KELLOGG: A MINI CAPITAL BUDGETING CASE[1]

Question Detail:
KELLOGG: A MINI CAPITAL BUDGETING CASE[1]

Rathin S. Rathinasamy

Professor of Finance

THE CONTEXT

Kellogg 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 Kelloggs 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.com

Kellogg 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 & Poors 500 Index and the Standard & Poors 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 Dutta

Managing Director, Kellogg India

Image source:

www.expresshealthcaremgmt.com

Currently, 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 Lays Quaker, HULs Amaze and Nestlés Cerevita.

In India, Kelloggs portfolio in India includes Kelloggs All Bran Wheat Flakes and Kelloggs 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 Kelloggs 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 US

Image source:

www.businessworld.in

Government 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: Kelloggs Summary Financial Data (20052007)

Consolidated results

(US$, in millions) 2007 2006 2005

Net Sales $11,776 $10,907 $10,177

Net Sales Growth: 8.0% 7.2% 5.9%

Operating Profit $1,868 $1,766 $1,750

Operating Profit Growth 5.8% 0.9% 4.1%

Diluted Net Earnings Per Share (EPS) $2.76 $2.51 $2.36

EPS Growth 10% 6% 10%

Table 2: Kelloggs Income Statements (20032007)

Financial data in US$

Values in millions (Except for per share items)

2007

2006

2005

2004

2003

Period End Date

12/29/2007

12/31/2006

12/31/2005

1/1/2005

12/27/2003

Period Length

12 Months

Revenue

11,776.00

10,906.70

10,177.20

9,613.90

8,811.50

Total Revenue

11,776.00

10,906.70

10,177.20

9,613.90

8,811.50

Cost of Revenue, Total

6,597.00

6,081.50

5,611.60

5,298.70

4,898.90

Gross Profit

5,179.00

4,825.20

4,565.60

4,315.20

3,912.60

Selling/General/Adminis-trative Expenses, Total

3,311.00

3,059.40

2,815.30

2,634.10

2,368.50

Research & Development

Depreciation/Amortization

Interest Expense (Income), Net Operating

Unusual Expense (Income)

Other Operating Expenses, Total

Operating Income

1,868.00

1,765.80

1,750.30

1,681.10

1,544.10

Interest Income (Expense), Net Non-Operating

-319

-308.4

-300.3

-308.6

-371.4

Gain (Loss) on Sale of Assets

Other, Net

-2

13.2

-24.9

-6.6

-3.2

Income Before Tax

1,547.00

1,470.60

1,425.10

1,365.90

1,169.50

Income Tax Total

444

466.5

444.7

475.3

382.4

Income After Tax

1,103.00

1,004.10

980.4

890.6

787.1

Minority Interest

Equity in Affiliates

US GAAP Adjustment

Net Income Before
Extraordinary Items

1,103.00

1,004.10

980.4

890.6

787.1

Total Extraordinary Items

Net Income

1,103.00

1,004.10

980.4

890.6

787.1

Total Adjustments to Net Income

Preferred Dividends

General Partners’Distributions

Basic Weighted Average Shares

396

397

412

407.9

Basic EPS Excluding Extraordinary Items

2.79

2.53

2.38

2.16

1.93

Basic EPS Including Extraordinary Items

2.79

2.53

2.38

2.16

1.93

Diluted Weighted Average Shares

400

400.4

415.6

416.4

410.5

Diluted EPS Excluding Extraordinary Items

2.76

2.51

2.36

2.14

1.92

Diluted EPS Including Extraordinary Items

2.76

2.51

2.36

2.14

1.92

Dividends per Share Common Stock Primary Issue

1.2

1.14

1.06

1.01

Gross Dividends Common Stock

475

449.9

435.2

417.6

412.4

Interest Expense, Supplemental

319

307.4

300.3

308.6

371.4

Depreciation, Supplemental

364

351.2

390.3

399

359.8

Normalized EBITDA

2,240.00

2,118.50

2,142.10

2,091.10

1,916.90

Normalized EBIT

1,868.00

1,765.80

1,750.30

1,681.10

1,544.10

Normalized Income Before Tax

1,547.00

1,470.60

1,425.10

1,365.90

1,169.50

Normalized Income After Taxes

1,103.00

1,004.10

980.4

890.6

787.1

Normalized Income Available to Common

1,103.00

1,004.10

980.4

890.6

787.1

Basic Normalized EPS

2.79

2.53

2.38

2.16

1.93

Diluted Normalized EPS

2.76

2.51

2.36

2.14

1.92

Amortization of Intangibles

1.5

Table 3: Kelloggs Consolidated Balance Sheet (in millions) (20032007)

