CASE: National Foods Corporation

In early 1994, Prentice Quick, executive vice president and chief financial officer of National
Foods Corporation, was reviewing capital expenditure procedures for the major divisions of
the company. This was in anticipation of management presenting the annual capital budget
to the board of directors in March. He was concerned about the allocation of capital process
among divisions and believed that the underlying standards might need to be changed.
Heretofore, the principal objectives of the company had been competitive advantage and
growth in the product areas in which National Foods chose to compete.
The company used a single after-tax cost of capital for a hurdle rate, regardless of the
division from which a capital proposal emanated. In the low inflationary environment of the
mid-1990s, the minimum acceptable return was 13%. This minimum return recently had been
lowered from 15%, but the basis for the reduction was largely subjective. The president of
the company, Roscoe Crutcher, simply felt the growth objectives of the company were
hampered by a 15% rate. Mr. Quick was uneasy not only about the overall required rate of
return but also about allocating capital at this single rate.
As a result he and Laura Atkinson, vice president and treasurer, commissioned a study
of transfer prices of capital among divisions. The study itself was undertaken by Wendell
Levine, manager of the corporate analysis and control office, who reported directly to
Atkinson. However, Atkinson frequently reviewed the study and together she and Levine
proposed the use of multiple required rates of return. As the March board of directors
meeting was less than two months away, Mr. Quick and others in senior management needed
to come forth with a proposal.

COMPANY BACKGROUND

National Foods Corporation is headquartered in Chicago, with roots going back to the late
nineteenth century when it began as a processor of corn and wheat. The company became a
public corporation in 1924, and its business gradually changed from commodity type products
to branded items. Presently, the company has three major divisions: agricultural products,
bakery products, and restaurants. The fastest growing is restaurants, which continually needs
more capital for expansion.
The agricultural product division traces its origin to the very beginning of the company.
For many years the company was only a grain processor. In the 1920s, it began to brand
certain wheat and corn products for sale to consumers. These included flour, margarine and
corn meal, followed by cake and biscuit mixes. From time to time, the division acquired other
enterprises, the most recent being a vitamin supplement feedstock company in 1974.
However, this business did not do well in the depressed agricultural marketplace of the 1980s.
As a result of this and the consultant report, the business was divested in 1985. Also divested
in the mid-1980s were certain pure commodity type businesses: bean cleaning and
wholesaling; the distribution for hog and cattle feeding; and the distribution of wheat and
other food processors. Though a few commodity operations remain, the emphasis is on
branded agricultural products.
The bakery products division consists entirely of branded products, with many of them
enjoying dominant positions in particular products segments. Products include bread, rolls,
biscuits, muffins, pizza crusts, some crackers, and an extensive line of cookies. Competition is
intense in this industry, but National Foods has achieved product dominance in a number of
lines. However, it is concerned about the cracker and cookie lines where the “monster”

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CASE: National Foods Corporation

Nabisco, has been dominant and aggressive. Nonetheless, the bakery products division is
profitable, and many lines enjoy considerable promise. Most food industry observers feel that
the agricultural commodity price declines during 1980s and 1990s have been helpful to food
processors. Many companies have plowed back their profits into research, development, and
marketing, thereby strengthening their franchises.
The last division of National Foods, the restaurant division, has enjoyed impressive
growth in recent years. The division has several types of fast food outlets, but the hamburger
chain has grown the most dramatically. As the U.S. population has changed demographically
as well as employment-wise over the past 20 years, expenditures on food away from home
have increased. This was particularly true in the 1970s and early 1980s. Throughout this time
frame there was a rapid expansion of new units, and National Food’s restaurant division was
among the leaders. By the early 1990s, this rapid expansion resulted in overcapacity.
However, different companies were affected differently, and the restaurant division of
National Foods continues to enjoy success. The division itself is operated as an independent
entity and is extremely aggressive. Headquartered in Miami, Robert Einhart, the president of
the division, has plotted a high growth path for the division. At times, he and other division
personnel clash with people from headquarters and from other divisions. Given to splashy
advertising and promotion devices, the division’s overall culture is different from that of the
company. Management of the bakery products division feels that the new headquarters
building in Miami, which is bright orange, is an embarrassment to others who carry the
National Foods banner.
With the rapid growth of the restaurant division, it has become a larger part of total
sales and operating profit. For 1993, restaurants accounted for 40% of the sales and 50% of
the operating profits of the overall company. In 1985, in contrast, the restaurant division
accounted for less than 10% of sales and profits. National Foods President Roscoe Crutcher
was aware of the rivalry among divisions but felt that it was healthy as long as it was kept in
balance. Many in the agricultural products and bakery products divisions did not think that
things were in balance. They felt they would ultimately end up working for a restaurant
company headed by Mr. Einhart. Mr. Crutcher was not about to give up the restaurant
division, yet he wanted it to play a healthy, stimulating role in the evolution of National Foods.
Nowhere did the rivalry become more focused than in the capital allocation process, where
the restaurant division requested ever-increasing capital to serve its expansion needs.

