A key difference between replacement and expansion project analyses is that with replacement
William Livingston has recently been hired as the CEO of Electrics, Inc. Previously he had been the marketing manager for a large manufacturing company and had established a reputation for identifying new consumer trends. Electrics Inc. is a California-based generator manufacturing company. The company is well known for manufacturing large, heavy-duty generators at a reasonable cost. One of its greatest achievements is that its generators can be easily modified or customized for different applications.
The company is considering an expansion of its current product line to include electric motors conversion kit for cars. Customers can use these kits to convert their cars from gas to electric drive systems. Mr. Livingston felt that due to high energy prices, consumers will be more willing to consider purchasing new conversion kits.
Profile of Electrics
Electrics, Inc. was established by the Smith brothers in 1910 as the Logging Saw Company. The firm started manufacturing large steam saws to serve the logging industry which processed lumber. Their customers were construction companies that provided housing for the population increase in California. The Smith brothers quickly realized that the times were changing. They started looking for the technologies that would keep them at the forefront of their field of business. In 1915, the Smith brothers decided that they needed to make generators as replacements for the saws. They realized that the logging industry was not viable anymore and that generators were starting to serve the same purpose.
The company started making generators in the early 1920’s. Electrics then opted to produce large-commercial AC electric motors. It was an easy decision to make since the commercial AC electric motors would use common parts with the company’s generators and the customers were local hospitals, schools, and governments. Starting in the 1950’s the commercial AC motors business accounted for about 50% of Electrics’ revenues.
The Car Conversion Kit
Mr. Livingston arranged a meeting with the firm’s top management and the chief design and the chief manufacturing engineers to propose a new product. Mr. Livingston presented an argument that more individuals in the United State and Canada would be willing to purchase the conversion kit because people are becoming more environmentally conscious. The electric cars are more efficient and environmentally friendlier. Also, the recent increase in fuel costs seems to be long lasting. This is an opportunity to get people hooked on environmentally friendly appliances as he put it.
The proposal under consideration is for the introduction of a new, car conversion kits to convert gas cars into electric ones. To distinguish Electrics from other manufacturers, the proposal included details about the efficiency and quietness of operation of the motors that need to be developed.
Mr. Phillips and Mr. Lopez, the two engineers, enthusiastically and quickly pointed out that the needed technology could be based on the company’s commercial AC motors. The framework currently used for building the commercial AC motors can be modified to work for smaller electric motors at a low cost. The marketing vice president, Mr. Chen, pointed out that the marketing analysis could be done quickly and at a reasonable cost. At this point, Mr. Livingston charged the participants in the meeting to produce a financial plan for the development and production of the electric motor.
Most people purchase gas cars and keep them for few years or until they stop working or a nicer new model is introduced. Recently, most states started educating people about the efficiency of electric cars and began offering rebates on the most efficient models. These approaches increased public interest. This renewed the public’s interest in low fuel-consuming cars.
Three weeks later, the vice presidents presented the sales and cost forecasts shown in the exhibits. The information presented contains the cost of production, financing information, and warranty cost estimates. In addition, there were two options for the controller of the electric motor in the conversion kits. The CTX – 13 is more expensive to install, but has a lower warranty cost. The MT – 78 is cheaper to install, but has a higher warranty cost. Which controller should be used?
Mr. Livingston noticed that there is an abundance of enthusiasm about entering the electric car conversion kit building business, but his cautious nature made him seek a more neutral analyst. This is your responsibility. You have been hired by Electrics to analyze the proposal to build the electric motor and provide recommendations to Mr. Livingston. The issues that need to be addressed in your report are the following:
- How much importance should be given to the energy cost situation?
- What is the project’s cost of equity?
- What is the appropriate discount factor to use for evaluating the electric motor project?
- Forecast the project’s cash flows for the next eight years. What assumptions did you use? Use MACRS depreciation for this case.
- Use the appropriate capital budgeting techniques to evaluate the project.
- Use the average demand scenario to evaluate the sensitivity of the project’s NPV with respect to sale price of the electric motor and the cost of the controller.
- Based on the scenario and sensitivity analysis you performed above, comment on the overall riskiness of the project.
- Which of the two controllers should be used in the conversion kit if you decide to go ahead with the project and why?
- Would you recommend that Electrics accept or reject the project? What is the basis for your recommendation?
(NOTE: This report is NOT part of the Final Exam – it is for illustration only. Based on the initial analysis, the recommendation was to accept the project and select the Controller model CTX-13. The attached excel file has the results that were used and accepted as support for the decision to accept the project.)
Exhibit 1 Sales forecasts:
The forecasts are based on projected levels of demand. The firm could face weak, average, and strong demand. All the numbers are expressed in today’s dollars. The forecasted average inflation per year is 3.0%.
|Price per electric motor||$9,100||$9,200||$9,250|
|Units sold per year||40,000||40,500||40,750|
|Labor cost per electric motor||$4,250|
|Selling General & Administrative||$9,500,000|
|Average warranty cost per year per electric motor for the first five years is $75. The present value of this cost will be used as a cost figure for each electric motor. Afterwards, the electric motor owners will become responsible the repairs.|
|The electric motors can be produced for eight years. Afterwards, the designs become obsolete.|
Exhibit 2 Controller costs:
|Controller model number||CTX – 13||MT – 78|
|Price per controller and installation||$1,280||$1,260|
|Average annual warranty cost per year for five years. Afterwards, the electric motor owner will become responsible the repairs*.||$90||$100|
|The chosen controller will be installed in every electric motor and will become a cost figure for each unit produced.* The controller manufacturers are not providing Electrics with any warranty. However, Electrics will provide warranty to its customers. After the initial five years, the electric motor owners may purchase extended warranty from any insurance company that offers such packages.|
Exhibit 3 Investment needs:
To implement the project, the firm has to invest funds as shown in the following table:
|Year 0||Year 1|
|$17 million||Production and selling of commercial appliances starts|
MACRS depreciation will be used.
To facilitate the operation of manufacturing the electric motors, the company will have to allocate funds to net working capital (NWC) equivalent to 10% of annual sales. The investment in NWC will be recovered at the end of the project.
Exhibit 4 Financing
The following assumptions are used to determine the cost of capital. Historically, the company tried to maintain a debt to equity ratio equal to 0.50. This ratio was used because lowering the debt implies giving up the debt tax shield and increasing it makes debt service a burden on the firm’s cash flow. In addition, increasing the debt level may cause a reduced rating of the company’s bonds. The marginal tax rate is 35%. All the numbers are expressed in today’s dollars. The forecasted average inflation per year is 3.0%.
Cost of debt:
The company’s bond rating is roughly at the high end of the A range. Surveying the debt market yielded the following information about the cost of debt for different rating levels:
|Interest cost range||4.5% ~ 5.5%||5.5% ~ 6.5%||6.5% ~ 9%|
The company’s current bonds have a rating of A.
Cost of equity:
The current 10-year Treasury notes have a yield to maturity of 3% and the forecast for the S&P 500 market premium is 6.5%. The company’s overall Beta is 1.35.
The following is information about companies that manufacture generators. The team was not able to find many companies that only manufacture AC motors.
|Debt to equity||0.5||0.3||0.5||0.45||0.35||0.25|
|Percentage of income from generators||50||45||90||95||85||90|
Based on the post-audit results of actual vs. budget after Year 1, Electrics, Inc. discovered the following:
- Inflation Rate – The actual inflation rate for expenses is expected to remain at 3.0%. However, the actual inflation rate for sales price is expected to be 2.0%, due to the newness of the product and the weaker than expected demand.
- Sales Price – The first-year average sales price was expected to be $9,200/unit. Actual average sales price was in fact $9,100/unit.
- Number of Units Sold – The budget was for 40,500 units to be sold annually, beginning in the first year. However, based on the first-year results of 37,500 units sold, forecasted sales for years 2-8 are as follows:
- Labor Costs– Labor costs were budgeted at $4,250/unit. Actual results were $4,610/unit. This is a permanent difference that is expected to continue through the life of the project.
- Parts Costs- Parts costs were budgeted at $2,500/unit. Actual results were $2,540/unit. This is a permanent difference that is expected to continue through the life of the project.
Given the results above, you need to re-forecast the Electrics, Inc. project, incorporating each change. Then, based on the new results, submit a report (2 – 5 pages long) summarizing the impact of the changes. This report must include a recommendation whether or not to continue with the project, and why. Be expansive on the “why”. Be definitive. Comment on your interpretation of the likelihood of achieving these new results. How confident are you with these new results? Your interpretation of the new forecast is a critical component. Mr. Livingston is looking to you, the budget expert (and objective participant), for direction with this project. Your finished product will be a written report, and an Excel file with the re-forecasted results.