As a Financial Analyst in the Finance Department of Zeta Auto Corporation they are 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.

Capital Investment 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 sell 7,000 Spenzas for $80,000 each in years 1 and 2, and 4,000 Spenzas for $80,000 each in years 3 and 4. The consultant also estimates that the increased sales of the Spenza 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 4 years. Monzas are priced at $65,000.

After 4 years it is expected the Spenza will be phased out, and the plant will be put to other uses generating $15 M annually. However, this decision can be reevaluated at the end of year 3, based on new information which will become at that time. Your consultant has prepared her estimates of what this new information might be. These estimates are given in the attached Excel spreadsheet.

The cost of setting up the plant is to be $250 M with annual manufacturing capacity of 10,000 cars. In addition, at the beginning of each year the plant will require the Net Working Capital outlay equal to 4.75% of direct manufacturing costs (excluding labor and overheads) in the coming year. The NWC outlay will be recovered after 4 years.

The CFO provided you with historical information about Monzas cost structure (Excel sheet attached) and noticed that Spenza will have the following differences:

Spenzas body will be made from reinforced carbon, which makes the car lighter, thus significantly improving mileage range per battery charge. 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 electricity cost projections 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 Monzas.

Labor cost of $4,000 per car is based on annual production of 10,000 Spenzas. 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 require land which the firm can put to other uses. These alternative uses will 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 Spenzas 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 is 40%.

What incremental taxes Zeta will pay if the Spenza plant is set up?

Net Income

What will be the incremental 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! At this point we are still assuming that the project will last only for four years.

What will be the FCF (Free Cash Flow) each year?

Zeta Spenza Project
Given
Monza's current annual sales	10,000			MACRS Schedule
Monza's price	$65,000			year 1	33%
Monza Cost structure per car				year 2	45%
Body materials	$11,000			year 3	15%
Engine	$4,000			year 4	7%
Drivetrain	$6,000
Battery Pack	$20,000
Electronics	$5,000
Labor (allocated)	$4,000
Overhead (allocated)	$2,000
Consulting Fees	$50,000
Spenza Price	$80,000
Spenza Sales projections
		Year 1	Year 2	Year 3	Year 4
Sales Volume		7,000	7,000	4,000	4,000
Plant Investment	$250 Mil
Alternative Land Use	$15 Mil
Plant Capacity	10,000 cars
Project life	4 years
Percentage of Debt Financing	50%
Interest Rate	7%
Tax rate	40%
NWC as % of direct manufacturing costs	4.75%
Monza Sales Cannibalization	1,000 cars
Electricity cost	$0.07 per kWh	#################
Carbon Body Cost per Car	$14,000
Percentage of electricity	80%
Electricity used per car
Other Spenza direct costs
Body materials (other than electricity)
Engine	$4,000
Drivetrain	$6,000
Battery Pack	$15,000
Electronics	$5,000
Solution
Choosing Depreciation
		Year 1	Year 2	Year 3	Year 4
Straight-Line depreciation
MACRS Depreciation
Your recommendation
Projected Net Income
		Year 2018	Year 2019	Year 2020	Year 2021
Sales Volume		7,000	7,000	4,000	4,000
Projected electricity cost (per kWh)
Revenues
Direct Costs
Body materials (electricity only)
Body materials (other than electricity)
Engine
Drivetrain
Battery Pack
Electronics
Total Direct Costs
Fixed Costs
Labor
Overheads
Depreciation
EBIT
Interest
EBT
Taxes
Net Income
Projected FCF
Monzas Lost Profit
Volume	1,000 cars
Price	$65,000
Direct Costs (per car)
Lost Profit (After-Tax)
OCF
CapEx
Investment in NWC
Opportunity Costs
Alternative Land Use
Lost Profit from Cannibalized Sales
FCF
WACC (From WACC Tab)
NPV
IRR
Six Scenarios
		Projected electricity cost (per kWh)
		Year 2018	Year 2019	Year 2020	Year 2021
Reference
High Oil Price
Low Oil Price
High Oil and Gas Resource Availability
High Economic Growth
Low Economic Growth