Fin630 Investment Valuation major Project 1: You have recently been hired as a Financial Analyst in the Finance Department of Zeta Auto Corporation which is seeking to expand production. The CFO asks you to help decide whether the firm should set up a new plant to manufacture the roadster model, the Zeta Spenza.
ASSIGNMENT INSTRUCTIONS
Introduction:
You have recently been hired as a Financial Analyst in the Finance Department of Zeta Auto Corporation which is seeking to expand production. The CFO asks you to help decide whether the firm should set up a new plant to manufacture the roadster model, the Zeta Spenza.
Deliverables:
Write a report providing the chief finance officer (CFO) with your recommendation whether Zeta should set up the plant to produce the Spenzas and support your recommendation by in-depth analysis in Excel. In your report, explain the results of each portion of your analysis (represented by the tabs on the Excel template). Submit all the completed Excel worksheets with the completed responses to the questions posed to support your report and recommendation. Report should include a one-page Executive Summary summarizing the results of your analysis and recommendation.
Project Data
To assess the suitability of the project you begin by listing the various cash flows. A consultant has been paid $150,000 to do a market survey. She reports back that Zeta can price Spenzas at $80,000 per car and sell 5,000 cars next year (in year 1), then sales will peak at 7,000 in year 2 and after that they will start declining with 6,000 Spenzas sold in year 3, 4,000 in year 4, and 3,000 in year 5. After that the sales decline will not make manufacturing of Spenzas profitable. The consultant also estimates that introduction of Spenza model will cannibalize the sale of an existing model, the Zeta Monza, resulting in 1,000 fewer units of the Monza sold in each of the 5 years. Monza’s are priced at $65,000.
After 5 years it is expected the Spenza will be phased out, and the plant will be put to other uses generating after-tax cash flow of $15 M annually.
The cost of setting up the plant is to be $250 M with annual manufacturing capacity of 10,000 cars. It is a one-time capital investment made at the very beginning of the project. In addition, at the beginning of each year the plant will require an outlay of Net Working Capital equal to 7.5% of direct manufacturing costs (excluding labor and overheads) in the coming year. The NWC outlay will be recovered at the end of the project in year 5.
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The CFO provided you with historical information about Monza’s cost structure (Excel sheet attached) and noticed that Spenza will have the following differences:
- Spenza’s body will be made from reinforced carbon, which makes the car lighter, thus significantly improving mileage range per battery charge. About 80% of the carbon cost is the cost of energy and the estimated carbon cost body per car of $14,000 is based on electricity cost of 7 cents /per kWh, which is the current cost of electricity in Michigan, where the plant will be located. This cost is 70% of the average nationwide retail electricity price. EIA nationwide electricity cost projections for future years are provided in the Excel sheet.
- Battery Pack cost for Spenza is $15,000 per car.
- Cost of materials for engine and other parts will be identical to Monza’s.
- Labor cost of $5,000 per car is based on annual production of 10,000 Spenza’s. Labor is unionized; number of workers and wages do not depend on the number of units produced.
- Overheads at the new plant will be identical to total overheads at the existing Monza plant.
IRS allows you to straight line depreciate the cost of the plant over 4 years for tax purposes (equal depreciation in all years and not an accelerated schedule of depreciation). You have a choice to use 3 year MACRS depreciation schedule (see the Excel sheet attached)
If you recommend setting up the plant, you should also consider that the plant will occupy a piece of land which the firm could put to other uses. These alternative uses would earn the firm $15 M after-tax annually.
Modeling Financial Metrics and Cash Flows
Depreciation
You have to decide whether Zeta should set up the plant to produce the Spenza’s by answering the following series of questions. After having enumerated the various cash flows you are now ready to analyze the project using capital budgeting techniques and project analysis methods.
- What will be the depreciation for tax purposes from the investment in the Spenza plant using the straight line method? What will be the depreciation using MACRS? Which schedule would you recommend to use?
EBIT
- What will be the costs and revenues for the first four years? What will be the incremental EBIT (Earnings before Interest and Taxes) each year?
Interest and Taxes
You now have to need to determine interest costs and taxes. Assume that the cost of setting up the plant will be 50% financed by debt with an interest rate of 6%.
At this point you are getting closer to the cash flows the project will produce, and need to determine the tax rate. You research tax rates and determine that the appropriate tax rate after the tax reform is 21%.
- What incremental taxes Zeta will pay if the Spenza plant is set up?
Net Income
- What will be the Net Income for Zeta from the project each year?
Incremental OCF
Now you can calculate the net increase in cash flows from the project.
- What will be the incremental OCF (Operating Cash Flow) each year?
Free Cash Flow
The next step will be calculating FCF taking into account OCF and other incremental cash flows, including opportunity costs!
- What will be the FCF (Free Cash Flow) each year?
WACC and CAPM
The next step will be estimating WACC. Using Yahoo Finance! or other financial sources available on the course website find auto-making industry’s beta, market risk premium and the risk free rate.
- Estimate the WACC using the earlier assumption about the project’s financing and the CAPM equation for the cost of equity.
Decision Criteria – NPV and IRR
Now you are ready to calculate the first criterion that is used to assess projects.
- What will be the Net Present Value of the project?
You should also calculate another widely used criterion.
- What will be the IRR of the project?
