Economic And Non-Economic Factors Consideration In Capital Budgeting And Allocation Case Study Examples


Business Financial Problems:

Executive Summary_________________________ 3
Brief History_________________________5
Statement of the problem_________________________6

Works Cited_________________________17

Executive Summary
Capital budgeting is one of the key functions that a business needs to underatake in order to establish effective and efficient ways of allocating its funds in various investments and projects. In that respect, businesses apply some basic methods of evaluating their prospective projects with IRR, Payback period and NPV forming the most widely applied methods. However, the evolving world of business is increasingly demanding a consideration of other factors beyond the conomic factor which is the key focus ofthe mentioned basic methods. In that respect, this analysis uses the case of Euroland Foods S.A. to demonstrate how capital budgeting peoblems can be adreeesed in an advanced manner by includIng other considerations in projevts evalution.
Euroland Foods had been faced by the problem of stagnating sales growth hence an need to enhance sales by either enganging in new products and markets development, market and products expansion or effeciency enhancing developments. However, the company had a massive debt that according to analysts advice to the management, limited its posibilities of raising more capital to fund significant developments which included a limitation on borrowing because it could increase the debt, limit on issuing share capital as it would dilute current shareholding and limitation on the posibility of cutting on divideds which would negatively afect its share price and value.
In that respect, the analysis evaluates the effectiveness of the basic methods that the company has set as the test for potentioal projecst aqd establishes that they are limited to the extent of adressing the capital limitation problem hence a need to consider other factors in the projects. Some of the other factors that have been noted as necessary include those which affect the company’s sustaibnability, reputaion, relation with stakeholders as well as brand protection in the market. In that respect, the key factors that have been identified and which needs consideration as ameans of managing risk include; social, cultutral, political, ethical, legal as well as environmetal. Finally, the analysis have shown that with consideration of those factors, it is possible to undertake projects which had been ranked unfavourably by the IRR and Cpital payback period methods but which have better unquantifiable benefits for the business.
Euroland Foods S.A.
– Brief History
Euroland Foods is a producer of bottled water, yoghurt, fruit juices and ice-cream operating in the international market with headquarters in Brussels Belgium. It was formed in 1924 by a Belgium farmer named Verdin as a way of getting his dairy products to the market. The company mainly sells its products in German, Britain, France, Scandinavia, Netherlands and Belgium. Although the company had been enjoying success, its sales growth had started facing a low growth which became static in 1998. In that respect, there had been varied views as to the cause of the problem with the management attributing it to low population growth in the region whereas the outside analysts and observers cited the failures in new products introduction as the cause. In that respect, the management’s view had been dominated by calls to expand market reach as a way of increasing the sales and address the growth stagnation problem. However, the company still enjoyed a favorable value and share price in the market with its price/ earnings ratio being low compared to its peers. (Casy & Bruner 2008)
In that respect, the management sought to find a solution by evaluating a number of projects for implementation which had been proposed by a board committee. In terms of projects evaluation, the company had been applying the payback period method and the internal rate of return (IRR) methods as the evaluation test for any investment since the year 1999. To illustrate the management’s projects benchmark, the table below presents the payback periods as well as internal rate of return that was suitable for any project to pass the evaluation test depending on its categorization. (Casy & Bruner 2008)
Source: (Casy & Bruner 2008)
– Statement of the problem
The key problem that the company faced related to capital allocation whose background can be described by the following brief on the company financial position. Euroland has had a high debt ratio that required to be addressed as the market stabilized. According to the company advisors, this could be done through amortization of debts by either reducing dividends payments as well as issuing more equity to shareholders in order to continue financing capital developments. However, this presented a problem to the company with the two options having challenges
– The option to issue more equity would deal a blow to the company by diluting value for the existing shareholders.
– The option of reducing divided payment would affect company’s value by sparking a company’s stock price deterioration in the stock market due to loss of its attractiveness to potential shareholders. (Casy & Bruner 2008)
In that respect, the undertaking of new projects required an evaluation that could consider each possible effect including not only economic benefits but also other factors. Some of those factors present a risk to the company that requires effective analysis including introduction of the market risk aspect in the tests. (Peterson & Fabozzi, 2004) Thus, the key problem was capital limitation that required a solution as to how to reduce capital budget in implementing new projects in order to address the debt problem by avoiding much borrowing, share capital issue as well as dividends while at the same time seeking to increase its sales hence enhancing performance.
