Exhibit ******* Cash flows from sales:
Electrics, Inc.
Introduction
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 cu
ent 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
others 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
others 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
others decided that
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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 a
anged 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.
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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 cu
ently 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.
Customer Cars
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 companies 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.
The Decision
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 wa
anty 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 wa
anty cost. The MT – 78 is cheaper to install but has a
higher wa
anty cost. Which controller should be used?
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The Analysis
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:
1. How much importance should be given to the energy cost situation?
2. What is the project’s cost of equity? What is the Cost of Debt?
3. What is the appropriate discount factor to use for evaluating the electric motor
project?
4. Which of the two controllers should be used in the conversion kit if you decide to
go ahead with the project and why?
5. Forecast the project’s cash flows for the next eight years. What assumptions did
you use? Use MACRS depreciation for this case.
6. Use the appropriate capital budgeting techniques to evaluate the project.
7. 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.
8. Based on the scenario and sensitivity analysis you performed above, comment on
the overall riskiness of the project.
9. Would you recommend that Electrics accept or reject the project? What is the
asis for your recommendation?
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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%.
Demand level Weak Average Strong
Probability 25% 45% 30%
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
Parts $2,500
Selling General & Administrative $9,500,000
Average wa
anty 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 choices:
Controller model number CTX – 13 MT – 78
Price per controller and installation $1280 $1260
Average annual wa
anty 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 wa
anty.
However, Electrics will provide wa
anty to its customers. After the initial five years,
the electric motor owners may purchase extended wa
anty from any insurance
company that offers such packages.
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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. Project life is eight years, zero salvage value.
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 XXXXXXXXXXThis ratio was used
ecause 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:
Bond rating AA A BBB
Interest cost range 4.5% ~ 5.5% 5.25% ~ 6.5% 6.5% ~ 9%
The company’s cu
ent bonds have a rating of A.
Cost of equity:
The cu
ent 10-year Treasury notes have a yield to maturity of .691% and the forecast for
the S&P 500 market premium is 7.0%. The company’s overall β is 1.25.
β analysis:
The following is information about companies that manufacture generators. The team
was not able to find many companies that only manufacture AC motors.
Company Electrics Gen,
Inc.
General
Generators
Universal
Power
Generators
Inc.
International
Motors
Over all β XXXXXXXXXX3 1.45
Debt to
equity
XXXXXXXXXX35 0.25
Percentage of
income from
generators
XXXXXXXXXX
Ru
ic for outcome assessment
College of Business and public Management
MBA Outcome Assessment
BUS 635: Managing Financial Resources
Ru
ic for objective measured: Maximize firm value by efficiently allocating
financial resources in an environment of uncertainty.
Forecast cash flows under different scenarios
Excellent Good Satisfactory Unsatisfactory
Co
ectly
1. Calculate the value of the
wa
anty
2. Make