CAPITAL INVESTMENT PROCEDURES AND FINANCING

Like most companies, National Foods Corporation has layered levels of approval, with the
largest projects being approved only by the board of directors. Each division was charged with
preparing capital budgeting requests, item by item. Routine types of expenditure could be
lumped together. However, any major expenditure had to be documented as to expected
cash flows, payback, internal rate of return, and a qualitative assessment of the risk involved.
The proposals were reviewed by the corporate analysis and control office, headed by Wendell
Levine. While neither he or his boss, Laura Atkinson, had final authority, they made
recommendations on each of the larger projects.

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CASE: National Foods Corporation

Exhibit 1
National Foods Corporation Consolidated Balance Sheet (in millions)
Assets October 31, October 31, October 31,
1993 1992 1991
Current assets
Cash and marketable securities $109.5 $87.7 $65.1
Receivables 536.9 505.1 484.9
Inventories 413.5 374.5 356.6
Other current assets 23.0 45.2 32.3
Total current assets $1,082.9 $1,012.5 $938.9
Long-term assets
Land, buildings, and equipment 1,234.4 1,082.4 1,073.3
Less accumulated depreciation 462.6 389.0 342.7
Net land, buildings, and equipment $771.8 $693.4 $730.6
Other tangible assets 58.0 10.8 22.2
Intangible assets 121.2 125.2 115.1
Total assets $2,033.9 $1,841.9 $1,806.8

Liabilities and Shareholders’ equity

Current liabilities
Short-term debt $275.6 $144.9 $214.3
Current portion of long-term debt 26.1 23.1 2.8
Accounts payable 204.3 179.1 196.1
Taxes payable 42.4 50.0 11.9
Accruals 237.7 214.7 197.0
Total current liabilities $786.1 $611.8 $622.1
Long-term debt 160.9 168.2 200.1
Other liabilities 48.7 59.9 62.1
Deferred income taxes 207.1 177.2 163.9
Total liabilities $1,202.8 $1,017.1 $1,048.2
Preferred stock - 37.9 38.5
Shareholders’ equity
Common stock 210.0 210.0 105.0
Paid-in capital 0.6 3.4 26.3
Retained earnings 847.7 728.4 703.2
Cumulative exchange adjustment (87.9) (103.2) (89.9)
Treasury stock, at cost (139.3) (51.7) (24.5)
Total shareholders’ equity $831.1 $786.9 $720.1
Total liabilities and equity $2,033.9 $1,841.9 $1,806.8

Projects fell into one of two categories: profit-adding and profit sustaining. The profit-
adding projects were those where cash flows could be estimated and discounted cash flows
methods employed. The profit-sustaining projects were those that did not provide a

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CASE: National Foods Corporation

measurable return. Rather, they were projects necessary to keep the business going; for
example, environmental and health controls as well as certain corporate assets.
Approximately 20% of the projects proposed and accepted, in dollar volume, were profit-
sustaining in nature. For profit-adding projects, the 13% required rate of return was used as
the hurdle rate. Projects that fell below this return simply were not sent forward. The use of
this discount rate was supplemented by the financial goal of “achieving growth in sales and
earnings per share without undue diminution in quality of the earnings stream”. This objective
was sufficiently “fuzzy” that most did not take cognisance of it in the capital budgeting
process. Rather, the 13% return was the key variable. It was simply assumed that if projects
provided returns in excess of this figure, they would give the company a continuing growth in
“quality” earnings per share.

