CASE: Queensland Food Corp

In early January 2003, the senior-management committee ofQueensland Food Corp was to meet to draw up the firm’s capitalbudget for the new year. Up for consideration were 11 majorprojects that totaled over $20.8 million. Unfortunately, the boardof directors had imposed a spending limit of only $8.0 million;even so, investment at that rate would represent a major increasein the firm’s asset base of $65.6 million. Thus the challenge forthe senior managers of Queensland Food Corp was to allocate fundsamong a range of compelling projects nominated forconsideration.

The Company

Queensland Food Corp, headquartered in Brisbane, Australia, wasa producer of high-quality ice cream, yogurt, bottled water, andfruit juices. Its products were sold throughout two states(Queensland, New South Wales) and two territories (ACT and NorthernTerritory). (See Exhibit 1 for map of the company’s marketingregion.)

Exhibit 1 – Queensland Food Corp, located in Australia

Queensland Food Corp sales had been static since 2000 (seeExhibit 2), which management attributed to low population growth inNorthern Territory and market saturation in some areas. Outsideobservers, however, faulted recent failures in new-productintroductions.

Exhibit 2 Summary of Financial Results (millions AUD except pershare 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 company’s marketpresence and introduce more new products to boost sales.

Resource Allocation

The capital budget at Queensland Food Corp was prepared annuallyby a committee of senior managers who then presented it forapproval by the board of directors. The committee consisted of fivemanaging directors, the president Chief Executive (CEO), and thechief finance officer (CFO). Typically, the CEO solicitedinvestment proposals from the managing directors. The proposalsincluded a brief project description, a financial analysis, and adiscussion of strategic or other qualitative consideration.

As a matter of company policy, investment proposals atQueensland Food Corp were subjected to two financial tests, paybackand internal rate of return (IRR). Financial tests were consideredhurdles and had been established in 2001 by the managementcommittee 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 thecapital-budgeting process, the CFO, Tony Austin, said, “We use thesliding scale of IRR tests as a way of recognizing differences inrisk among the various types of projects. Where the company takesmore risk, we should earn more return. The payback test signalsthat we are not prepared to wait for long to achieve thatreturn.”

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 FleetReplacement/Expansion. Wayne Ramsey proposed to purchase 100 newrefrigerated tractor trailer trucks, 50 each in 2003 and 2004. Bydoing so, the company could sell 60 old, fully depreciated trucksover the two years for a total of $120,000. The purchase wouldexpand the fleet by 40 trucks within two years. Each of the newtrailers would be larger than the old trailers and afford a 15percent increase in cubic meters of goods hauled on each trip. Thenew tractors would also be more fuel and maintenance efficient. Theincrease in number of tucks would permit more flexible schedulingand more efficient routing and servicing of the fleet than atpresent and would cut delivery times and, therefore, possiblyinventories. It would also allow more frequent deliveries to thecompany’s major markets, which would reduce loss of sales cause bystock-outs. Finally, expanding the fleet would support geographicalexpansion over the long term. As shown in Exhibit 3, the total netinvestment in trucks of $2.2 million and the increase in workingcapital to support added maintenance, fuel, pay-roll, andinventories of $200,000 was expected to yield total cost savingsand added sales potential of $770,000 over the next seven years.The resulting IRR was estimated to be 7.8 percent, marginally belowthe minimum 8 percent required return on efficiency projects. Someof the managers wondered if this project would be more properlyclassified as “efficiency” than “expansion.”

2.    New Plant Construction. Ian Gardnernoted that Queensland Food Corp’s yogurt and ice-cream sales in thesoutheastern region of the company’s market were about to exceedthe capacity of its Sydney manufacturing and packaging plant. Atpresent, some of the demand was being met by shipments from thecompany’s newest most efficient facility, located in Darwin,Australia. Shipping costs over that distance were high however, andsome sales were undoubtedly being lost when marketing effort couldnot be supported by delivery. Gardner proposed that a newmanufacturing and packaging plant be built in ACT, Australia, justat the current southern edge of Queensland Food Corp’s marketingregion, 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 equipmentwould be amortized over seven years, and the plant over ten years.Through an increase in sales and depreciation, and decrease indelivery costs, the plant was expected to yield after-tax cashflows totaling $2.4 million and an IRR of 11.3 percent over thenext ten years. This project would be classified as a marketextension.

