Heavenly Foods Corporation is a food conglomerate with major product lines of cereals, frozen

dinners, and canned sodas and fruit juices. The rm was founded in 1955 by Henry Abercrombie, an
ambitious college graduate who had just acquired a small inheritance and who wanted to be his
own boss. Equipped with an idea for an instant hot cereal, Henry founded Heavenly Foods. The
instant hot cereal was well received by the public, and through Henrys industriousness, his supe-
rior ideas, and his excellent business instincts, the company has expanded considerably during its 40-
plus years of existence, both by acquisitions and innovative product ideas. Three years ago, because
of his age and declining health, Henry hired his daughter, Abigail, as a management trainee with
the intention that she would eventually succeed him as president of the company.
Abigail, a Harvard MBA and a dedicated marathoner, has a number of ideas for new prod-
ucts she would like the company to introduce. She believes Heavenly Foods has not kept up with
general food trends, especially the trend toward low fat and low sodium content products, and the
introduction of athletic drinks to replace essential body uids lost during exercise. While Heavenly
Foods nancial position is still strong, Abigail believes the company must introduce new products
directed toward an increasingly athletically inclined and health conscious public to keep its posi-
tion in the marketplace. She believes that if the company doesnt get on the bandwagon soon, it
will see a decline in revenues and its position in the marketplace.
In fact, immediately after she was hired, Abigail worked with the companys marketing and
new product development departments to launch a new athletic drink called High Energy. Mar-
keting surveys had shown that the public was dissatised with athletic drinks currently on the mar-
ket because they tasted too much like watered down fruit juice or else they left a bad aftertaste.
High Energy tastes like a milkshake, comes in chocolate, French vanilla, and strawberry flavors, has
no bad aftertaste, and replaces the electrolytes lost from the body during exercise. However, because
of the urgency given to High Energys development and its hasty market introduction, both Abigail
and the new product development team had not overcome High Energys one major weakness
the fact that it contained ve grams of fat per eight ounce serving. Abigail, along with the market-
ing department, agreed that it was critical to introduce the product quickly, and if it seemed that High
Energy had reasonable market acceptance, then a lite version containing fewer calories and fat
Copyright 1994. The Dryden Press. All rights reserved.
Case 60
Heavenly Foods Corporation
Capital Budgeting
Directed
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grams could be developed. In fact, if the lite athletic drink is introduced, this might open new mar-
ket opportunities for Heavenly Foods in their frozen dinner line. The company might then use a sim-
ilar lite process to develop a line of lite frozen pizzas. However, if the lite athletic drink is not
undertaken, then Heavenly Foods would not be in a position to develop other lite frozen products.
High Energy has been on the market for eighteen months, and recent market surveys indicate
that the drink does indeed have a small following, but would receive a much larger market share if
it were available in a lite version. So, Abigail and Heavenly Foods management team are cur-
rently evaluating High Energy-Lite. A test marketing program carried out earlier this year at a cost
of $262,500 showed enthusiastic acceptance for the product, which would cost more than the origi-
nal version but offer 50% less calories, have only two grams of fat per eight ounce serving, and
still have a good milkshake taste. Abigail has hired you and your consulting rm as nancial analysts
to help her analyze this project and to present the ndings to Heavenly Foods Executive Commit-
tee. Abigail has stressed the importance of this presentation to you, to the consulting rm, and to her.
If the presentation goes well, theres a very good chance that Abigail will be promoted to Vice
President-Operations, that you will be promoted to senior nancial analyst, and that Abigail would
use the consulting rm on a regular basis.
Production facilities for High Energy-Lite would be set up in an unused section of Heavenly
Foods main plant. Relatively inexpensive used machinery with an estimated cost of only $700,000
would be purchased, but shipping costs to move the machinery to Heavenly Foods plant would
add another $35,000, and installation charges would amount to another $70,000. Further, Heavenly
Foods inventories (raw materials, work-in-process, and nished goods) would have to be increased
by $30,000 at the time of the initial investment. If the used machinery is purchased, it would have a
remaining economic life of 4 years, and the company has obtained a special tax ruling that would
allow it to depreciate the equipment under the MACRS 3-year class. The depreciation allowances are
0.33, 0.45, 0.15, and 0.07 in Years 1 through 4, respectively. The machinery is expected to have a
salvage value of $87,500 after 4 years of use.
Heavenly Foods management expects to sell 700,000 16-ounce cartons of the new lite drink
