yes 208 (109) 208 no 337 538 no yes 538 yes 538 538 no 667 no yes 855 855 no 984 no