Projects’ evaluations have in traditional sense been based on aspects including expected return and payback period. However, the business world is evolving hence a need to address other contemporary issues and factors that affects a business operations, profitability in long-run as well as sustainability hence warranting a consideration in capital budgeting and investments evaluation. (Sharpio, 2008) In that respect, the problem of capital allocation for Euro land Foods can be analyzed by looking at the proposed projects and their aims as well as their economic and non economic factors and benefits. With that, the analysis can demonstrate how the company management could have applied other considerations beyond the basic capital budgeting methods’ economic view in seeking to address the capital budgeting issue as a result of the limitations that existed and in light of long-run business sustainability and profitability enhancement. (Peterson & Fabozzi, 2004) Thus, for the 11 proposed projects that required capital expenditure, an analysis of the effectiveness of the basic finance analysis based on IRR and payback periods as well as the possible improvements by considering other factors is as below.
Project 1: Expansion and replacement of the truck fleet
Project aim: Solve problem of fuel inefficiency, high maintenance cost as well as delivery inefficiency.
Economic benefit: Addition of 100 trucks in the years 2001 and 2001 for a total budget of €4.05 million with 50 being added each year. The project was projected to have an IRR of 7.8% which was than the 8% set benchmark for efficiency improvement projects. (Casy & Bruner 2008)
Other benefits and considerations:
Although the project does not pass the basic IRR test, it has other benefits that could manage risks for the business like
– Efficiency enhancement in terms of timely delivery
– Avoid market loss to competitors which could erode the company’s market share in the long-run.
– Would enhance geographical expansion reaching new markets that would pave way for market share growth in long run. (Sharpio, 2008)
Project 2: New plant development as market extension project
Project aim: To solve delivery problem since supply for the southeastern market was done in the new plant far located Strasbourg in France
Economic benefit: At a total cost of €37.5 million IRR of 11.3% over a period of 10 years. Thus the project passes the evaluation test. (Casy & Bruner 2008)
Other benefits and considerations:
Although the new plant development has economic benefits, it is also subject to some factors that could present risks to the business including
– Different cultures and environment in the new location hence a need to consider it suitability in terms of plant operations efficiency in the new location.
– Other factors including political and legal differences between the two regions would mean adapting to new laws and business requirements that could affect the business operations. (Peterson & Fabozzi, 2004)
Project 3: Plant expansion as market extension
Project aim: Meant to address the problem of facilities overutilization which stretched the plant’s capacity hence affecting maintenance when necessary.
Economic benefits: For a total of €15 million, the plant’s capacity could be expanded by 20% to provide an IRR of 11.2 %.( Casy & Bruner 2008)
(Sharpio, 2008)
Project 4: Snack foods development as new product introduction
Project aim: To make use of excess capacity in the Antwerp spice and nut processing facility.
Economic benefits: For a total of €27 million, the project would have an IRR of 13.4% which is higher than the set benchmark of 12 %. (Casy & Bruner 2008)
Other benefits and considerations:
Besides the economic benefits the project would have other befits including
– Enhancing brand reputation by promoting its name with production of more health conscious products. This would take advantage of the market’s changing social and health preferences of more health conscious products. (Sharpio, 2008)
Project 5: Plant expansion and conveyor system development as an efficiency focused project.
Project aim: Improve the systems in six of its old plants to enhance efficiency and speed of operation.
Economic benefits and consideration: At a cost of €21 million the project would produce an IRR of 8.7% which equals the set minimum of 8 %.( Casy & Bruner 2008)
Other benefits and considerations:
In addition to delivering economic benefits with the IRR just equal to the test rate, the project has numerous non economic benefits that have long-term effects on its sustainability.
– It would reduce injuries hence improve working conditions for its workers hence reducing lawsuits involving employees that would have cost the company a significant amount.
– This would also create a favorable brand image for the company in the market hence enhancing its sustainability. (Sharpio, 2008)
Project 6: Water treatment system set up at four of the company plants as an environment focuses project
Project aim: Would address the environmental problem of water pollution.
Economic benefits and considerations: At a cost of €4 million the company would help save money by not buying the equipment four years later at a cost of €15 million when it would become mandatory according to newly introduced environmental regulation rules. (Casy & Bruner 2008)
Other benefits and considerations:
Although the project has no immediate quantifiable economic benefit, it has a significant effect on the business operations and long-run sustainability that include among others
– Avoiding conflict with environmental regulatory authorities.
– Enhancing relationship with neighboring community.
– Brand reputation enhancement from ethical conduct in terms of environmental conservation. (Peterson & Fabozzi, 2004)
Project 7 & 8: Market expansion south and eastwards
Projects aim: Meant to include more markets in Southern France, Switzerland, Spain and Italy as well as Austria, Poland, eastern Germany and Czechoslovakia.
Economic considerations and benefits: At a total cost of €30 million the two expansions would be expected to deliver IRRs of 21.4% and 18.8% for southern and eastern markets respectively. (Casy & Bruner 2008)
Other benefits and considerations:
Besides the economic benefits, the project would have
– Expansion east would take advantage of taste for frozen food and take advantage of the highly growing population hence enhance brand growth in the international market.
