Chiffon Case

Chiffon Case

General Foods is a company from the foods industry that is evaluating the project of introducing a new product to its portfolio. The product is a dessert called Chiffon, the initial investment of the project is $20 million that include building modifications $8M and equipment $10M. Additionally the plan is to use the extra capacity of one of the existing products (Jell-O).

The company is evaluating the project in three different ways that varies on the allocation of the capital investment. Each way gives widely different results, so the decision has to be the most coherent. The first one is the incremental basis, which is the original way of evaluating for the company, accounting only the additional investment and the incremental cost and revenue. The doubtful thing about this alternative is that the valuation is not accounting the usage on the existing product extra capacity and the opportunity losses that this would imply.

The second alternative is facilities used basis, which accounts the initial investment as the first alternative and the usage of the excess capacity. The project represented two thirds of Jell-O's building (2/3 x $20M = $13.3M) and half of the agglomerator (1/2 x $64M = $32.0M). Above it is important to account the opportunity loss of introducing other profitable projects or a possible growth of Jell-O. It is important to note that the building capacity can be filled with a lot different projects, but the equipment is really specialized and not many projects can take advantage of it and it represent the most part of the excess capacity. So if the Jell-O has a real opportunity to grow it would not be a great idea to fill the capacity with a less profitable project, but if the growth is limited and can be planed, it would make sense to take advantage of it for a project that is greater than WACC. Knowing that after calculating the ROFE for the project it fell to 34%.

The third alternative is fully allocated basis, this includes the overhead costs; of course it wouldn't make sense to account the total only the overhead costs that increase due to the project. We know that the overhead increases were made in 5 of the 10 years of the evaluation period and share of 4 million of the distribution system assets were part of it. The other costs are not displayed but we know that the overhead expense is the only difference between alternative 2 and 3, so we can use the calculations made by the company. Fully allocated has a net investment of $63.4M and facilities used is $62.3M, so the difference is $1.9M, that will be divided in the last 5 periods of the evaluation ($0.38M).

Considering the alternatives it is decided to use the third one, fully allocated, because it evaluates the project accounting all the facts of every alternative. Considering this decision the financial statements were calculated. The objective is to build to the free cash flows