Super Project

The Super Project

■ Net Present Value (NPV) method should be employed instead of “incremental” basis

■ Cash Flow(CF) is a more accurate measurement to value an project rather than accounting income

■ The opportunity cost of building and agglomerator influences final decision a lot

Overview

Super is a new product of General Foods, which is a large corporation with several product lines. The proposal of the Super project is categorized under “Increase profit” by providing facilities to manufacture and distributing a new product.

Valuation method

General Foods evaluates new projects in terms of their “Payback period” and “return on funds employed (ROFE). Normally, a risky project is required of a ROFE more than 40% with a payback period shorter than 10 years.

The shortcoming of the criteria is that it fails to take into the opportunity cost of capital into account. In this case, Net Present Value (NPV) method is more reasonable, as the discount ratio indicates the cost of capital or the opportunity cost of capital forgone for the project.

The NPV method uses Cash Flow (CF) income rather than accounting income to evaluate profitability of projects. As a result, further adjustment is employed to compute periodic CF in projecting the income/loss of the project.

Project valuation

Three alternatives are proposed in calculating initial capital investment: Incremental basis, Facilities-used basis and Fully allocated basis.

■ Incremental basis: Only the additional $200mns.(or may thousands in fact) are considered.

■ Facilities-used: In addition to Incremental basis, it shifts pro rata facilities costs to Super, the adjustment is a accounting measure which will not cause any CF.

■ Fully allocated basis: It takes all facilities-used basis cost as well as overheads deriving from the Super project. Although it is wrong for consider facilities cost, its concern on overheads is reasonable.

Some expenditure in Super evaluation is adjusted according to...