The capital budget at Queensland Food Corp was prepared annually by a committee of senior managers who then presented it for approval by the board of directors. The committee consisted of five managing directors, the president Chief Executive (CEO), and the chief finance officer (CFO). Typically, the CEO solicited investment proposals from the managing directors. The proposals included a brief project description, a financial analysis, and a discussion of strategic or other qualitative consideration.
As a matter of company policy, investment proposals at Queensland Food Corp were subjected to two financial tests, payback and internal rate of return (IRR). Financial tests were considered hurdles and had been established in 2001 by the management committee and varied according to the type of project:
Exhibition 3 (See Attached)
In January 2003, the estimated weighted-average cost of capital (WACC) for Queensland Food Corp was 10.5 percent. In describing the capital-budgeting process, the CFO, Tony Austin, said, “We use the sliding scale of IRR tests as a way of recognizing differences in risk among the various types of projects. Where the company takes more risk, we should earn more return. The payback test signals that we are not prepared to wait for long to achieve that return.”
At the conclusion of the most recent meeting of the directors, the board voted unanimously to limit capital spending in 2003 to $8.0 million.
Exhibition 4 (See Attached)
1. Distribution Truck Fleet Replacement/Expansion. Wayne Ramsey proposed to purchase 100 new refrigerated tractor trailer trucks, 50 each in 2003 and 2004. By doing so, the company could sell 60 old, fully depreciated trucks over the two years for a total of $120,000. The purchase would expand the fleet by 40 trucks within two years. Each of the new trailers would be larger than the old trailers and afford a 15 percent increase in cubic meters of goods hauled on each trip. The new tractors would also be more fuel and maintenance efficient. The increase in number of tucks would permit more flexible scheduling and more efficient routing and servicing of the fleet than at present and would cut delivery times and, therefore, possibly inventories. It would also allow more frequent deliveries to the company’s major markets, which would reduce loss of sales cause by stock-outs. Finally, expanding the fleet would support geographical expansion over the long term. As shown in Exhibit 3, the total net investment in trucks of $2.2 million and the increase in working capital to support added maintenance, fuel, pay-roll, and inventories of $200,000 was expected to yield total cost savings and added sales potential of $770,000 over the next seven years. The resulting IRR was estimated to be 7.8 percent, marginally below the minimum 8 percent required return on efficiency projects. Some of the managers wondered if this project would be more properly classified as “efficiency” than “expansion.”
2. New Plant Construction. Ian Gardner noted that Queensland Food Corp’s yogurt and ice-cream sales in the southeastern region of the company’s market were about to exceed the capacity of its Sydney manufacturing and packaging plant. At present, some of the demand was being met by shipments from the company’s newest most efficient facility, located in Darwin, Australia. Shipping costs over that distance were high however, and some sales were undoubtedly being lost when marketing effort could not be supported by delivery. Gardner proposed that a new manufacturing and packaging plant be built in ACT, Australia, just at the current southern edge of Queensland Food Corp’s marketing region, to take the burden off the Sydney and Darwin plants.
The cost of this plant would be $2.5 million and would entail $500,000 for working capital. The $1.4 million worth of equipment would be amortized over seven years, and the plant over ten years. Through an increase in sales and depreciation, and decrease in delivery costs, the plant was expected to yield after-tax cash flows totaling $2.4 million and an IRR of 11.3 percent over the next ten years. This project would be classified as a market extension.
3. Existing Plant Expansion. In addition to the need for greater production capacity in Queensland Food Corp’s southeastern region, its Cairns’ plant had reached full capacity. This situation made the scheduling of routine equipment maintenance difficult, which, in turn, created production-scheduling and deadline problems. This plant was one of two highly automated facilities that produced Queensland Food Corp’s entire line of bottled water, mineral water, and fruit juices. The Cairn’s plant supplied Northern Territory and Queensland (the major market).
The Cairn’s plants capacity could be expanded by 20 percent for $1.0 million. The equipment ($700,000) would be deprecated over seven years, and the plant over ten years. The increased capacity was expected to result in additional production of up to $150,000 per year, yielding an IRR of 11.2 percent. This project would be classified as a market extension.
4. Fat Free(!) Greek Yogurt/Ice Cream Development/Introduction. David D. Jones noted that recent developments in the European market showing promise of significant cost savings to food producers as well as stimulating growing demand for low-calorie products. The challenge was to create the right flavor to complement or enhance the other ingredients. For ice-cream manufacturers, the difficulty lay in creating a balance that would result in the same flavor as was obtained when using traditional yogurt/ice cream.
$1.5 million would be needed to commercialize a yogurt line that had received promising results in consumer and production tests. This cost included acquiring specialized production facilities, working capital, and the cost of the initial product introduction. The overall IRR was estimated to be 17.3 percent.
Jones stressed that the proposal, although highly uncertain in terms of actual results, could be viewed as a means of protecting present market share, because other high-quality ice-cream producers carrying out the same research might introduce these products; if the HooRoo Cakes brand did not carry a fat free line and its competitors did, the HooRoo Cakes brand might suffer. This project would be classed in the new-product category of investments.
