CASE: Queensland Food Corp

In early January 2003, the senior-management committee of Queensland Food Corp was to meet to draw up the firms capital budget for the new year. Up for consideration were 11 major projects that totaled over $20.8 million. Unfortunately, the board of directors had imposed a spending limit of only $8.0 million; even so, investment at that rate would represent a major increase in the firms asset base of $65.6 million. Thus the challenge for the senior managers of Queensland Food Corp was to allocate funds among a range of compelling projects nominated for consideration.

The Company

Queensland Food Corp, headquartered in Brisbane, Australia, was a producer of high-quality ice cream, yogurt, bottled water, and fruit juices. Its products were sold throughout two states (Queensland, New South Wales) and two territories (ACT and Northern Territory). (See Exhibit 1 for map of the companys marketing region.)

Exhibit 1 Queensland Food Corp, located in Australia

Queensland Food Corp sales had been static since 2000 (see Exhibit 2), which management attributed to low population growth in Northern Territory and market saturation in some areas. Outside observers, however, faulted recent failures in new-product introductions.

Exhibit 2 Summary of Financial Results (millions AUD except per share amounts)

End of Fiscal Year
	2000	2001	2002
Gross Sales	$100.8	$100.7	$100.8
Net Income	5.1	4.9	3.7
Dividends	2.0	2.0	2.0
Earnings Per Share	0.85	0.82	0.66
Shareholders Equity (Book Value)	18.2	20.6	23.5
Shareholders Equity (Market value)	45.3	39.0	22.9
Total Assets	47.7	58.0	65.6

Most members of management wanted to expand the companys market presence and introduce more new products to boost sales.

Resource Allocation

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:

Exhibit 3 Company Policy for Project Approval

Project Type	Minimum Acceptable IRR	Maximum Acceptable Payback (Years)
1. Market/Product Extension	12%	6
2. New Product/Markets	10%	5
3. Efficiency Improvements	8%	4
4. Environmental/Safety	Not required	Not Applicable

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.

Exhibit 4 Project Proposals

Project ID	Project Description	Cost (Millions)	Project Type
1	Distribution Truck Fleet Replacement/Expansion	2.2	Efficiency (or Expansion)
2	New Plant Construction	3.0	Market Extension
3	Existing Plant Expansion	1.0	Market Extension
4	Fat Free(!) Greek Yogurt/Ice Cream Development/Introduction	1.5	New Product
5	Plant Automation and Conveyor System	1.4	Efficiency
6	Wastewater Treatment (4 plants)	0.4	Environmental Compliance
7	Market Expansion West (Western Territory)	2.0	New Market
8	Market Expansion South (Victoria)	2.0	New Market
9	Snack Food Development/Introduction	1.8	New Product
10	Computer-based Inventory Control System	1.5	Efficiency
11	Bundaberg Rum Acquisition	4.0	New Product

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 companys 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 Corps yogurt and ice-cream sales in the southeastern region of the companys 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 companys 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 Corps 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 Corps 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 Corps entire line of bottled water, mineral water, and fruit juices. The Cairns plant supplied Northern Territory and Queensland (the major market).

The Cairns 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 companys 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 companys 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 DellOrco 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, DellOrco 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. DellOrco 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 companys 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 companys 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 projects 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 companys mature core business but doing so in a way that exploited the companys 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 companys 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.

Conclusion

Each member of the management committee was expected to come to the meeting prepared to present and defend a proposal for the allocation of Queensland Food Corps capital budget of $8.0 million. Exhibit 3 summarizes the various projects in terms of their free cash flows and the investment-performance criteria.