3.    Existing Plant Expansion. In additionto the need for greater production capacity in Queensland FoodCorp’s southeastern region, its Cairns’ plant had reached fullcapacity. This situation made the scheduling of routine equipmentmaintenance difficult, which, in turn, createdproduction-scheduling and deadline problems. This plant was one oftwo highly automated facilities that produced Queensland FoodCorp’s entire line of bottled water, mineral water, and fruitjuices. The Cairn’s plant supplied Northern Territory andQueensland (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 overseven years, and the plant over ten years. The increased capacitywas expected to result in additional production of up to $150,000per year, yielding an IRR of 11.2 percent. This project would beclassified as a market extension.

4.    Fat Free(!) Greek Yogurt/Ice CreamDevelopment/Introduction. David D. Jones noted that recentdevelopments in the European market showing promise of significantcost savings to food producers as well as stimulating growingdemand for low-calorie products. The challenge was to create theright flavor to complement or enhance the other ingredients. Forice-cream manufacturers, the difficulty lay in creating a balancethat would result in the same flavor as was obtained when usingtraditional yogurt/ice cream.

$1.5 million would be needed to commercialize a yogurt line thathad 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 interms of actual results, could be viewed as a means of protectingpresent market share, because other high-quality ice-creamproducers carrying out the same research might introduce theseproducts; if the HooRoo Cakes brand did not carry a fat free lineand its competitors did, the HooRoo Cakes brand might suffer. Thisproject would be classed in the new-product category ofinvestments.

5.    Plant Automation. Ian Gardner alsorequested $1.4 million to increase automation of the productionlines at six of the company’s older plants. The result would beimproved throughout speed and reduced accidents, spillage, andproduction tie-ups. The last two plants the company had builtincluded conveyer systems that eliminated the need for any heavylifting by employees. The systems reduced the chance of injury toemployees; at the six older plants, the company had sustained onaverage of 75 missed worker-days per year per plant in the last twoyears because of muscle injuries sustained in heavy lifting. At anaverage hourly wage of $14.00 per hour, over $150,000 per year wasthus lost, and the possibility always existed of more seriousinjuries and lawsuits. Overall cost savings and depreciationtotaling $275,000 per year for the project were expected to yieldan IRR of 8.7 percent. This project would be classed in theefficiency category.

6.    Water Treatment (4 plants). QueenslandFood Corp preprocessed a variety of fresh fruits at its Brisbaneand Darwin plants. One of the first stages of processing involvedcleaning the fruit to remove dirt and pesticides. The dirty waterwas simply sent down the drain and into the like-named rivers.Recent legislation from the Department of Sustainability,Environment, Water, Population and Communities (AustralianGovernment) called for any waste water containing even the slighttraces of poisonous chemicals to be treated at the sources and gavecompanies four years to comply. As and environmentally orientedproject, this proposal fell outside the normal financial tests ofproject attractiveness. Gardner noted, however, that the wastewatertreatment equipment could be purchased today for $400,000; hespeculated that the same equipment would cost $1.0 million in fouryears when immediate conversion became mandatory. In theintervening time, the company would run the risks that AustralianGovernment and local regulators would shorten the compliance timeor that the company’s pollution record would become public andimpair the image of the company in the eyes of the consumer. Thisproject would be classed in the environmental category.

7.    Market Expansion West (WesternTerritory) and 8. Market Expansion South (Victoria). Mick Dell’Orcorecommend that the company expand its market westward to includethe Western Territory and to the south (Victoria, South Australiaand Tasmania). He believed it was time to expand sales of icecream, and possibly yogurt, geographically. It was his theory thatthe company could sustain expansions in both directionssimultaneously, but practically speaking, Dell’Orco doubted thatthe sales and distribution organizations could sustain bothexpansions at once.

Each alternative geographical expansion had its benefits andrisks. If the company expanded southward, it could reach a largepopulation with a great appetite for frozen dairy products, but itwould also face more competition from local and state ice creammanufacturers. The southward expansion would have to be supplied byfacilities in ACT and New South Wales, at least initially.