Exhibit 2
National Foods Corporation Consolidated Statement of Earnings (in millions)
FISCAL YEAR
1993 1992 1991
Net sales $3,670.7 $3,520.1 $3,344.1
Gross profit 1,551.5 1,387.1 1,271.0
Profit before taxes 321.0 292.7 260.1
Taxes 141.4 136.1 121.4
Profit after taxes $179.6 $156.6 $138.7
Dividends (common and preferred) 57.6 54.1 48.3
Earnings per share (in dollars) $4.49 $3.76 $3.35
Dividends per common share (in dollars) 1.40 1.24 1.10

Overall, the company has a total debt-to-equity ratio of 1.45. However, much of the
total debt is represented by accounts payable and accruals. All borrowings are controlled at
the corporate level, and there is no formal allocation of debt or equity funds to the individual
divisions. Everything is captured in the minimum hurdle rate, 13%. However, the restaurant
division is characterised by having to undertake a number of lease contracts in order to
expand outlets. Although many of the outlets are owned outright, others are leased. National
Foods does not monitor the number of leases being undertaken by the restaurant division,
but it does monitor expansion plans by the division. While the required rate of return of the
company once represented a blending of costs of debt and equity financing, this is no longer
the case. In recent years it has been adjusted on a subjective basis, in keeping with returns
earned by competitors in the industry. National Foods has little difficulty in financing itself. It
enjoys an A investment rating by both Moody’s and Standard & Poor’s. In addition, it has
ample lines of credit with commercial banks.

REQUIRED RATES OF RETURN

Mr. Levine’s office was charged with determining what would happen if the company moved
from a single required rate of return to multiple hurdle rates. His group focused on using
external market valuations for the required rates of return of the various divisions. For debt
capital, it proposed using the company’s overall rate of interest on bonds. In early 1994, this
rate was approximately 8%. The company faced a tax rate of approximately 40%.

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CASE: National Foods Corporation

Exhibit 3
National Foods Corporation Segment Analysis (in millions)
FISCAL YEAR
1993 1992 1991
Sales
Agricultural products $710 $855 $819
Bakery products 1,487 1,384 1,416
Restaurants 1,474 1,281 1,109
$3,671 $3,520 $3,344
Operating profit
Agricultural products 69 75 51
Bakery products 148 123 136
Restaurants 219 161 129
$436 $359 $316
Identifiable assets
Agricultural products 241 301 353
Bakery products 589 560 549
Restaurants 799 619 538
Corporate 405 362 367
$2,034 $1,842 $1,807

For the required return on equity capital, the study group used the capital asset pricing
model (CAPM). In this context the measure of risk is beta, the covariability of a stock’s return
with that of overall market as represented by Standard & Poor’s 500-Stock Index. The return
on equity is simply

Rj = Rf + (𝑅̅m – Rf)j
Where Rf is the risk-free rate, 𝑅̅m is the return required in the market portfolio, as represented
by the S&P 500-Stock Index, and j is the beta of security j. In early 1994, 3-month Treasury
bills yielded approximately 3.1%, 3-year Treasury notes 4.6%, 5-year Treasury notes 5.4% and
long-term Treasury bonds 7.0%. Because the typical investment project had an “average life”
of 5 years, Mr. Levine’s group proposed using the 5-year Treasury rate as the risk-free rate in
their calculations. Estimates by various investment banks of the required return on the overall
market portfolio of common stocks averaged 11.0% in early 1994.

To determine the betas for the divisions, Mr. Levine and his staff proposed the use of
proxy, or “pure play” companies, that is, companies that were closely identified with business
of the division, but that had publicly traded stocks. After extensive study, Mr. Levine and his
staff proposed the list of companies shown in Exhibit 4. For restaurant division there were a
reasonable number of proxy companies. This was not the case for agricultural products or for
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CASE: National Foods Corporation

bakery products. Unfortunately for bakery products, some of the larger businesses were
divisions of multidivision companies. In particular, Nabisco was part of R.J.R. Nabisco and
could not be differentiated. For agricultural products, some of the largest grain processors
are privately owned, so that they do not appear in the sample.

