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.

Project Data

To assess the suitability of the project you begin by listing the various cash flows. A consultant has been paid $50,000 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 won't 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 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 4.75% 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.

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 $4,000 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 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 7%.

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 (extra credit 5%) - ATTENTION, THIS PART IS OPTIONAL

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.