in each of the next 4 years. The price is expected to be $2.00 per carton. Fixed costs are estimated
to be $190,000, and variable cash operating costs are estimated at $1.25 per unit. Note that operating
costs are a function of the number of units sold rather than unit price, so unit price changes have no
direct effect on operating costs.
In examining the sales gures, you noted a short memo from Heavenly Foods sales manager
which indicated that High Energy-Lite would cut into the firms sales of High Energy-Original;
this type of effect is called cannibalization. Specifically, the sales manager estimated that sales of
High Energy-Original would fall by 30 percent if High Energy-Lite were introduced. You pursued
this further, with both the sales and production managers, and they estimated that the new athletic
drink would probably lower the rms High Energy-Original sales by $80,000 per year. However,
this volume reduction would also reduce production costs by $35,000 per year on a pre-tax basis,
so the net pre-tax cannibalization effect would be -$80,000 + $35,000 = -$45,000.
Heavenly Foods federal-plus-state tax rate is 40 percent, and its overall cost of capital is 12
percent, calculated as follows:
WACC = w
d
k
d
(1 - T) + w
s
k
s
= 0.4(13%)(0.6) + 0.6(14.8%) = 12.0%.
As you began to look into the situation, you learned from Abigail that All Natural Foods,
Inc. has expressed an interest in leasing the space that would be used to produce High Energy-Lite.
The terms of the lease, if it were made, would call for Heavenly Foods to receive rental payments
of $43,750 at the beginning of each year, and, at All Natural Foods insistence, the lease would
have to run for 20 years. However, it is not at all certain that All Natural Foods will ultimately
agree to rent the space. Yet another consideration is the possibility that Heavenly Foods could
itself rent space in the local Coca Cola bottling plant. In that event, almost no capital would have to
be invested in the project, but rental payments would have to be made to the Coke bottler. Finally,
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Abigail has made you aware of a concern the production VP has raised, namely, that while the
space is not being used now, it will be needed for other products within the next 2 or 3 years,
assuming normal growth in sales of those products.
Your task is to work with Abigail to analyze the situation. You must recommend acceptance
or rejection, and evaluate the projects acceptability using the NPV, IRR, modified IRR (MIRR),
accounting rate of return (ARR), and the payback criteria. The company currently requires a pro-
ject payback to be less than two and one-half years. For purposes of calculating ARR, assume
straight line depreciation and that the equipment is depreciated to its salvage value of $87,500. For
the initial analysis, assume that High Energy-Lite is of average risk, so the 12% WACC is the appro-
priate discount/hurdle rate. Abigail is also concerned about the proper estimation of the relevant cash
ows associated with the project. For example, should the test marketing costs be charged to the pro-
ject? How should the cannibalization effect be handled under different assumptions of expected
competitor actions? How about All Natural Foods interest in leasing the space that would be used
for High Energy-Lite production, and the other divisions plant needs 2 or 3 years hence?
Abigail also noted that the 12% discount rate is based on quoted, or nominal, market-determined
component costs of capital, while both the sales price and the operating cost per unit are in current dol-
lar terms; does that present a problem? She also wondered whether it would be appropriate to assume
neutral ination equal to the 4% general rate of ination, and if not, how sensitive the results would
be to alternative assumptions of differential inflation impacts on revenues and costs. Also, if the
Coke plant is really available, how should this factor be taken into account? Abigail expects these
and other questions to be raised when she presents the recommendations to the Executive Commit-
tee, and she would like your input in response to these questions.
In addition to the basic capital budgeting analysis, Abigail would like you to perform a risk
analysis on the lite projectit appears to be protable, but what are the chances that it might nev-
ertheless turn out to be a loser, and how should risk be analyzed and worked into the decision pro-
cess? Abigail asked you to start with the base case situation and then to discuss risk analysis, both
in general terms and as it should be applied to the lite athletic drink project.
You met with the marketing and production managers to get a feel for the uncertainties
involved in the cash flow estimates. After several sessions, you concluded that the greatest uncer-
tainty involved unit sales and salvage value. Cost estimates were fairly well dened, but unit sales
could vary widely, and the realized salvage value could be quite different from the $87,500 estimate.
Companies in competitive markets typically set sales prices on the basis of competitors prices, so,
at least initially, you decided to treat the sales price as being fairly certain. However, the supply of
ingredients for the lite drink can rise or fall sharply due to market production and demand conditions,
