Auto Safety, Inc. is a producer of electronic safety components used by automobile manufacturers. Over the past three years, the firm's R&D department has been working on the development of a new sensor trigger mechanism to be used in car air bag assemblies. The distinctive advantage of this mechanism is the drastically reduced deployment impact of air bags on car passengers. Car manufactures are aware of the development and the car-crush test results provided by Auto Safety and have expressed a strong interest in the new mechanism. Over the past three years, the firm has spent $10,000,000 on the development of this mechanism and in December 2020 is at the point of making a decision about whether or not to proceed with its production Auto Safety is currently operating at full capacity. To begin production of the new mechanism, the firm is planning to buy an existing plant for $4,000,000; payment for the plant is scheduled to take place on December 31, 2021 and includes the cost of its renovation during 2022. At the end of the project's economic life, the plant is expected to have a salvage value of $1,750,000: however, the firm plans to utilize the plant for a different project at that time. In addition to the plant, Auto Safety has to buy new equipment worth $1,500,000. The equipment will be shipped and installed once the plant renovation is complete and will be paid for on December 31, 2022. At the end of the project's economic life, the equipment is expected to have a salvage value of $900,000. For depreciation purposes, the plant falls into the MACRS 10-year class, while the equipment falls into the MACRS 3-year class. Depreciation charges for the plant and equipment will begin in 2023. In addition to the investment in the plant and equipment, the project requires that Auto Safety maintains a NWC level equal to 5% of next year's revenues starting December 31, 2022. If the new project is approved, production will start on January 2, 2023 and will last for five years. In 2023, sales of the new mechanism are expected to be 500,000 units at a price of $30 each; afterwards, sales are expected to increase 1.5% annually over the project's life. Annual fixed costs are estimated to be $300,000, while SG&A costs are expected to be 3% of revenues. In 2023 variable costs of production are estimated to be $23 per unit and are expected to increase at an annual rate of 1% thereafter. The introduction of the new mechanism is expected to adversely affect the sales of the firm's "old" generation of trigger mechanisms. Specifically, management estimates that sales of "old" trigger mechanisms will decline by $1,000,000 annually. However, it is expected that production costs of "old" mechanisms will decline by $600,000 annually. Auto Safety's marginal tax rate is 40%. 1 You are the Assistant Budget Director of Auto Safety. The Budget Director, Timothy Brown, has put you in charge of the new trigger mechanism project. Tim is expected to make a presentation to the firm's top-management regarding the merits of the project. Given the information provided above, Tim has asked you to prepare a report with estimates of the project's net cash flows over its life and measures of its desirability or lack thereof. Tim has asked you to demonstrate in fine detail your calculations for the net cash flow in the project's third year of production. Further, Tim has asked you to fully explain how you estimated all the one-time items you encountered in your analysis of the project. Also, Tim indicated that since the new sensor/trigger mechanism project has the same risk as the firm's average project, the appropriate discount rate for the project should be the firm's 7.9% weighted average cost of capital (WACC). Finally, Tim has asked you to be ready to provide any additional analysis and offer answers to the questions top-management may raise during his presentation 2. Following Tim's presentation, top-management appears to be convinced about the use of NPV in assessing the project's merits. Nevertheless, all else the same, they would like to know by how much the 2023 selling price per unit: OR 2023 variable production costs per unit: OR 2023 sales volume in units) has to change for the project to become unattractive. How would you address these inquiries? It is imperative that you demonstrate in an easy to understand way the impact changes in each of these three metrics have on the project's NPV. 3. Upon inquiry, the sales VP indicates that although the 2023 sales are expected to be 500,000 units, they could go up to 700,000 units or drop as low as 300,000 units. At the same time, the marketing VP indicates that barring any negative economic developments which may adversely impact their profit margins car manufacturers are willing to pay $30 per trigger mechanism; nevertheless, unit price may fall as low as $27 if the economy deteriorates. In addition, the production VP points out that the $23 variable production cost per unit in 2023 is a rather optimistic figure and suggests it could go up to $26. As a result, management is wondering what all these possible scenarios imply for the project. How do you respond to that? 4. Another executive suggests that although the salvage value estimate of the equipment appears to be reasonable, that of the plant rather low and wonders whether this impacts Tim's recommendation about the project adversely. How would you address this concern? 