Energy Gel Case Report
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With the High Performance Corporation Energy Gel case before us, we recommend to Florence Vivar, chief financial officer of HPC, that the company should not invest in the energy gel project. We came to this conclusion after amending the existing capital budgeting process, and assessing the opinions of Harry Wickler, Mark Leiter, and Frank Nanzen in how to evaluate the project. The capital budget process in place is to use the payback period and return on invested capital (ROIC) for the project. The payback period criterion is a flawed way to determine the value of the project because it does not take into account cash flows after the required payback period (7 years). For example, if the Energy Gel project had not paid back the initial investment by year seven, but was very profitable in the years before liquidation, it would result in rejecting a profitable project. In addition, because the cutoff period is very subjective and the time value of money and the risk of the project are ignored, we believe the payback period was an ineffective valuation method.
The ROIC approach is also flawed. In their calculation of the return on investment capital, they did not factor in any dividends the firm would be paying, whether it is about continuing to pay out dividends or a plan to start paying out dividends. We utilized the net present value formula to decide if High Performance Corporation should invest in Energy Gel. This valuation method combats all the shortcomings of the capital budgeting measures currently in place. This formula states that if the net present value of the discounted cash flows resulting from energy gel is positive, then HPC should invest in the project. However, if the net present value of the discounted cash flows from the project is negative, then HPC should not invest. With the new capital budgeting process in place, we needed to consider the opinions of HPC employees on which costs should be included in the valuation. We can either choose the direct costing, full costing, or equipment based costing methods that were recommended or we could come up with our own method. We decided that we would look at all the costs included in each of the recommended methods and use the ones that arise solely from the Energy Gel project.
We only needed to focus on the incremental cash flows that would come from HPC’s undertaking of the Energy Gel project in order for the net present value calculation to have any relevance in the investment decision. Our first step in valuing the project was coming up with the forecasted after tax profits over the next ten years (starting in 2001). To do this, we used Energy Gel financial statements, Energy Bar financial statements, and various assumptions from HPC management. In the Energy Gel After-Tax Profits Chart (Chart 1), the first four items: Units (1), Sales (2), Cost of Goods Sold plus Depreciation (3), and Advertising Expense (4), were all provided by the HPC Energy Gel Financial Evaluation Form (Exhibit 2). Research and Development and Market Research Expense (7) were as well (R&D was not capitalized as we could not be certain Energy Gel would be profitable). However, in order to figure out the before-tax profits we needed to identify any other incremental costs. Two costs we did decide to include were Selling Expense (5), and General and Administrative Expense (6).
These two costs fit the definition of incremental costs because they will be incurred if HPC follows through with the project and not incurred if they do not. We agreed with Energy Bar Product Manager, Mark Leiter, that Energy Gel would incur the same selling expense per unit as the Energy Bar. To project Energy Gel’s Selling Expense in Chart 1, we divided Energy Bar’s Selling Expense in 2001 ($4.90 M) by their total units in 2001 ($43.30 M)(Exhibit 1) to get $0.113. Then, we multiplied $0.113 by the projected Energy Gel units over the next ten years. We also agreed with Leiter’s assumption that Energy Gel would incur 12 percent of Energy Bar’s general and administrative expense in 2001, and then 8 percent each year thereafter. To project this expense, we used 12 percent of Energy Bar’s general and administrative expense from 2001($12.7 M), for 2001 (Exhibit 1). Then we multiplied the previous years value by 1.08 (8 percent growth) for the next nine years starting in 2002.
We decided that cannibalization was not a cost to consider because the Energy Gel product was in a completely different consumer category than the Energy Bar. Customers using Energy Gel will be consuming the product shortly before, during, or right after strenuous activities, while Energy Bars will continue to be consumed throughout the day at the volume as pre energy gel. To back this up, we can consider the various gel products that have already been on the market since the late 1990s. If Energy Bar consumers wanted to switch to Gel, there were already products on the market to fulfil their needs. However, Energy Bar still continued to experience steady growth and will continue if Energy Gel arrives on the market. After we had accounted for all the incremental costs factoring into profits, we could find the before tax profits. This calculation can be followed in Chart 1 as ((2)-(3+4+5+6+7))=Pre-Tax Profits (8). Once we calculate ten years of Pre-Tax Profits, we can apply the Tax Rate (9) of 35 percent to get After-Tax Profits (10). The calculation at the bottom of Chart 1 is (8)*(9)= (10). The first two years of after-tax profits are negative, meaning HPC will receive tax credits.