and that can lead to large price swings in both variable costs and product sales prices.
As estimated by the marketing staff, if product acceptance is normal, then sales quantity dur-
ing the life of the project would be 700,000 units annually; if acceptance is poor, then only 450,000
units would be sold during the life of the project (the price would be kept at the forecasted level); and
if consumer response is strong, then the sales volume would be 950,000 units annually during the life
of the project. In all cases, the price would probably increase in each successive year at the infla-
tion rate (currently estimated to be 4 percent), while cash variable costs per unit would increase in
each successive year at a 2 percent rate. The production manager believes that the equipments
Year 4 salvage value could be as low as zero and as high as $125,000, depending on the demand
for such equipment after 4 years.
Abigail also discussed the scenarios probabilities with the marketing staff. After considerable
debate, they nally agreed on a guesstimate of 25 percent probability of poor acceptance, 50 per-
cent probability of average acceptance, and 25 percent probability of excellent acceptance. In addi-
tion, Tasty Foods executive committee requires that all sensitivity analyses consider changes in at
least the following variables: sales quantity, sales price, variable costs, salvage value, and the cost of
capital. Company policy also mandates that each of the variables be allowed to deviate from its
expected value by plus or minus 10 percent, 20 percent, and 30 percent in such an analysis.
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Abigail also discussed with Claude Vandermere, Heavenly Foods director of capital budget-
ing, both the risk inherent in the rms average project and how it typically adjusts for risk. Based on
historical data, most of Heavenly Foods projects have had coefcients of variation of NPV in the
range of 0.50 to 1.00, and Vandermere has been adding or subtracting 3 percentage points to the cost
of capital for projects whose CVs lie outside that range to adjust for differential project risk. Abi-
gail and you wonder about whether the cash ows from the lite athletic drink project would be pos-
itively or negatively correlated with the sales of Heavenly Foods other drinks and the S&P 500, and
you also wondered how those correlations should be dealt with in the analysis.
The discussion with Vandermere raised another issue: Should the projects cost of capital be
based on its stand-alone risk, on its risk as measured within the context of the firms portfolio of
assets (within-rm, or corporate, risk), or in a market risk context? Heavenly Foods target capital
structure calls for 40 percent debt and 60 percent common equity, and the before-tax marginal cost
of debt is currently 12 percent. You also determined that the T-bond rate, which you use as the
long-term risk-free rate, is 8.2 percent, and that the market risk premium is 7 percent. In addition,
you estimated that the market beta for the project would be about 1.75.
One additional question was raised by Heavenly Foods treasurer. He has been reading articles
in a corporate nance applications journal that discuss the fact that NPV analysis doesnt consider
opportunities created or destroyed by the acceptance of a project. These articles suggest that an
option valuation approach should be used for these additional or lost opportunities. Vandermere
has asked that the strategic option value provided by the lite athletic drink project be quantied.
This analysis should consider the scenario analysis performed but should include inflation effects
and any necessary risk adjustments to the cost of capital. Heavenly Foods will only go ahead with
the line of lite frozen pizzas if the lite athletic drinks NPV is positive. If the rm goes ahead with the
lite frozen pizza project, the initial investment outlay in Year 1 would be $500,000. The used equip-
ment purchased for the project would have an economic useful life of 3 years, after which new equip-
ment would have to be purchased. The pizza projects cash inflows for Years 2, 3, and 4 are
estimated to be $193,591, $234,751, and $278,593, respectively. In addition, the variance of the pro-
jects returns is approximately 3 percent and the short-term risk-free rate is 5 percent. Vandermere
believes that once it has been determined that the lite athletic drink project is successful, then the
cash ows for the lite pizza project should be evaluated at the cost of capital for the rms average-
risk project. Abigail would like you to determine the strategic option value provided by the lite drink
project by using both a decision tree analysis and an option valuation approach (using the Black-
Scholes model).
You have been hired to help Abigail perform the basic capital budgeting analysis and then to
introduce the concepts of ination, risk, and strategic option value to the analysis. Since most mem-
bers of Heavenly Foods Executive Committee are unfamiliar with modern techniques of risk anal-
ysis, Abigail would like to address the types of risk that are normally considered in capital budgeting,
and then consider the strengths and weaknesses of risk analysis. Next, she plans to discuss a com-