– For southward, markets the company would have an advantage of low competition in a market with high purchasing power which could enhance performance in long-run. (Sharpio, 2008)
Project 9: Introduction of new and sweetened ice-cream and yoghurt
Project aim: Meant as strategy to enhance current brands market as well as protect market share from competitors who would be introducing new products hence presenting a threat for the company.
Economic consideration and benefits: At a total cost of €27 million the project is expected to have an IRR of 20.5 %.( Casy & Bruner 2008)
Other benefits and considerations:
Besides the economic benefit, the project would enhance brands sustainability by fighting competitors to protect its market share as well as bear a reputation for introduction of new brands. (Peterson & Fabozzi, 2004)
Project 10: Establish a networked inventory system for field and warehouses use as an efficiency project.
Project aim: As a means of enhancing market and demand forecasting as well as increasing warehouse and field operations efficiency.
Economic consideration and benefits: At a total cost of €22.5 million the project would have an IRR of 16.2% compared to the 8% benchmark. (Casy & Bruner 2008)
Other benefits and considerations:
Although the project ranks favorably on economic benefits, it presents other risks including the need to constantly adapt new technologies as new technology advances with its dynamism. (Sharpio, 2008)
Project 11: Acquisition of Schnapps brand and its associated facilities
Project aim:
Economic considerations and benefits: At a total cost of 55 million for both acquisition and renovations, the project is expected to have an IRR of 27.5% which is higher than the 12 % benchmark for new products category (Casy & Bruner 2008)
Other benefits and considerations:
Although the project presents a high return on investments, it would require a significant change in organization structure in order to adapt the newly acquired business and its system.
However, the project offers protection in the market through an enhanced brand (Peterson & Fabozzi, 2004)
In respect to the above description of the 11 projects, the IRR evaluation which ranks them on the basis of the expected economic return, the projects can be ranked as shown on the table below.
Source: (Casy & Bruner 2008)
According to the method, the most favorable project to undertake is project no. 11 which entails acquisition of a plant and its associated facilities costing the company €60 million and having the highest URR rate of 27.5%. On the other hand, the least favorable project is the environmental focused project number 6 which costs the company €4 million but has no identifiable IRR from the lack of ability to quantify its benefits of addressing the water pollution problem. In addition, project 10 would not have qualified as a worthwhile project from its expected IRR of 7.8% falling below the benchmark rate of 8%. (Casy & Bruner 2008)
Some of the strengths and weaknesses of the basic methods that apply only economic considerations including IRR and the payback period include. Although the methods presents a clear comparison of the projects return as well as the payback period, they have weaknesses in assuming that returns are always reinvested to earn a return equivalent of IRR, failing to consider different category of projects and their risks as well as the projects’ size and timeline. (Sharpio, 2008)
Thus, the ranking presents a challenge on the decision for the project to be undertaken given that the best ranked project has the highest cost as well. This is in consideration that the company is facing a problem of debt and seeks to reduce its debt level hence cannot afford such a high capital borrowing as well as cannot afford to cut the dividend payment or issue more share capital in order to finance its projects. Further, there are other factors that go beyond the economic benefits of each project as described which can be used as evaluation measures in determining the most suitable projects. This factors considers non economic benefits and risks that could affect business aspects like sustainability depending of factors like ethics, reputation, brand protection and other which may not have quantifiable benefits in short-run but which could have a significant contribution for the business’s sustainability and profitability in long-run. In that respect, considering those factors affects the projects favorability ranking in capital allocation with the company being able to undertake low capital requirement projects that have better non economic benefits than others in its view. (Peterson & Fabozzi, 2004) In summary the economical based ranking would differ from ranking that considers other non economic factors on bases of their effects as explained on each projects analysis. Thus the projects with the lowest capital requirement and suitable IRR as well as non economic benefits are the projects that should be recommended to the board for implementation. Among those projects are project no. 6 and no. 5.
In light of the analysis, the discussion clearly demonstrates that Euroland Foods Company needs to apply other considerations to the basic capital evaluation methods of IRR and Payback period in order to address the existing problem of capital budgeting limitation presented by the high debt that the company has. In that respect, the analysis has demonstrated that the company needs to have a long run view in evaluating projects and not only adapting projects’ based only on their short run quantifiable economic benefits. Such other factors that warrant consideration have been shown to include environmental, political, cultural, social, technological and legal all of which have an effect on the business’s sustainability.
Works cited
Casy, O. & Bruner, R. F. 2008. Euroland Foods S.A. Darden Case No. UVA-F-1356. SSRN:
1279310. Web. 21 September 2013.
Peterson, P. & Fabozzi, F. Capital Budgeting: Theory and Practice. New York: John
Wiley & Sons, 2004. Print.
Sharpio. 2008. Capital Budgeting and Investment analysis. New York: Pearson Education,
2008. Print.