We will keep the tax credits where they are, rather than deferring them to future years because the corporation will also be profitable in other projects. The tax due on the Energy Bar alone ($6.9 M in 2001 and $8 M in 2002) will surpass the tax credit on Energy Gel ($-1.57 M in 2001 and $-.13 M in 2002). The next step in the process of valuing Energy Gel was to find the annual changes in working capital. To do this, we used the total working capital from Energy Gel’s “Financial Evaluation Form” (Exhibit 2) and labeled it as Working Capital (11) in the “Energy Gel Change in Working Capital Chart” (Chart 2). To convert working capital into the change in working capital (12), we took the current year’s working capital and subtracted from it the prior year’s. We followed this same pattern until liquidation (end of 2010), at which point HPC would recover the $4.8 M of working capital invested in the project. The third step in valuing the Energy Gel Project was to come up with the cash flows to plug into the NPV calculation. For this step, we took the after-tax profits (10) from Chart 1, added back depreciation (13), and subtracted change in working capital (12) from Chart 2, as well as the building expenditure (14), and the machinery modification expenditure (15), to get the projected cash flow (16).
This can be followed as ((10+13)-((12+14+15))=(16). Our depreciation per year ($0.3M) is based on the assumption that we are only depreciating the capital expenditures needed to produce Energy Gel. Mark Leiter’s thought to include the cost of the existing machine in the valuation is misguided because HPC already has the machine. They will not have a cash outflow to purchase a new machine; they will only have an outflow for the new building modification ($1.5 M, 15 year S-L, $.1 M Depreciation per year) and the new packaging machinery ($2 M, 10 year S-L, $.2 M Depreciation per year). Therefore, there will be a capital expenditure of $3.5 M in 2000 and depreciation of $0.3 M annually for the next 10 years. At liquidation at the end of 2010, the packaging machinery will have zero book value, but the building modification will have a $0.5M book value. Assuming that we follow HPC’s projection of zero salvage value for both the packaging machinery and building modifications at liquidation in 2010, the Energy Gel project will experience a loss of $0.5 million. This loss will experience the same tax benefit of 35% and will result in a cash outflow of $0.325 million.
Therefore, at liquidation, the Energy Gel project will experience a total cash inflow of $4.48 million followed in chart 3 at liquidation in 2010 as the negative sum of (12)+(14). The $4.48 million at liquidation is comprised of the recovery of Net Working Capital and the taxed loss on the building modification. With the projected cash flows (16) in place, we calculated their net present value, using HPC’s 15% required rate of return. To get the discounted cash flows (17) from the projected cash flows we start in 2000. This cash outflow is not discounted because it occurs at time zero. In 2001, we discount the cash outflow by 1.15^1. In 2002, we discounted the cash outflow by 1.15^2 and 2003’s inflow by 1.15^3, 2004 by 15^4 and continued with this pattern until we discounted both the cash flow and liquidation proceeds in 2010 by 1.15^10.
This calculation can be followed in Chart 4 as (16)/(1.15)^t, where t equals years after 2000. After we had all the discounted projected cash flows, we summed them to get the net present value of the energy gel project (18) of $-0.85 million. After amending the capital budgeting process, and determining that we should use an incremental costing method, it is clear that high performance corporation should not invest in the Energy Gel project. The projects net present value of $-850,000 means that by embarking in Energy Gel, the overall value of HPC would decrease by $-850,000. By reading over our analysis, Florence Vivar should be confident in her decision to not invest.
With the mixing machine usage, it would make sense if Wickler covered these costs or at least considered covering these costs in his initial analysis. Asking Leiter to cover all of the costs when his division is only responsible for 40% of the usage is unfair. Also, if Wickler is dead set on investing in Energy Gel and really having it as a staple in the company, then he should consider if the segment will be profitable while including all possible and necessary costs instead of piggybacking off of other segments. With the consideration of the cost of the machine figured into the valuation, Wickler should also factor in the remaining depreciation on the machine.