prehensive risk analysis including sensitivity analysis (refer to Table 3), scenario analysis (refer to
Table 4), and an estimate of the projects differential risk-adjusted profitability. She also plans to
carry out or at least discuss Monte-Carlo simulation, and then to provide a comparison of the vari-
ous risk-analysis techniques. Finally, she wants to address the issue of strategic option valuation.
Your task is to help her perform these analyses and to write up a report so that she can make a rec-
ommendation to the Executive Committee. To help structure your analysis and report, answer the fol-
lowing questions. (Hint: If you are not using the spreadsheet model, it would be very time-consuming
to quantify your answers to some of the questions. Therefore, in some instances, it would be appro-
priate to simply think about the situation and indicate the direction in which a change would occur.
With the model, quantied answers can be developed for most of the questions.)
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QUESTIONS
1. Dene the term incremental cash ow. Since the project will be nanced in part by debt,
should the cash ow statement include interest expenses? Explain.
2. Should the $262,500 test marketing cost be included in the analysis? Explain.
3. Suppose All Natural Foods, Inc. actually made a rm offer to lease the High Energy-Lite
production site for $43,750 a year (beginning-of-year payments) for 20 years. How should
that information be incorporated into the analysis?
4. If Heavenly Foods does not have an opportunity to lease the space, does this mean that the
space is free, or costless, from the standpoint of the lite product project?
5. Should the erosion of prots from High Energy-Original sales be charged to the High
Energy-Lite project? What if it were believed that if Heavenly Foods did not introduce the
lite product, a competing rm would develop a very similar lite product, so that High
Energy-Original sales would be adversely affected regardless of whether or not the project
in question is accepted?
6. What is Heavenly Foods Year 0 net investment outlay on this project? What is the expected
nonoperating cash ow when the project is terminated at Year 4? (Hint: Use Table 1 as a
guide.)
7. Estimate the projects operating cash ows including cannibalization effects but excluding
consideration of the cash ows associated with use of the building. (Hint: Again, use Table 1
as a guide.) What are the projects NPV, IRR, modied IRR (MIRR), accounting rate of
return (ARR), and payback? Should the project be undertaken?
8. At this point in the analysis Abigail drew your attention to the fact that whereas you were
using the market-determined nominal cost of capital as the discount rate, the sales price and
operating cost per unit were assumed to remain constant throughout the projects life. This
raised the following questions:
a. What are the problems with such an analysis in which the discount rate is in nominal
terms but the cash ows are measured in current dollar terms, unadjusted for ination?
b. If cash ows are to be adjusted for ination, is it appropriate to assume that ination is
neutral, i.e., that ination has the same impact on all elements of the cash ow stream?
9. Now assume that the sales price will increase by the 4 percent ination rate beginning after
Year 0. However, cash operating costs will increase by only 2 percent annually from the ini-
tial cost estimate, because over half of the costs are either depreciation or are xed by long-
term contracts. For simplicity, assume that no other cash ows (net cannibalization costs,
salvage value, or net working capital) are affected by ination. Find the projects NPV, IRR,
MIRR, ARR, and payback with ination taken into account. (Hint: The Year 1 cash ows,
as well as succeeding years cash ows, must be adjusted for ination because the original
estimates were in Year 0 dollars. Use Table 2 as your guide.)
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10. How would the projects NPV change if:
a. Sales prices and operating cash costs per unit increased at the same rate, 4 percent per
year?
b. Sales price rises by only 2 percent, but costs increase by 4 percent per year?
If you are using the spreadsheet model also determine the impact on the companys IRR,
MIRR, ARR, and payback.
11. If you are using the model, return to the initial ination assumptions (4 percent for price and
2 percent for cash operating costs).
a. Assume that the estimate of unit sales remains at 700,000 units per year. To the closest
penny, what Year 0 unit price would the company have to set to cause the project to just
break even, that is, to force NPV = $0?
b. Now assume that the sales price starts at $2, and that prices increase by 4 percent per year
thereafter while cash costs increase by 2 percent per year. To the closest 1,000, how low
could annual unit sales be and still have the project break even?
12. a. Why should rms be concerned with the riskiness of individual projects?
b. (1) What are the three types of risk that are normally considered in capital budgeting?
(2) Which type of risk is most relevant?
(3) Which type of risk is easiest to measure?
(4) Would you normally expect the three types of risk to be highly correlated? Would
they be highly correlated in this specic instance?
13. a. What is sensitivity analysis?