Exhibit 4
National Foods Corporation
Financial Information of Proxy Companies
BETA LONG-TERM
LIABILITIES TO
CAPITALISATION
Agricultural products
American Maize Products .90 .45
Archer Daniels, Inc. 1.05 .30
Conagra, Inc. .76 .42
Staley Continental 1.20 .51
Average .98 .42

Bakery products
American Bakeries .85 .38
Flowers Industries .75 .46
Interstate Bakeries .85 .31
Average .82 .38

Restaurants (fast foods)

Carl Karcher Enterprises 1.10 .55
Chi Chi’s 1.35 .43
Church’s Fried Chicken 1.24 .15
Collins Foods 1.35 .48
Jerrico, Inc. 1.10 .30
McDonald’s Corporation 1.10 .49
Ponderosa, Inc. 1.30 .30
Sizzler Restaurants 1.60 .40
Vicorp Restaurants 1.40 .56
Wendy’s International 1.15 .36
Average 1.27 .40

However, the study group felt that the proxy companies were representative, and that the
summary information was useful. For the betas, the group proposed using a simple average
for each category of proxy companies. This meant a beta of .98 for agricultural products, .82
for bakery products, and 1.27 for restaurants.
Concerning the debt employed to get blended costs of capital, National Foods recently
established a target long-term liabilities-to-capitalisation ratio of 40%. Capitalisation

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CASE: National Foods Corporation

consisted of all long-term liabilities (including current portion of long-term debt), plus
shareholders’ equity. The target of 40% was somewhat higher than the existing ratio. For
capital expenditure purposes, the relevant financing vehicles were felt to be long-term
liabilities and equity, not short-term debt, payables and accruals.
The agricultural products and the bakery products divisions did not need that much
in debt funds, as their internal cash flows were sufficient to finance most capital expenditures.
(The agricultural products uses short-term debt to carry inventories). Originally, Mr. Levine
proposed that for calculation purposes these two divisions have long-term liability-to-
capitalisation ratios of .35. Given growth in demands of the restaurant division, he proposed
that this division have a ratio of .45. The representative for the restaurant division objected
to this percentage, claiming that it should be higher. When Mr. Einhart learned of this he went
directly to Mr. Levine and Ms. Atkinson. He claimed that if the restaurant division were stand-
alone, it could command a ratio of at least .60, based on its real estate value. In order to
compete, he claimed that he must have a debt ratio consistent with the more aggressive
companies in the industry. Mr. Einhart threatened to the take the matter directly to Roscoe
Crutcher, the president, unless he got his way. Eventually, Einhart, Atkinson, and Levine struck
a compromise and agreed to a long-term liability-to-capitalisation ratio of .50 for the
restaurant division. To accommodate this change within the overall capitalisation structure
objectives of the company, Mr. Levine cut the agricultural products and bakery products
divisions’ ratios to .30.
In order to allow for profit-sustaining projects, Mr. Levine proposed grossing up the
divisional required returns. With 20% of the projects on average being profit-sustaining,
which were presumed to have zero percent expected return, the “gross-up” multiplier was
1.25. That is, if a division were found to have an overall after-tax required return of 9.6%, it
would be grossed up to be 9.6% * (1.25) = 12.0%. As profit-sustaining project were a cost of
doing business, profit-adding projects had to earn enough to carry them. The simple gross-up
was easiest to apply, and Mr. Levine proposed that it be the same for all divisions.
When Laura Atkinson, vice president and treasurer, was talking with Mr. Levine, she
reminded that the question of single versus multiple required returns was not resolved.
Therefore, it would be useful to calculate a required return for the overall company in the
same manner as was to be done for the divisions. The beta for National Foods Corporation in
early 1994 was 1.05 and it had been relatively stable in recent years. It was felt that a target
long-term liabilities-to- capitalisation ratio of .40 should be employed.

THE MEETING

As the required returns report would be completed shortly, Prentice Quick, the CFO, needed
to arrange a meeting among himself, other members of senior management, and the
presidents of the three divisions. He asked Laura Atkinson to present the report to
management.
The meeting would be an important one, because the decisions reached would
determine the method by which capital would be allocated to various divisions both now and
in the future. It also would establish the standard for judging return-on-asset performance.
Mr. Crutcher was anxious to get the matter resolved so that management would be on a solid
footing when it went to the board of directors in March for capital allocations. While Mr.

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CASE: National Foods Corporation

Einhart, president of the restaurant division, was familiar with the report, the other divisional
presidents were not. Mr. Einhart made it known Mr. Crutcher that although he could live with
the system proposed in the report, he felt it much simpler to have a single required rate of
return for all the divisions. “If your objective is competitive advantage and growth, you have
to keep your eye on the fundamentals of the business. These financial whizzes don’t produce
value for the shareholders – we do. Don’t shackle us with too many constraints,” was a
statement he made in passing to Mr. Crutcher.

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