CASE: Queensland Food Corp

In early January 2003, the senior-management committee of Queensland Food Corp was to meet to
draw up the firm’s 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 firm’s 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 company’s 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 company’s 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 Maximum Acceptable
IRR 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 Cost
ID (Millions)
Project Description Project Type
Distribution Truck Fleet Efficiency (or
1 2.2
Replacement/Expansion Expansion)
2 New Plant Construction 3.0 Market Extension
3 Existing Plant Expansion 1.0 Market Extension
Fat Free(!) Greek Yogurt/Ice Cream
4 1.5 New Product
Development/Introduction
5 Plant Automation and Conveyor System 1.4 Efficiency
Environmental
6 Wastewater Treatment (4 plants) 0.4
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 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.

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 Corp’s 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)
1. 2. 3. 4. 5. 7. 8 9 10 11

Distribution New Plant Existing Yogurt/ Ice Plant Market Market Snack Food Computer- Bun
Truck Fleet Construction Plant Cream Automation Expansion Expansion Development/ based Rum
Replacement/ Development/ (Western South Introduction Inventory Acq
Introduction Territory) (Victoria) Control (No
 Expansion Expansion System

(Note 3)
ent
operty 2.0 2.5 1 1.5 1.4 0 0 1.5 1.5
orking 0.20 0.50 0 0 0 2.0 2.0 0.30 0
Capital
ar Expected Free Cash Flow (Note 4)
-1.14 -3.0 -1.0 -0.50 -1.4 -2.0 -2.0 -1.8 -1.2
-0.79 0.20 0.125 -0.50 0.275 0.35 0.3 0.3 0.55
0.30 0.50 0.150 -0.50 0.275 0.4 0.35 0.4 0.55
0.35 0.55 0.175 0.3 0.275 0.45 0.4 0.45 0.50
0.40 0.60 0.20 0.3 0.275 0.5 0.45 0.50
0.45 0.63 0.225 0.4 0.275 0.55 0.5 0.50
0.50 0.65 0.25 0.45 0.275 0.6 0.55 0.50
0.70 0.675 0.15 0.5 0.275 0.65 0.6 0.50
0.50 0.15 0.55 0.7 0.65 0.50
0.53 0.15 0.6 0.75 0.7 0.50
0.55 0.15 0.65 0.8 0.75 0.50

unted 0.77 2.375 0.725 2.25 0.525 3.75 3.25 2.85 0.4

k 6 6 6 7 6 5 6 5 3

yback 4 5 5 6 4 6 6 6 4
d
7.8% 11.3% 11.2% 17.3% 8.7% 21.4% 18.8% 20.5% 16.2% 2
8.0% 10.0% 10.0% 12.0% 8.0% 12.0% 12.0% 12.0% 8.0% 1
d

Corp -0.192 0.099 0.028 0.521 -0.087 1.199 0.900 0.895 0.116

Min -0.013 0.187 0.055 0.388 0.032 0.990 0.071 0.731 0.178 4

ent -0.002 0.030 0.009 0.069 0.006 0.175 0.125 0.129 0.069 0
y

Project Number 6 not included

1

Equivalent Annuity is that level of equal payments over 10 years that yields a NPV at the
2

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

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

assets

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