b. Complete the sensitivity tables in Table 3, assuming initially that the project has average
risk. Also, develop new tables which show sensitivity of NPV and the other variables to
the initial variable cost and the cost of capital. Assume that each of these variables can
deviate from its base case, or expected value, by plus or minus 10 percent, 20 percent,
and 30 percent.
c. Prepare a sensitivity diagram and discuss the results.
d. What are the primary weaknesses of sensitivity analysis? What are its primary advantages?
14. Complete the scenario analysis in Table 4. What is the base case (most likely) NPV? The
best-case IRR? Use the worst-case, most likely, and best-case NPVs, and their probabilities
of occurrence, to nd the projects expected NPV, standard deviation, and coefcient of
variation.
15. What are the primary advantages and disadvantages of scenario analysis?
16. What is Monte Carlo simulation, and what are simulations advantages and disadvantages
vis-`a-vis scenario analysis?
17. a. Would the lite athletic drink project be classied as high risk, average risk, or low risk by
your analysis thus far? (Hint: Consider the projects coefcient of variation of NPV.)
What type of risk have you been measuring?
b. What do you think the projects corporate, or within-rm, risk would be, and how could
you measure it?
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c. How would it affect your risk assessment if you were told that the cash ows from this
project were totally uncorrelated with Heavenly Foods other cash ows? What if they
were expected to be negatively correlated?
d. How would the projects cash ows probably be correlated with the cash ows of most
other rms, say the S&P 500, hence with the stock market? What difference would that
make in your capital budgeting analysis?
18. Calculate the projects risk-adjusted NPV. Should the project be accepted? What if it had a
coefcient of variation (CV) of NPV of only 0.15 and was judged to be a low-risk project?
19. Abigail and you thought long and hard about the lite athletic drink projects market beta.
You nally agreed to use 1.75 as your best estimate of the beta for the equity invested in the
project.
a. On the basis of market risk, what is the projects required rate of return?
b. Describe briey two methods that might possibly be used to estimate the projects beta.
Do you think those methods would be feasible in this situation?
c. What are the advantages and disadvantages of focusing on a projects market risk rather
than on the other types of risk?
20. Should the additional opportunity to develop a line of lite frozen pizzas be considered in
the analysis of the High Energy-Lite project? Explain. Use both a decision tree and option
valuation approach to quantify your answer. (If you are not using the spreadsheet model, use
only the decision tree approach.)
21. What is your recommendation? Should Heavenly Foods accept or reject the lite athletic
drink project?
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TABLE 1
Model-Generated Data: Heavenly Foods Corporation
Excluding Ination Effects
Net Investment Outlay: Depreciation Schedule: Basis: $805,000
MACRS Dep. End-of-Year
Year Factor Expense Book Value
Equipment cost 1 33% $265,650 $539,350
Freight 2
Installation 3 15 $120,750 56,350
Change in NWC 4 7 56,350 (0)
100% $805,000
Cash Flows: Year 0 Year 1 Year 2 Year 3 Year 4
Unit price $2.00 $ 2.00 $ 2.00 $ 2.00
Unit sales 700,000 700,000 700,000
Revenues $1,400,000 $1,400,000 $1,400,000
Fixed operating costs 190,000 190,000 190,000
Variable operating costs 875,000 875,000 875,000
Total operating costs $1,065,000 $1,065,000 $1,065,000
Depreciation 265,650 120,750 56,350
Net cannibalization effects 45,000 45,000 45,000
Before-tax income $ 24,350 $ 169,250 $ 233,650
Taxes 9,740 67,700 93,460
Net income $ 14,610 $ 101,550 $ 140,190
Plus depreciation 265,650 120,750 56,350
Net operating cash ow $ 280,260 $ 222,300 $ 196,540
Salvage value
SV tax
Recovery of NWC
Termination CF
Project NCF ($835,000) $ 280,260 $ 222,300
Decision Measures: Cumulative Cash Flows:
NPV 0
IRR 1
TV 2
MIRR 3
Payback 4
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TABLE 2
Model-Generated Data: Tasty Foods Corporation
Including Ination Effects
Net Investment Outlay: Depreciation Schedule: Basis: $805,000
MACRS Dep. End-of-Year
Year Factor Expense Book Value
Equipment cost $700,000 1 33% $265,650 $539,350
Freight 2 45
Installation 3 15
Change in NWC 4 7 56,350 (0)
$835,000 100% $805,000
Cash Flows: Year 0 Year 1 Year 2 Year 3 Year 4
Unit price $2.00 $ 2.08 $ 2.34
Unit sales 700,000 700,000 700,000 700,000
Revenues $1,456,000 $1,637,802
Fixed operating costs 190,000 190,000
Variable operating costs 892,500 947,128
Total operating costs $1,082,500 $1,137,128
Depreciation 265,650 56,350
Net cannibalization effects 45,000 45,000 45,000 45,000
Before-tax income $ 62,850 $ 399,324
Taxes 25,140 159,730
Net income $ 37,710 $ 239,594
Plus depreciation 265,650 56,350
Net operating cash ow $ 303,360 $ 295,944
Salvage value $ 87,500
SV tax 35,000
Recovery of NWC 30,000
Termination CF $ 82,500
Project NCF ($835,000) $ 303,360 $ 378,444
Decision Measures: Cumulative Cash Flows:
NPV $178,337 0 ($835,000)
IRR 1 (531,640)
TV 1,594,505 2 (165,406)
MIRR 17.6% 3
ARR 28.5% 4 508,090
Payback 2.56 years
1997 South-Western, a part of Cengage Learning
P
R
O
P
E
R
T
Y