2007

2006

2005

2004

2003

Period End Date

12/29/2007

12/31/2006

12/31/2005

1/1/2005

12/27/2003

Assets

Cash and Short Term Investments

524

410.6

219.1

417.4

141.2

Cash & Equivalents

524

410.6

219.1

417.4

141.2

Total Receivables, Net

1,026.00

944.8

879.1

776.4

754.8

Accounts Receivable Trade, Net

903

833.5

775.8

776.4

754.8

Accounts Receivable Trade, Gross

908

839.4

782.7

Provision for Doubtful Accounts

-5

-5.9

-6.9

Receivables – Other

123

111.3

103.3

Total Inventory

924

823.9

717

681

649.8

Prepaid Expenses

140

131.8

Other Current Assets, Total

103

115.9

381.3

247

242.1

Total Current Assets

2,717.00

2,427.00

2,196.50

2,121.80

1,787.90

Property/Plant/Equipment, Total Net

2,990.00

2,815.60

2,648.40

2,715.10

2,780.20

Goodwill, Net

3,515.00

3,448.30

3,455.30

3,445.50

3,098.40

Intangibles, Net

1,450.00

1,419.70

1,438.20

1,442.20

2,034.40

Long Term Investments

Note Receivable Long Term

Other Long Term Assets, Total

725

603.4

836.1

837.3

441.8

Other Assets, Total

Total Assets

11,397.00

10,714.00

10,574.50

10,561.90

10,142.70

Liabilities and Shareholders’Equity

Accounts Payable

1,081.00

910.4

883.3

726.3

703.8

Payable/Accrued

Accrued Expenses

694

649.1

597.4

322

323.1

Notes Payable/Short Term Debt

1,489.00

1,268.00

1,111.10

750.6

320.8

Current Portion of Long Term Debt/Capital Leases

466

723.3

83.6

278.6

578.1

Other Current Liabilities, Total

314

469.4

487.4

768.5

840.2

Total Current Liabilities

4,044.00

4,020.20

3,162.80

2,846.00

2,766.00

Total Long Term Debt

3,270.00

3,053.00

3,702.60

3,892.60

4,265.40

Long Term Debt

3,270.00

3,053.00

3,702.60

3,892.60

4,265.40

Deferred Income Tax

647

619.3

945.7

959.1

1,062.80

Minority Interest

Other Liabilities, Total

910

952.5

479.7

607

605.3

Total Liabilities

8,871.00

8,645.00

8,290.80

8,304.70

8,699.50

Redeemable Preferred Stock

Preferred Stock – Non Redeemable, Net

Common Stock

105

104.6

103.8

Additional Paid-In Capital

388

292.3

58.9

24.5

Retained Earnings (Accumulated Deficit)

4,217.00

3,630.40

3,266.10

2,701.30

2,247.70

Treasury Stock – Common

-1,357.00

-912.1

-569.8

-108

-203.6

Other Equity, Total

-827

-1,046.20

-576.1

-439.9

-729.2

Total Equity

2,526.00

2,069.00

2,283.70

2,257.20

1,443.20

Total Liabilities & Shareholders Equity

11,397.00

10,714.00

10,574.50

10,561.90

10,142.70

Total Common Shares Outstanding

390.05

397.7

405.33

413.02

409.7

Total Preferred Shares Outstanding

THE TASK

Kelloggs 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 projects required rate of return should be based on the risk of the project. As an analyst, your task is to evaluate Kelloggs proposed new investment and assess if the project should be accepted.

GUIDE TO THE TASK

Having 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 Pricing

Model and

– Weighted Average Cost of Capital
Compute the Net Present Value (NPV), Internal Rate of Return (IRR) and the Modified IRR (MIRR) of the project.
Re-calculate the NPVs, IRRs and the MIRRs for the two exchange rate scenarios given below:

Scenario A

t = time 1 2 3 4 5

Rs. 45/US$ Rs. 47.50/US$ Rs. 50/US$ Rs. 52.5/US$ Rs. 55/US$

Scenario B

t = time 1 2 3 4 5

Rs. 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 05 years. (A website on exchange rates can be found here.) Give your opinion as to whether exchange rate expectations provide auspicious support for Kelloggs 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.

Also read: