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KELLOGG: A MINI CAPITAL BUDGETING CASE[1]

Question Detail:KELLOGG: A MINI CAPITAL BUDGETING CASE[1]BYRathin S. RathinasamyProfessor of Finance© 2008 – Affordable Custom Essay Writing Service | Write My Essay from Pro Writers Rathin S. Rathinasamy & U21GTHE CONTEXTKellogg Company, together with its subsidiaries, is engaged in the manufacture and marketing of ready-to-eat cereal and convenience foods, such as cookies, crackers, toaster pastries, cereal bars, fruit snacks, frozen waffles and veggie foods. These products are manufactured by Kellogg in 19 countries and marketed in more than 180 countries. Its cereal products are generally marketed under the Kellogg’s name, and are sold principally to the grocery trade through direct sales forces for resale to consumers. It also markets cookies, crackers, and other convenience foods under Kellogg’s, Keebler, Cheez-It, Murray, Austin, and Famous Amos brands to supermarkets in the US through direct store-door delivery system and other distribution methods.Image source:www.kelloggcompany.comKellogg is doing quite well with annual sales of more than US$12 billion, gross profit margin of 43.7%, and a net profit margin of 9.1% last year. Its recent Return on Equity (ROE) is an impressive 48.7%, while Return on Assets (ROA) and Return on Capital funds are 9.7% and 14.8% respectively.Kellogg stock is a very popular and highly sought-after investment in the US and the rest of the world and is held by several institutions as part of their portfolio holdings. The company is listed on the New York Stock Exchange (NYSE) under the symbol ‘K’. Kellogg is part of the Standard & Poor’s 500 Index and the Standard & Poor’s 1500 Composite Index.Its Indian subsidiary is now among the fastest growing markets although it had a rocky start in the Indian market. In 1994, Kellogg entered the Indian marketwith a plan to create new breakfast habits. At that time, the Indian market held great significance for Kellogg because its US sales were stagnating and only regular price increases had helped boost the revenues in the 1990s. Besides cornflakes, its product offerings were wheat flakes and basmati rice flakes. However, it initially met with failure as Indians were used to eating hot breakfast such as paratas or thosais and pouring hot milk on crispy cornflakes made the flakes soggy.The subsequent launch of Chocos and Frosties in India was the turning point and Kellogg decided to localize its products with the introduction of the Mazza series in local flavors such as coconut, mango and rose.“It would be foolhardy for me to say Kellogg has replaced cooked breakfast,” said Anupam Dutta, managing director of Kellogg India. “I don’t think we can ever hope for that. But we’ve become a part of the consideration set for breakfast in many Indian homes, and that’s a tipping point.”Anupam DuttaManaging Director, Kellogg IndiaImage source:www.expresshealthcaremgmt.comCurrently, its key competitors in the Indian market include General Mills Inc., Kraft Foods and PepsiCo, Inc. but the rapidly growing breakfast cereal market is seeing an influx of rivals such as Frito Lay’s Quaker, HUL’s Amaze and Nestlé’s Cerevita.In India, Kellogg’s’ portfolio in India includes Kellogg’s All Bran Wheat Flakes and Kellogg’s Just Right Muesli. With the increasing globalization, and the emphasis on convenience and ready-to eat foods, Kellogg sees an opportunity to manufacture a new rice-based cereal called ‘Kelli-Rice-Mix’. The new plant will be based in Bangalore, India, and will cost Rs. 400 million. The salvage value of the plant at the end of its five-year economic life is estimated to be Rs. 50 million, net of any tax effects. This plant will also call for extra inventory holding of Rs. 200 million, and extra accounts payables of Rs. 100 million. In addition, it is estimated that the new product would reduce the sale of Kellogg’s existing Frosties cereal in India by Rs. 30 million per year, with the effect of “cannibalizing” it.Projected sales from this new plant are Rs. 300 million per year. The fixed costs are estimated to be Rs.100 million per year, and the variable costs are estimated to be Rs. 50 million per year. Depreciation on the new plant after accounting for the salvage value will be Rs. 70 million per year. The Indian government will impose a 35% tax on the earnings whereas the USImage source:www.businessworld.inGovernment will not impose any taxes. 