O
F


L
E
A
R
N
I
N
G

F
O
R

R
E
V
I
E
W

O
N
L
Y

N
O
T

F
O
R

S
A
L
E

O
R

C
L
A
S
S
R
O
O
M

U
S
E

C
E
N
G
A
G
E
TABLE 3
Sensitivity Analysis Results
Summary of Sensitivity Analysis
Variable Change NPV after Indicated Change
from Base Level Unit Salvage
Sales Price Value VC k
30% ($160,688) ($ 662,068)
20% (381,933)
10% 65,329 (101,798) 175,000
Base Case 178,337 178,337 178,337
+10% 291,345 458,472 181,673
+20%
+30% 517,361 1,018,741 188,346
Ination (Data Table 2 with NPV as Output Variable)
Price
Ination Cost Ination
+$C$113 0% 1% 2% 3% 4%
0% $ 5,021 ($ 32,949) ($ 71,638) ($111,056) ($151,213)
1 65,773 27,803 (10,886) (50,304) (90,461)
2 127,676 89,705 11,599 (28,559)
3 190,744 152,774 114,085 74,667 34,510
4 217,026 178,337 138,919
5 320,447 282,447 243,788 204,370 164,213
6 387,116 349,146 310,457 230,882
7 455,018 378,359 338,941 298,784
8 524,172 486,202 447,513 408,095 367,938
TABLE 4
Scenario Analysis Results
Scenario Prob. NPV IRR MIRR ARR
Worst 25% ($258,628) 4.1 % 2.1 % 5.0%
Base 50% 21.6 % 17.6 % 28.5%
Best 25% 596,236
Expected value 20.18% 16.34%
Standard deviation 16.23% 9.30%
Coefcient of variation 0.8 0.6
1997 South-Western, a part of Cengage Learning
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L
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N
I
N
G

F
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R
E
V
I
E
W

O
N
L
Y

N
O
T

F
O
R

S
A
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E

O
R

C
L
A
S
S
R
O
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U
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E

C
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N
G
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E