Super Project

Prof. Jayanth R. Varma

Indian Institute of Management, Ahmedabad

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 1/10

Approach

Work out the Base Case NPV under Exhibit 6 assumptions with only
minimal changes to obtain cash flows with correct timing.
Work out the NPV adjustment required for each issue mentioned
assuming that the argument is accepted:
• Test Marketing
• Jello facility usage
• Incremental SGA
• Cannibalization of Jello
Decide which adjustments are appropriate or partly appropriate
Arrive at final NPV after incorporating the accepted adjustments
We will use the idea of Value Additivity:
• NPV of the sum of two cashflow streams is the sum of the two NPVs
• Suppose we are given a sequence of cashflows 𝐴 and another sequence
of cashflows 𝐵. Then
• 𝑁 𝑃 𝑉 (𝐴 + 𝐵) = 𝑁 𝑃 𝑉 (𝐴) + 𝑁 𝑃 𝑉 (𝐵)

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 2/10

Base Case Analysis

Exhibit 6 is accounting oriented and not cash flow oriented.

• We will add back depreciation to convert the after tax profits into cash
flows
For terminal value, we will use the salvage value (Book Value from
Exhibit 6)
The ROFE of 20% is applied to pre-tax cashflows.
• We multiply this by 1 − 𝑡 to get a post-tax discount rate.
• Tax rate is 52%
• WACC is 9.6%

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 3/10

Timing Adjustments

Some cashflows are actually in 1967 (Year 0), but Exhibit 6 puts
these cashflows in 1968 (Year 1).
We use Exhibit 5 Estimated Expenditure Rate to move most of the
Capex to Year 0
• FY 1967 $160M
• FY 1968 $40M
Working Capital
• There can be a debate about whether Working Capital is required at
the beginning of the year or the end of the year.
• End of the year is a very common and convenient assumption and we
will use this.
Test Marketing is obviously 1967 (Year 0)
• This is relevant only if decide not to remove it entirely

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 4/10

Base Case NPV

Under these assumptions, the Base Case NPV works out to 214

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 5/10

Test Marketing

The Test Marketing costs are 360, but this is pre-tax

After tax, this amounts to be 173
Since this cash flow is in year 0, the NPV impact of removing this
item would also be 173.
Is it a sunk cost?
If so, how will you decide whether to do test marketing?
• In theory?
• In practice?

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 6/10

Jello Facilities Usage

Instead of allocation, let us think of cashflows

Jello facilities are “free” in the short run, but not in the long term.
Since Jello sales are growing at 40%, a new agglomerator and
building expansion will be needed soon
• But when?
• Year 1?
• Year 2?
Investment required is 453
• In say Year 1
• Depreciate using the same pattern as in Exhibit 6
• Salvage value = book value in Year 10
NPV is -255

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 7/10

Increased SGA (Alternative 3)

The average PBT in Alternative 2 was 211, but it is only 157 in

Alternative 3.
The change in average PBT is 54
Over the ten year period, the total change in PBT is 540 which is
therefore the total increase in SGA over the entire period.
But SGA goes up only in years 5-10.
The increase in SGA during each of these 6 years must be 90.0
After tax, this amounts to 43
The cash flows to be discounted are therefore:
• [0, 0, 0, 0, -43, -43, -43, -43, -43, -43]
The NPV works out to -132

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 8/10

Cannibalization

The Jello loss is computed in Exhibit, but this is a pre-tax figure

Multiplying by 1 − 𝑡 gives the after-tax numbers as
• [86, 96, 101, 106, 110, 110, 115, 115, 120, 120]
The NPV is 659
Some of this cannibalization would have happened anyway
• If you do not cannibalize yourself, somebody else will
We could therefore take say 50% as this as the loss attributable to the
project.
The Cannibalization adjustment is then 329

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 9/10

NPV after all adjustments

Base Case NPV = 214

Removal of test marketing expenses = 173
Accounting for usage of JellO facilities = -255
Adjustment for increase in SGA = -132
Cannibalization of JellO = 329
NPV after all adjustments = 329

©Prof. Jayanth R. Varma Indian Institute of Management, Ahmedabad 10/10