1. How much importance should be given to the energy cost situation?
2. What is the electric motor conversion kit project’s cost of equity? 

(hint: you need to use the pure play method to find the company’s beta for the generators. Then, find the beta for the AC motors which will be used in CAPM for the cost of equity)   --- see page 6 for more detailed guide!

3. What is the appropriate discount rate (WACC) to use for evaluating the electric motor project?

(hint: from the above, you got cost of equity. Then, using information in Exhibit 4, you need to find cost of debt, weight for debt and equity to find WACC)

4. Which of the two controllers should be used in the conversion kit if you decide to go ahead with the project and why? Show which method(s) you used to make the decision. 
5. Forecast the project’s cash flows for the next eight years. What assumptions did you use? Use MACRS depreciation (use the textbook depreciation table. For this case, it is a heavy manufacturing equipment) 
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 (hint: increases and decreases of 1%, 2%, and 3% in sales price and engine price).

Based on the scenario and sensitivity analysis you performed above, comment on the overall riskiness of the project. Would you recommend that Electrics accept or reject the project? What is the basis for your recommendation?

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 conversion kit	$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 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 choices:

Controller model number	CTX – 13	MT – 78
Price per controller and installation	$1280	$1260
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 conversion kit 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 electric motor conversion kit 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 (means closer to BBB). 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%

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 b is 1.35.

b analysis:

The following is information about companies that manufacture generators. The team was not able to find many companies that only manufacture AC motors. Assume all the companies’ marginal tax rate is 35%.

Company	Electrics	Gen, Inc.	General Generators	Universal Power	Generators Inc.	International Motors
Over all b	1.35	1.4	1.5	1.6	1.3	1.45
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

* Finding cost of equity

1. You should specify which companies are comparable ones -those whose main businesses are generators.

2. You need to find the unlevered beta for each of them using the given formula: b_u = b_levered /(1 + (1 - T)D/E);  here, b_levered is each company's overall beta.

For example, 1.5 is General company's b_levered

You were given Tax rate and D/E too. Thus, you can get b_u

Get each of the comparable firm's unlevered beta using the above formula including the Electrics Inc.  

Then, you can average the unlevered betas of those comparable firms -- the answer is the unlevered beta for generator business..

• Do not include the unlevered beta of the Electrics Inc. when you average them. We will use it in next step.

3. From the unlevered beta for the Electrics Inc. which we found from the previous step, we know that the unlevered beta for the Electrics. Inc. is the combination of 1/2 unlevered beta for Generators and 1/2 unlevered beta for AC motors.

Thus, we will have this equation: this unlevered beta we found from the previous step =  0.5 *Generators  + 0.5 *Unlevered beta for AC motors

(Above, Generators =  the average industry beta we got from the previous step. Thus, the only unknown in the equation is unlevered beta for AC motors)

4. Since we now have unlevered beta for AC motors, we can get levered beta for AC motors using b levered = bu (1 + (1 - T)D/E)

5. Finally, use this AC motors levered beta as the beta in the CAPM formula.
Then, you will get  the cost of equity for the project (AC motors)

Answer rating: 100% (QA)

ANSWER 1 The electric motor conversion kit projects cost of equity is 125 2 The appropriate discount rate WACC to use for evaluating the electric motor project is 114 3 The MT 78 controller should be ... View the full answer