Exhibit 5 Free Cash Flow and Analysis of Proposed Projects (Note 1) ($ millions AUD)

Project		1. Distribution Truck Fleet Replacement/ Expansion (Note 3)	2. New Plant Construction	3. Existing Plant Expansion	4. Yogurt/ Ice Cream Development/ Introduction	5. Plant Automation	7. Market Expansion (Western Territory)	8 Market Expansion South (Victoria)	9 Snack Food Development/ Introduction	10 Computer-based Inventory Control System	11 Bundaberg Rum Acquisition (Note 5)
Investment
Property		2.0	2.5	1	1.5	1.4	0	0	1.5	1.5	3.0
Working Capital		0.20	0.50	0	0	0	2.0	2.0	0.30	0	1.0
	Year	Expected Free Cash Flow (Note 4)
	0	-1.14	-3.0	-1.0	-0.50	-1.4	-2.0	-2.0	-1.8	-1.2	-1.5
	1	-0.79	0.20	0.125	-0.50	0.275	0.35	0.3	0.3	0.55	-2.0
	2	0.30	0.50	0.150	-0.50	0.275	0.4	0.35	0.4	0.55	0.50
	3	0.35	0.55	0.175	0.3	0.275	0.45	0.4	0.45	0.50	0.90
	4	0.40	0.60	0.20	0.3	0.275	0.5	0.45	0.50		1.1
	5	0.45	0.63	0.225	0.4	0.275	0.55	0.5	0.50		1.3
	6	0.50	0.65	0.25	0.45	0.275	0.6	0.55	0.50		1.5
	7	0.70	0.675	0.15	0.5	0.275	0.65	0.6	0.50		1.7
	8		0.50	0.15	0.55		0.7	0.65	0.50		1.9
	9		0.53	0.15	0.6		0.75	0.7	0.50		2.1
	10		0.55	0.15	0.65		0.8	0.75	0.50		5.9
Undiscounted Sum		0.77	2.375	0.725	2.25	0.525	3.75	3.25	2.85	0.4	13.4
Payback (Years)		6	6	6	7	6	5	6	5	3	5
Max Payback Accepted		4	6	5	5	4	6	6	6	4	6
IRR		7.8%	11.3%	11.2%	17.3%	8.7%	21.4%	18.8%	20.5%	16.2%	28.7%
Min Accepted ROR		8.0%	10.0%	10.0%	12.0%	8.0%	12.0%	12.0%	12.0%	8.0%	12.0%
NPV at Corp WAAC (10.5%)		-0.192	0.099	0.028	0.521	-0.087	1.199	0.900	0.895	0.116	4.79
NPV at Min ROR		-0.013	0.187	0.055	0.388	0.032	0.990	0.071	0.731	0.178	4.143
Equivalent Annuity (Note 2)		-0.002	0.030	0.009	0.069	0.006	0.175	0.125	0.129	0.069	0.733

1Project Number 6 not included

2Equivalent Annuity is that level of equal payments over 10 years that yields a NPV at the minimum required rate of return for that project. It corrects for

differences in duration among various projects. In ranking projects based on EA, larger annuities create more investor wealth than smaller annuities.

3Reflects $1.1 million spent initially and at end of year 1

4Free cash flow = incremental profit or cost savings after taxes + depreciation investment in fixed assets

5$1.5 million would be spent in year one, $2.0 million in year two, and 0.5 million in year 3.

Case Study Questions 1. Financial Analysis: a. Which NPV of those shown in Exhibit 3 should be used? Why? b. Using all NPV forms presented in Exhibit 3, rank the projects. c. Since the wastewater treatment project is a cost of doing business, it does not have a NPV. Suggest a way to evaluate the effluent project. d. List the projects that would be funded or unfunded using the financial analysis (include Project 6 in your list) 2. Weighted Scoring Model Analysis Based on the paper by Englund and Graham (1999), Chapter 2 (Kloppenborg (2017)) and the case information, a. Use a scoring model to evaluate and select projects (pp. 45-47, Kloppenborg): i. List and define potential criteria ii. List and define those criteria that are mandatory (i.e., screening) criteria iii. Weight the remaining criteria using an AHP process b. Which projects were screened from further consideration in part 2a, ii? c. Rank order the remaining projects based on the group analysis. 3. Were the results different between the financial analysis (Question 1) and the weighted scoring model (Question 2) approach? If yes, why?