Looking to the west, consumers in Western Territory havesubstantial purchasing power due to the explosion in the miningindustry, but the population is significantly less than in thesouthward expansion geographical area. Expansion to the west wouldrequire building consumer demand and planning for future plants toproduce products in Western Territory. Expansion to the west wouldneed to be supplied by rail from Darwin facilities and furtherredistribution truck fleet.

The initial cost for each proposal was $2 million in workingcapital. The bulk of the costs were expected to involve thefinancing of distributorships, but over the ten-year forecastperiod, the distributors would gradually take over the burden ofcarrying receivables and inventory. Both expansion proposalsassumed the rental of suitable warehouse and distributionfacilities. The after-tax cash flow was expected to be $3.75million for southward expansion and $2.75 million for westwardexpansion. Dell’Orco pointed out that southward expansion meant ahigher possible IRR but that moving westward was a less riskyproposition. The projected IRRs were 21.4 percent and 18.8 percentfor southward and westward expansion, respectively. These projectswould be classed in the new market category.

9.    Snack Food Development/Introduction.David D. Jones suggested that the company use the excess capacityin its Darwin facility to produce a line of snack foods of driedfruits to be test-marketed in Northern Territory. He noted thestrength of the HooRoo brand in that area and the success of otherfood and beverage companies that had expanded into snack foodproduction. He also argued that the company’s reputation forwholesome, quality products would be enhanced by a line of driedfruits and that name association with the new product wouldprobably even lead to increased sales of the company’s otherproducts among health-conscious consumers.

Equipment and working capital invests were expected to total$1.5million and $300,000, respectively, for this project. Theequipment would be depreciated over seven years. Assuming the testmarket was successful, cash flows from the project would be able tosupport further plant expansions in other strategic locations. TheIRR was expected to be 20.5 percent, well above the IRR requiredfor new product projects (12 percent).

10.  Computer-based Inventory Control System. WayneRamsey had pressed for three years unsuccessfully for astate-of-the-art computer-based inventory-control system that wouldlink field sales reps, distributors, drivers, warehouses, andpossibly retailers. The benefits of such a system would beshortening delays in ordering and order processing, better controlof inventory, reduction of spoilage, and faster recognition ofchanges in demand at the customer level. Ramsey was reluctant toquantify these benefits, because they could range between modestand quite large amounts. This year he presented a cash-flowforecast as part of a business case for the project. An initialoutlay of $1.2 million for the system, followed by $300,000 nextyear for ancillary equipment. The inflows reflected depreciationtax shields, tax credits, cost reductions in warehousing, andreduced inventory. He forecasted these benefits to last for onlythree years. Even so, the project’s IRR was estimated to be 16.2percent. This project would be classed in the efficiencycategory.

11.  Bundaberg Rum Acquisition. Anthony Mitchel hadadvocated making diversifying acquisitions in an effort to movebeyond the company’s mature core business but doing so in a waythat exploited the company’s skills in brand management. He hadexplored six possible related industries, in the general field ofconsumer packaged goods, and determined that a promising smallliquor manufacturer, Bundaberg Rum, offered unusual opportunitiesfor real growth and, at the same time, market protection throughbranding. He had identified Bundaberg Rum as a well-establishedbrand of liquor as the leading private Australian manufacturer ofrum, 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 whilesimultaneously expanding distribution to new geographical markets.The expected returns were high: after-tax cash flows were projectedto be $13.4 million, yielding an IRR of 28.7 percent. This projectwould be classed in the new-product category of proposals.

Conclusion

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

Exhibit 5 Free Cash Flow and Analysis of Proposed Projects (Note1) ($ 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 10years that yields a NPV at the minimum required rate of return forthat project. It corrects for

differences in duration among various projects. In rankingprojects based on EA, larger annuities create more investor wealththan 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 yeartwo, and 0.5 million in year 3.

Case Study Questions 1. Financial Analysis: a. Which NPV ofthose shown in Exhibit 3 should be used? Why? b. Using all NPVforms presented in Exhibit 3, rank the projects. c. Since thewastewater treatment project is a cost of doing business, it doesnot have a NPV. Suggest a way to evaluate the effluent project. d.List the projects that would be funded or unfunded using thefinancial analysis (include Project 6 in your list) 2. WeightedScoring 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 anddefine those criteria that are mandatory (i.e., screening) criteriaiii. Weight the remaining criteria using an AHP process b. Whichprojects 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?