Analyzing Risk using Scenario Analysis
You consider the electricity cost and projected sales volume as two major factors affecting your variable costs and revenues. Therefore, you would like to perform some additional analysis to check the project’s sensitivity to electricity costs and to sales volumes. You want to analyze these two factors separately, one at a time.
As was mentioned EIA has several electricity cost projections (Excel sheet, tab Energy Prices Forecast). First you decide to see how your recommendations might change under different cost scenarios.
- Perform scenario analysis on the electricity cost and present the summary of results.
Given uncertainty of sales volume forecast, you would like to look at optimistic and pessimistic scenarios for sales. Optimistic scenario assumes sales volume to be 500 cars more than predicted (i.e., 5,500 cars in year 1, 7,500 in year 2 etc.). Pessimistic scenario assumes sales volume to be 500 cars less than predicted (i.e., 4,500 cars in year 1, 6,500 in year 2 etc.).
- Run scenario analysis on the sales volume and present the summary of results.
Break-even Analysis
Next, you would like to find the maximum electricity cost in year 1 at which the project would still be advisable. For simplicity assume 0.5% annual growth of electricity costs.
- Find the break-even value for the electricity cost in year 1.
Monte Carlo Simulation
Finally, you would like to perform a Monte Carlo simulation. Possible distribution assumptions are provided in Excel Spreadsheet tab “Crystal Ball Simulation,” but you are welcome to make (and explicitly state) your own and use Random Numbers generator in Data Analysis Pack.
- Based on your analysis, what is the probability that the project will be profitable?
[Crystal Ball] You also want to estimate the sensitivity of your project to different factors.
- Using Crystal Ball, please create a Tornado Diagram and discuss its results.
SAMPLE STUDENT ANSWER
Download the Excel File Below
Executive Summary
The capital budgeting analysis involved analyzing the Spenzas project and advising Zeta Auto Corporation on whether to expand production. The outcome showed that the project yields a negative NPV of -$2.38 million and an IRR of 4.12, below the firm’s WACC of 4.53%. The project will break even when the electricity cost is $0.073284. If the electricity price falls below the breakeven electricity value, the project will have a positive NPV and a high IRR, which is acceptable. The examination of three sales scenarios shows that the project is only feasible in the high sales case scenario. Overall, Zeta should not consider the project because it has a negative NPV and has the possibility of negatively influencing its performance.
Introduction
Capital budgeting is an important process when analyzing investment projects. It provides insight for the management for making take or reject decisions. The primary capital budgeting techniques entail the net present value (NPV), internal rate of return (IRR), and profitability index. The process starts with analyzing the projected cash flows related to the project and then discounting the cash flows using the weighted average cost of capital (WACC). The same procedure was used when analyzing the prospect of Zeta Auto Corporation in its expansion program involving the production of Spenzas.
Capital Budgeting Recommendations
Spenzas incremental cash flows show an increase in the firth three years and decreases in years 4 and 5. There was a constant decrease from year 2 to year five for the free cash flows. The decrease was commensurate with the decrease in sales. The project reported positive cash flows. The project’s NPV, when using the base case scenario sales, is -$2.38 million and an IRR of 4.22%. Based on these outcomes, the project should not be undertaken.
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Risk analysis
The calculation of WACC was informed by assuming options like the risk-free rate is the value offered by the 10-year long-term treasury bond. The risk premium is the equity risk premium estimated by the Damodaran country risk premium website. Further, a tax rate of 21% was assumed to apply to all the competitors’ firms considered in calculating Zeta’s relevered beta. The project would break even when the cost of electricity is equal to $0.073284 per kwh. If the cost of electricity is below $0.073284 per kwh., the project would yield a positive NPV and a cost higher IRR.
From the simulation, the project is very risky because the probability of NPV being positive is 46.43%. This means the chances of making positive returns are slim.
Electricity Scenarios
The examination of the various electricity scenarios shows that the project is unsuitable in the reference, high economic growth, low oil price, low oil and gas supply, and high renewable cost cases. In all of these cases, NPV is negative, and the IRR is below the cost of capital (WACC). The project can be considered in the low economic growth case, high oil price case, the high oil and gas supply case, and the low renewable case because they have positive NPC and the IRRs are greater than the WACC.
Sales Volume Scenarios
The calculation of sales volume for the Spenzas project in the standard reference, high sales, and low sales volume scenarios shows that the project is feasible in one case. During the high sales volume cased, NPV is positive at $55.7 million, and IRR is 13.18%. This is higher than the cost of capital of 4.53%. The reference case scenario yields a negative NPV of -$2.4 million and an IRR of 4.12%, below the company’s hurdle rate. The probability of the project yielding a positive NPV is 33%. This is because only the high sales volume cases yield positive NPV and an IRR greater than the cost of capital.
Conclusion
The analysis of the various elements of the Spenzas project shows that it is infeasible. This is because of having a negative NPV and IRR, which is less than the cost of capital. The breakeven electricity cost shows that the project can only be feasible in the scenario of low economic growth. Besides, the project only generates a positive NPV in the high case scenario, which is less likely to occur. The expansion program would have a negative outcome on the performance of Zeta Auto Corporation and hence should be disregarded.
References
Jermaine Byrant
Nicole Johnson
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