At every beginning of the year, Euroland food has a senior management committee meeting. It will help board of directors to draw up the firm’s capital budget for the new year. In early January 2011, the senior management committee submitted company’s board of directors 11 major projects that totaled more than EUR316 million. Unfortunately, in this year the company’s spending limit on capital projects was only EUR120 million. The board of directors was necessary to choose the projects that will help company growth and maximize the shareholders’ wealth.
Background
Euroland Food, founded in 1924by Theo Verdin, wasa multinational company that produces high-quality ice cream, yogurt, bottled water, and fruit juices. As a multinational corporation, Euroland Food’s headquarter is located in Brussels, Belgium and product is sold throughout Scandinavia, Britain, Belgium, the Netherlands, Luxembourg, western Germany, and northern France. The company’s revenue is received 60% from ice cream, 20% from yogurt, and the remaining 20% distributed between bottled water and fruit juices.
The performance of the company was steady over the years, but since 1998 to 2000 the company had no growth. The management team thought that was because of the low population growth in northern Europe and market saturation in some areas. The management team hoped that increase in market share and sales would help company growth.
In all of 11 projects, there are three projects are related tonew product or new market.Fourof all projects are about product or market extension.Three of the projects areabout efficiency improvements, and one project is about safety or environmental. The new product or new markets have minimum acceptable IRR is 12% and maximum acceptable payback yearsis 6 years. For product or market extension, the minimum acceptable IRR is 10% and with 5 years maximum accept payback years. Efficiency improvements have the 8% in minimum acceptable IRR and 4 years in maximum accept payback years.And there is no test on safety or environment.
Statement of the Situation
The Eurolandfood currently faces a lot of issues. The limitation on the spending is a big block and might cause to lose future growth prospects. They already face a lot of criticism on recent failed projects. This might make the managers conscious of their efforts and make them extra cautious in their approach.Euroland food’s price/earnings are comparatively very lower which depicts low shareholders and low confidence. This might give a word of extra caution to the management that they can’t afford any other failed ventures. The risk identifying practice in the budgeting process is a subjective approach and it may as well be questioned. The management needs a more thorough approach.The financial tests might prove a problem. The statement that we should earn more where risk is high is not always true. This is because risk is a relative term meaning that what might be a risk for Eurolandfood may not be so for others and therefore yield comparatively lower for Euroland food. Also, Eurolandfood should not go for quick returns. They might be closing themselves to certain opportunities that yield better but in the long term. The creditors and institutional investors seem to be pushing for their benefit via their representation on the board. No further leverage is available to Eurolandfood and that is going to cause severe strain on financing policies.
All in all, with no new financing being available and the lack of trust by the current investors, the management seems to be facing a lot of financial strain. Also, the owner’s expect a lot of betterment in performance while decreasing the level of capital expenditure.
Possible Solutions
From financial view to consider these projects, they will be ranked as exhibit 1. There arebenefits and weaknesses of each of the decision method used by Euroland food. Each decision method provides different preferences in terms of project acceptability. The project preferences and the strengths and weaknesses of each decision method can be summarized as follows (exhibit 2):
NPV
NPV is difference between the present value of cash inflows and the present value of cash outflows. It is used in capital budgeting to analyze the profitability of an investment or project. This method gives absolute increase in shareholder’s wealth. If this is made the basis for decision, Eurolandfood will go for the following three projects:
1. Strategic Acquisition (EUR 60 million)
2. Southward Expansion (EUR 30 million)
3. Eastward Expansion (EUR 30 million)
This method gives absolute increase or decrease in shareholder’s wealth. it is considered the most safe decision criterion and is most widely adopted.
On the other hand, it has weaknesses as well. The most common one is the basic assumption in NPV method that all the subsequent inflows will be reinvested at current WACC.
IRR
IRR is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. This method gives the return that a project generates for the company after covering its cost of capital. If this criterion is used, Euroland food will adopt these projects:
1. Strategic Acquisition (EUR 60 million)
2. Southward Expansion (EUR 30 million)
3. Artificial Sweetener (EUR 27 million)
Its strengths are the fact it provides a simple hurdle rate for investment decision-making and easily understood by the non-technical people involved.
Its weaknesses are not easy to compute andcomputational anomalies can produce misleading results, particularly with regard to reinvestments.
Equivalent Annuity
A manager can run into problems with the replacement chain approach if the common “newfound” number between the two projects turns out to be a very large number. In that case, it will be easier to use the equivalent annual annuity approach. If decision is made of the basis of this, the following package will be selected:
1. Strategic Acquisition (EUR 60 million)
2. Southward Expansion (EUR 30 million)
3. Artificial Sweetener (EUR 27 million)
This method is comparatively difficult to understand and even more difficult to calculate. Even so, it gives a more reasonable and comparable view of projects than simple averaging.
PaybackPeriod
This method only focuses on the length of time required to recover the cost of an investment. Using this method, Euroland food will opt for the Inventory Control System project and after that will go for any of the other four acceptable ones, because these four have same payback.
This method is very easy to operate. It is easy to compute, easy to understand and provides some indication of risk by separating long-term projects from short-term projects.
On the other hand, it doesn't measure profitability, doesn't account for the time value of money and ignores financial performance after the break-even period. Also, it tends to lead to short term projects while a business needs long term projects for sustainable organic growth.
In case of Euroland food, the factors considered above are purely financial in nature. There are many other considerations that must be kept in mind. For example, although none of the financial measures indicate that Effluent-water treatment at four plants project should be implemented as a priority but it must be kept in mind that it is now a legal obligation for the organization and the company will be neglecting its social responsibility and compromising its ethical result as a consequence. Apart from this, the business delivery vehicles are all fully depreciated and need replacement. These will have to be replaced either now or in future. Even though it doesn’t come up as a priority in any of the financial indicators, this issue must be kept in mind. The project that comes up as a priority in most of the financial indicators is a better project, if evaluated on the long term perspective but it must be kept in mind that company is expected to generate and realize profits in the near future. The strategic move under concern is a high risk venture and therefore is prone to criticism under the current circumstances such as cash flow shortage and low trust.
The most important matter that needs to be considered is the assessment of comparative risks related to the projects. By default, all the projects categorized as extension would be a high risk and therefore they would require different risk adjusted WACC to be used as an assessment criterion. Another important factor to be considered is the strategic size and importance of a project to the organization. This particularly needs to be addressed as the organization may miss out on certain projects which will yield in large amounts later on, these projects may as well be loss leaders if other hidden benefits are to be obtained from such projects. Some projects may be mutually related in which case the business must opt for them or forgo both.
Recommended Solution
In view of related strategic factors that may affect these projects, it is not feasible for the company to decide on the basis of single assessment method. The company should not even decide on the basis of financial indicators alone. A trade off should be established between financial and non-financial factors. Keeping in view these regards, Euroland food should adopt this decision package:
1. Effluent-water treatment at four plants (€ 06 million)
