Abstract: This case study examines a companys management team utilization of capital budgeting techniques such as sensitivity and scenario analyses for a new product development project. The capital budgeting approach includes net present value, internal rate of return, profitability index, payback period, and discounted payback period. The case study uses accounting cost and revenue projections to determine and applies sensitivity and scenario analysis to assess overall uncertainty and risks to changes in sales price, units sold, variable and fixed costs, capital investment, and net working capital. Introduction: Ralph Voras is the product manager at Clavius Electronics Components, Incorporated in California. The company is a large manufacturer of electronic connectors and many other products, and is involved in the research and development of all aspects of their products. Clavius customers are in the United States and globally, and the company experiences growth in sales, gross and operating income, and net profit. Management was discussing taking the company public if the trend continued in the next five years. Clavius was now involved in a new product of an electronic connector for one of its largest clients. It needed to obtain good rates of return and consider all the variables associated with manufacturing and selling its new electronic connector. Company background: Clavius was acquired by three electrical engineers who were close friends at CalTech but did not enjoy working for someone else for long hours and low pay. Steve Rogers, Paul Westfall, and Jerry Southern met at CalTech and attended the same courses through school. After completing college, they went to work for companies that dealt in different aspects of electrical components: from designing, to manufacturing, to researching and developing of new components. They got married, had families, and kept in touch over the years and discussed their dream of owning their very own company. They knew it would take a substantial amount of financial resources and business acumen to have a successful business, but they were determined and willing to make the necessary sacrifices to succeed. Steve heard that Clavius Electronics Components, Incorporated was facing bankruptcy. He spoke with Paul and Jerry about purchasing the company with money they would each put together and try to get the best deal to obtain the funds. Paul and Jerry took out second mortgages on their homes, while Steve used inheritance money he received from his parents estate and his childrens college money. There had been plenty of sleepless nights for all three of them, but the deal went through and they became co-owners of Clavius. Steve handled the negotiations with the creditors and suppliers and was able to obtain good terms for the company. He got an extension on paying back funds that the company borrowed and negotiated with the banks a new line of credit. Steve made it a top priority that all the creditors and suppliers would get paid fully. Paul was able to work with the new and old customers about the products they needed. Slowly but surely sales started to grow and Clavius cash flows went from negative to positive in eighteen months. Once the company showed consecutive quarters of positive cash flow, the bottom line on the income statement went from red to black. This allowed Clavius to get a line of credit from a major bank in the state, which was used to increase their operations and seek new markets. It also meant hiring new employees, offering new products and services, and see their financial statements grow healthier every year. While there were still challenges that the three engineers faced, they knew they could do it if they had the determination and fortitude to move ahead. Current Situation: Ralph Voras, a product manager at Clavius Electronics Components, is currently involved in a new product for an existing customer. His team was concerned about the rate of return for the product and the cost for tooling to make it. Ralph is responsible for establishing the sales price, sales quantity, cost structure, and capital cost for tooling to manufacture the new product. A key problem with the product was that it contained a significant amount of gold that needed to be hedged in the futures market but was unsure how hedging would impact the projected cash flows. Ralphs team knew they had to lock in a price for gold that would make the product profitable and provide a good rate of return. Below are the aspects of the various components of the project and the assumptions used in communicating with the client: Price per Connector After some initial discussions with the client, Clavius projected the price per electronic connector at $3.00. If the demand for the units stays at the level the customer forecasted (see units forecast below), Clavius expects a price inflation factor of 2.5%,per connector, each year for the next 10 years. The customer is asking for quantity discounts if the quantity ordered is in excess of 500,000 units. Quantity Demanded The customer has indicated that the first-year orders will be around 1,000,000 units and they are looking for price discounts at different levels of quantity commitments. The customer feels that after the first 500,000 units are ordered a price discount of 10% on all purchases. The customer has also indicated that if the product works as suspected, they will order an additional 2.5% each year for the next 10 years. Fixed Costs (Overhead) The cost accountant at the factory determined the fixed overhead for this project would initially be $500,000 and that will hold until the unit produced exceeds 1,400,000 units. Above this output, there will need for additional fixed cost of $100,000. The cost accountant indicated that fixed costs seem to be rising with inflation at 2.5% each year. Variable Costs per Connector Material Component Cost per Connector Plastic $0.05 Metal $0.15 Gold $1.25 Wire $0.20 These material costs are projected to increase at an inflation rate of 2.5% each year for the ten- year life of the project. The one cost that management is very concerned about is the cost of gold. It is obvious that gold is the costliest component of the connector and is the most volatile. Clavius knows that once it sets the price in the contract with the customer it will not be able to adjust it despite gold price fluctuations. The cost accountant also worked with the operation people to understand how much labor costs go into making each connector. Following a time study, labor cost was projected to be $0.35 per connector, which includes salary, fringe benefits and taxes. As with all other costs, labor cost was projected to increase at an inflation rate of 2.5% each year during the life of the contract. Capital Required This is a gigantic order for Clavius, and even though they engineered a very good product, there is a substantial investment needed in fixed capital to produce the connectors. Clavius estimated they will need to invest $500,000 in plastic molds and $1,000,000 in metal stamping equipment to meet the demand. These molds and stamps will be used in existing molding and stamping machines and the overhead costs of the machines will be incorporated in the fixed costs discussed above. Depreciating the molds and stamps will follow a 7-year Modified Accelerated Cost Recovery System (MACRS) depreciation method for tax (cashflow) purposes shown below : MACRS 7 Year Table Half Year Convention Year Depreciation Rate 1 14.29% 2 24.49% 3 17.49% 4 12.49% 5 8.93% 6 8.92% 7 8.93% 8 4.46% The total investment of $1,500,000 is very large for Clavius and they have had some initial discussions with the customer about their contributing to the capital investment. If the customer does contribute to the capital investment, Clavius could lower its initial investment, and increase the potential return on the project. However, the customer will then ask for exclusivity on the product and Clavius will not be able to market to others. As a result, Clavius is not sure how to proceed with this issue but they are intrigued that the customer is willing to contribute towards the capital investment. Net Working Capital Investment To perform the discounted cashflow analysis, consider the need to invest in working capital; specifically, accounts receivable, inventory, and accounts payable. The sales terms for the customer are net 30 days from the invoice date, but it sometimes has been about 5-10 days longer. As for inventory, Clavius has been able to keep it days inventory outstanding at approximately 44 days. The terms associated with accounts payable have usually resulted in days accounts payable of approximately 3% of sales. Since this project is lasting for 10 years, Clavius will recover all net working capital investment at the end of the project. Other General Assumptions The corporate tax rate for Clavius is 21% and the firm believes that it will remain profitable over the next 10 years. Clavius weighted average cost of capital (WACC) is 8% and given that this is a new product, Clavius is thinking that the risk adjusted WACC could be as high as 10%. Ralph wrote a memo to his team working on the product addressing key concerns. Assignment Memo: To: Student Financial Analyst From: Ralph Voras Product Manager Date: June 2, 2020 Re: Product Cost Analysis and Recommendation We have been given a great opportunity to work with a customer to produce a highly engineered product that will be used in the customers product offering. We are in negotiations to determine the sales price, quantity demanded, cost structure and capital cost to manufacture the product. We are asking you, the Financial Analyst, to assist the marketing team in the negotiations with the customer. Your knowledge of capital budgeting techniques and identifying the key drivers of this project are essential in allowing us to better value this project for Clavius. The analyses we are looking for to assist in negotiating with the client are the following:

1. A strategy to hedge the price of gold, which is the highest variable cost to the product.