100% of the cash flows will be remitted to the parent company. The exchange rate is expected to be stable at Rs. 43.50 per US$.Commenting on the Indian market, Jayanta Roy of consulting company Frost & Sullivan said, “Every company that wants a share has to invest heavily, localise extensively and be very patient.”Table 1: Kellogg’s Summary Financial Data (2005–2007)Consolidated results(US$, in millions) 2007 2006 – Write a paper; Professional research paper writing service – Best essay writers 2005Net Sales $11,776 $10,907 $10,177Net Sales Growth: 8.0% 7.2% 5.9%Operating Profit $1,868 $1,766 $1,750Operating Profit Growth 5.8% 0.9% 4.1%Diluted Net Earnings Per Share (EPS) $2.76 $2.51 $2.36EPS Growth 10% 6% 10%Table 2: Kellogg’s Income Statements (2003–2007)Financial data in US$Values in millions (Except for per share items)20072006 – Write a paper; Professional research paper writing service – Best essay writers200520042003Period End Date12/29/200712/31/2006 – Write a paper; Professional research paper writing service – Best essay writers12/31/20051/1/200512/27/2003Period Length12 Months12 Months12 Months12 Months12 MonthsRevenue11,776.0010,906.7010,177.209,613.908,811.50Total Revenue11,776.0010,906.7010,177.209,613.908,811.50Cost of Revenue, Total6,597.006,081.505,611.605,298.704,898.90Gross Profit5,179.004,825.204,565.604,315.203,912.60Selling/General/Adminis-trative Expenses, Total3,311.003,059.402,815.302,634.102,368.50Research & Development00000Depreciation/Amortization00000Interest Expense (Income), Net Operating00000Unusual Expense (Income)00000Other Operating Expenses, Total00000Operating Income1,868.001,765.801,750.301,681.101,544.10Interest Income (Expense), Net Non-Operating-319-308.4-300.3-308.6-371.4Gain (Loss) on Sale of Assets00000Other, Net-213.2-24.9-6.6-3.2Income Before Tax1,547.001,470.601,425.101,365.901,169.50Income Tax – Total444466.5444.7475.3382.4Income After Tax1,103.001,004.10980.4890.6787.1Minority Interest00000Equity in Affiliates00000US GAAP Adjustment00000Net Income BeforeExtraordinary Items1,103.001,004.10980.4890.6787.1Total Extraordinary Items00000Net Income1,103.001,004.10980.4890.6787.1Total Adjustments to Net Income00000Preferred Dividends00000General Partners’Distributions00000Basic Weighted Average Shares396397412412407.9Basic EPS Excluding Extraordinary Items2.792.532.382.161.93Basic EPS Including Extraordinary Items2.792.532.382.161.93Diluted Weighted Average Shares400400.4415.6416.4410.5Diluted EPS Excluding Extraordinary Items2.762.512.362.141.92Diluted EPS Including Extraordinary Items2.762.512.362.141.92Dividends per Share – Common Stock Primary Issue1.21.141.061.011.01Gross Dividends – Common Stock475449.9435.2417.6412.4Interest Expense, Supplemental319307.4300.3308.6371.4Depreciation, Supplemental364351.2390.3399359.8Normalized EBITDA2,240.002,118.502,142.102,091.101,916.90Normalized EBIT1,868.001,765.801,750.301,681.101,544.10Normalized Income Before Tax1,547.001,470.601,425.101,365.901,169.50Normalized Income After Taxes1,103.001,004.10980.4890.6787.1Normalized Income Available to Common1,103.001,004.10980.4890.6787.1Basic Normalized EPS2.792.532.382.161.93Diluted Normalized EPS2.762.512.362.141.92Amortization of Intangibles81.51.51113Table 3: Kellogg’s Consolidated Balance Sheet (in millions) (2003–2007)20072006 – Write a paper; Professional research paper writing service – Best essay writers200520042003Period End Date12/29/200712/31/2006 – Write a paper; Professional research paper writing service – Best essay writers12/31/20051/1/200512/27/2003AssetsCash and Short Term Investments524410.6219.1417.4141.2Cash & Equivalents524410.6219.1417.4141.2Total Receivables, Net1,026.00944.8879.1776.4754.8Accounts Receivable – Trade, Net903833.5775.8776.4754.8Accounts Receivable – Trade, Gross908839.4782.700Provision for Doubtful Accounts-5-5.9-6.900Receivables – Other123111.3103.300Total Inventory924823.9717681649.8Prepaid Expenses140131.8000Other Current Assets, Total103115.9381.3247242.1Total Current Assets2,717.002,427.002,196.502,121.801,787.90Property/Plant/Equipment, Total – Net2,990.002,815.602,648.402,715.102,780.20Goodwill, Net3,515.003,448.303,455.303,445.503,098.40Intangibles, Net1,450.001,419.701,438.201,442.202,034.40Long Term Investments00000Note Receivable – Long Term00000Other Long Term Assets, Total725603.4836.1837.3441.8Other Assets, Total00000Total Assets11,397.0010,714.0010,574.5010,561.9010,142.70Liabilities and Shareholders’EquityAccounts Payable1,081.00910.4883.3726.3703.8Payable/Accrued00000Accrued Expenses694649.1597.4322323.1Notes Payable/Short Term