5. Plant Automation. Ian Gardner also requested $1.4 million to increase automation of the production lines at six of the company’s older plants. The result would be improved throughout speed and reduced accidents, spillage, and production tie-ups. The last two plants the company had built included conveyer systems that eliminated the need for any heavy lifting by employees. The systems reduced the chance of injury to employees; at the six older plants, the company had sustained on average of 75 missed worker-days per year per plant in the last two years because of muscle injuries sustained in heavy lifting. At an average hourly wage of $14.00 per hour, over $150,000 per year was thus lost, and the possibility always existed of more serious injuries and lawsuits. Overall cost savings and depreciation totaling $275,000 per year for the project were expected to yield an IRR of 8.7 percent. This project would be classed in the efficiency category.
6. Water Treatment (4 plants). Queensland Food Corp preprocessed a variety of fresh fruits at its Brisbane and Darwin plants. One of the first stages of processing involved cleaning the fruit to remove dirt and pesticides. The dirty water was simply sent down the drain and into the like-named rivers. Recent legislation from the Department of Sustainability, Environment, Water, Population and Communities (Australian Government) called for any waste water containing even the slight traces of poisonous chemicals to be treated at the sources and gave companies four years to comply. As and environmentally oriented project, this proposal fell outside the normal financial tests of project attractiveness. Gardner noted, however, that the wastewater treatment equipment could be purchased today for $400,000; he speculated that the same equipment would cost $1.0 million in four years when immediate conversion became mandatory. In the intervening time, the company would run the risks that Australian Government and local regulators would shorten the compliance time or that the company’s pollution record would become public and impair the image of the company in the eyes of the consumer. This project would be classed in the environmental category.
7. Market Expansion West (Western Territory) and 8. Market Expansion South (Victoria). Mick Dell’Orco recommend that the company expand its market westward to include the Western Territory and to the south (Victoria, South Australia and Tasmania). He believed it was time to expand sales of ice cream, and possibly yogurt, geographically. It was his theory that the company could sustain expansions in both directions simultaneously, but practically speaking, Dell’Orco doubted that the sales and distribution organizations could sustain both expansions at once.
Each alternative geographical expansion had its benefits and risks. If the company expanded southward, it could reach a large population with a great appetite for frozen dairy products, but it would also face more competition from local and state ice cream manufacturers. The southward expansion would have to be supplied by facilities in ACT and New South Wales, at least initially.
Looking to the west, consumers in Western Territory have substantial purchasing power due to the explosion in the mining industry, but the population is significantly less than in the southward expansion geographical area. Expansion to the west would require building consumer demand and planning for future plants to produce products in Western Territory. Expansion to the west would need to be supplied by rail from Darwin facilities and further redistribution truck fleet.
The initial cost for each proposal was $2 million in working capital. The bulk of the costs were expected to involve the financing of distributorships, but over the ten-year forecast period, the distributors would gradually take over the burden of carrying receivables and inventory. Both expansion proposals assumed the rental of suitable warehouse and distribution facilities. The after-tax cash flow was expected to be $3.75 million for southward expansion and $2.75 million for westward expansion. Dell’Orco pointed out that southward expansion meant a higher possible IRR but that moving westward was a less risky proposition. The projected IRRs were 21.4 percent and 18.8 percent for southward and westward expansion, respectively. These projects would be classed in the new market category.
9. Snack Food Development/Introduction. David D. Jones suggested that the company use the excess capacity in its Darwin facility to produce a line of snack foods of dried fruits to be test-marketed in Northern Territory. He noted the strength of the HooRoo brand in that area and the success of other food and beverage companies that had expanded into snack food production. He also argued that the company’s reputation for wholesome, quality products would be enhanced by a line of dried fruits and that name association with the new product would probably even lead to increased sales of the company’s other products among health-conscious consumers.
Equipment and working capital invests were expected to total $1.5million and $300,000, respectively, for this project. The equipment would be depreciated over seven years. Assuming the test market was successful, cash flows from the project would be able to support further plant expansions in other strategic locations. The IRR was expected to be 20.5 percent, well above the IRR required for new product projects (12 percent).
10. Computer-based Inventory Control System. Wayne Ramsey had pressed for three years unsuccessfully for a state-of-the-art computer-based inventory-control system that would link field sales reps, distributors, drivers, warehouses, and possibly retailers. The benefits of such a system would be shortening delays in ordering and order processing, better control of inventory, reduction of spoilage, and faster recognition of changes in demand at the customer level. Ramsey was reluctant to quantify these benefits, because they could range between modest and quite large amounts. This year he presented a cash-flow forecast as part of a business case for the project. An initial outlay of $1.2 million for the system, followed by $300,000 next year for ancillary equipment. The inflows reflected depreciation tax shields, tax credits, cost reductions in warehousing, and reduced inventory. He forecasted these benefits to last for only three years. Even so, the project’s IRR was estimated to be 16.2 percent. This project would be classed in the efficiency category.
11. Bundaberg Rum Acquisition. Anthony Mitchel had advocated making diversifying acquisitions in an effort to move beyond the company’s mature core business but doing so in a way that exploited the company’s skills in brand management. He had explored six possible related industries, in the general field of consumer packaged goods, and determined that a promising small liquor manufacturer, Bundaberg Rum, offered unusual opportunities for real growth and, at the same time, market protection through branding. He had identified Bundaberg Rum as a well-established brand of liquor as the leading private Australian manufacturer of rum, located in Bundaberg, Queensland.
The proposal was expensive: $1.5 million to buy the company and $2.5 million to renovate the company’s facilities completely while simultaneously expanding distribution to new geographical markets. The expected returns were high: after-tax cash flows were projected to be $13.4 million, yielding an IRR of 28.7 percent. This project would be classed in the new-product category of proposals.