Debt1,489.001,268.001,111.10750.6320.8Current Portion of Long Term Debt/Capital Leases466723.383.6278.6578.1Other Current Liabilities, Total314469.4487.4768.5840.2Total Current Liabilities4,044.004,020.203,162.802,846.002,766.00Total Long Term Debt3,270.003,053.003,702.603,892.604,265.40Long Term Debt3,270.003,053.003,702.603,892.604,265.40Deferred Income Tax647619.3945.7959.11,062.80Minority Interest00000Other Liabilities, Total910952.5479.7607605.3Total Liabilities8,871.008,645.008,290.808,304.708,699.50Redeemable Preferred Stock00000Preferred Stock – Non Redeemable, Net00000Common Stock105104.6104.6103.8103.8Additional Paid-In Capital388292.358.9024.5Retained Earnings (Accumulated Deficit)4,217.003,630.403,266.102,701.302,247.70Treasury Stock – Common-1,357.00-912.1-569.8-108-203.6Other Equity, Total-827-1,046.20-576.1-439.9-729.2Total Equity2,526.002,069.002,283.702,257.201,443.20Total Liabilities & Shareholders’ Equity11,397.0010,714.0010,574.5010,561.9010,142.70Total Common Shares Outstanding390.05397.7405.33413.02409.7Total Preferred Shares Outstanding00000THE TASKKellogg’s board of directors is meeting tomorrow to decide whether or not to go ahead with the proposed plant construction In Bangalore, India. The board requires a comprehensive report on the economic viability of the proposed project. If it decides to go ahead with the project, a decision has to be made as to how to finance the project. The board is currently considering two options – the issue of new common stock at a cost of 15% or the issue of 15-year bonds at a net before-tax cost of 10%.Steve Johnson, CFO of Kellogg who has been with the company for a long time, feels that both the project investment and financing should be carried out in tandem. As such, he feels that the required rate of return on the new capital investment would depend on how it is financed. In other words, if Kellogg chooses to go with the equity, the ROR here should be 15%; and if debt is used, then the relevant debt cost should be used.On the other hand, his young deputy, Brangelina Aniston who has an MBA from Stanford Graduate School of Business, feels strongly that investment and financing decisions should be kept separate, and that the project’s required rate of return should be based on the risk of the project. As an analyst, your task is to evaluate Kellogg’s proposed new investment and assess if the project should be accepted.GUIDE TO THE TASKHaving just completed 612 Finance, you are confident you are up to the task of evaluating the proposed new plan investment in its entirety. Reflecting on what you have learnt in the course, you decide that, at the very least, you need to calculate the following:Estimate Net Investment Cost at time 0.Estimate Incremental After-tax Cash Flows in Years 1 through 5.Using data from the latest income statement and balance sheet, compute the relevant cost of debt.Using data from the latest income statement and balance sheet, compute the relevant cost of equity. (For this part, assume all funds for the project are raised internally.)Estimate the Required Rate of Return for the project using- the Security Market line Equation of the Capital Asset PricingModel and- Weighted Average Cost of CapitalCompute the Net Present Value (NPV), Internal Rate of Return (IRR) and the Modified IRR (MIRR) of the project.Re-calculate the NPV’s, IRR’s and the MIRR’s for the two exchange rate scenarios given below:Scenario At = time 1 2 3 4 5Rs. 45/US$ Rs. 47.50/US$ Rs. 50/US$ Rs. 52.5/US$ Rs. 55/US$Scenario Bt = time 1 2 3 4 5Rs. 45/US$ Rs. 42.50/US$ Rs. 40/US$ Rs. 38/US$ Rs. 36/US$Using the historical Indian rupee exchange rates, provide a (subjective) forecast of the Indian rupee versus US dollar during the investment horizon of 0–5 years. (A website on exchange rates can be found here.) Give your opinion as to whether exchange rate expectations provide ‘auspicious’ support for Kellogg’s proposed investment at the present time.Reconcile the divergent views of Johnson and Aniston, and incorporate the right approach in your analysis wherever appropriate.Convert the cash flows to US dollars and provide your answers also in US dollars.Note:The long-run average return on the S&P 500 Index is 12.4%. T-bills and T-bill rates can be found here. Information on beta of Kellogg can be obtained atYahoo Finance or MSN Money pages.Include charts and tables, where appropriate. Clearly state your assumptions and provide detailed calculations, where necessary.

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