5. The firm's CFO remarks that although Tim's analysis allows variable production costs to rise, annual fixed costs and selling price appear to remain unchanged over the project's life. He indicates that economic reports suggest inflation expected to be 2% annually over the January 1, 2024 to December 31, 2027 period. The CFO believes that fixed costs will definitely rise along with inflation; however, he acknowledges that selling price could rise at a pace equal to the inflation rate, or half the inflation rate, or may not rise with inflation. He wonders how accounting for inflation will affect the project's analysis. Although Tim will be the one who makes the final recommendation to the firm's top-management, he explicitly asks you to explain in your written report whether in your opinion Auto Safety should invest in the new trigger mechanism project or not 6. Auto Safety, Inc. is a producer of electronic safety components used by automobile manufacturers. Over the past three years, the firm's R&D department has been working on the development of a new sensor trigger mechanism to be used in car air bag assemblies. The distinctive advantage of this mechanism is the drastically reduced deployment impact of air bags on car passengers. Car manufactures are aware of the development and the car-crush test results provided by Auto Safety and have expressed a strong interest in the new mechanism. Over the past three years, the firm has spent $10,000,000 on the development of this mechanism and in December 2020 is at the point of making a decision about whether or not to proceed with its production Auto Safety is currently operating at full capacity. To begin production of the new mechanism, the firm is planning to buy an existing plant for $4,000,000; payment for the plant is scheduled to take place on December 31, 2021 and includes the cost of its renovation during 2022. At the end of the project's economic life, the plant is expected to have a salvage value of $1,750,000: however, the firm plans to utilize the plant for a different project at that time. In addition to the plant, Auto Safety has to buy new equipment worth $1,500,000. The equipment will be shipped and installed once the plant renovation is complete and will be paid for on December 31, 2022. At the end of the project's economic life, the equipment is expected to have a salvage value of $900,000. For depreciation purposes, the plant falls into the MACRS 10-year class, while the equipment falls into the MACRS 3-year class. Depreciation charges for the plant and equipment will begin in 2023. In addition to the investment in the plant and equipment, the project requires that Auto Safety maintains a NWC level equal to 5% of next year's revenues starting December 31, 2022. If the new project is approved, production will start on January 2, 2023 and will last for five years. In 2023, sales of the new mechanism are expected to be 500,000 units at a price of $30 each; afterwards, sales are expected to increase 1.5% annually over the project's life. Annual fixed costs are estimated to be $300,000, while SG&A costs are expected to be 3% of revenues. In 2023 variable costs of production are estimated to be $23 per unit and are expected to increase at an annual rate of 1% thereafter. The introduction of the new mechanism is expected to adversely affect the sales of the firm's "old" generation of trigger mechanisms. Specifically, management estimates that sales of "old" trigger mechanisms will decline by $1,000,000 annually. However, it is expected that production costs of "old" mechanisms will decline by $600,000 annually. Auto Safety's marginal tax rate is 40%. 1 You are the Assistant Budget Director of Auto Safety. The Budget Director, Timothy Brown, has put you in charge of the new trigger mechanism project. Tim is expected to make a presentation to the firm's top-management regarding the merits of the project. Given the information provided above, Tim has asked you to prepare a report with estimates of the project's net cash flows over its life and measures of its desirability or lack thereof. Tim has asked you to demonstrate in fine detail your calculations for the net cash flow in the project's third year of production. Further, Tim has asked you to fully explain how you estimated all the one-time items you encountered in your analysis of the project. Also, Tim indicated that since the new sensor/trigger mechanism project has the same risk as the firm's average project, the appropriate discount rate for the project should be the firm's 7.9% weighted average cost of capital (WACC). Finally, Tim has asked you to be ready to provide any additional analysis and offer answers to the questions top-management may raise during his presentation 2. Following Tim's presentation, top-management appears to be convinced about the use of NPV in assessing the project's merits. Nevertheless, all else the same, they would like to know by how much the 2023 selling price per unit: OR 2023 variable production costs per unit: OR 2023 sales volume in units) has to change for the project to become unattractive. How would you address these inquiries? It is imperative that you demonstrate in an easy to understand way the impact changes in each of these three metrics have on the project's NPV. 3. Upon inquiry, the sales VP indicates that although the 2023 sales are expected to be 500,000 units, they could go up to 700,000 units or drop as low as 300,000 units. At the same time, the marketing VP indicates that barring any negative economic developments which may adversely impact their profit margins car manufacturers are willing to pay $30 per trigger mechanism; nevertheless, unit price may fall as low as $27 if the economy deteriorates. In addition, the production VP points out that the $23 variable production cost per unit in 2023 is a rather optimistic figure and suggests it could go up to $26. As a result, management is wondering what all these possible scenarios imply for the project. How do you respond to that? 4. Another executive suggests that although the salvage value estimate of the equipment appears to be reasonable, that of the plant rather low and wonders whether this impacts Tim's recommendation about the project adversely. How would you address this concern? 5. The firm's CFO remarks that although Tim's analysis allows variable production costs to rise, annual fixed costs and selling price appear to remain unchanged over the project's life. He indicates that economic reports suggest inflation expected to be 2% annually over the January 1, 2024 to December 31, 2027 period. The CFO believes that fixed costs will definitely rise along with inflation; however, he acknowledges that selling price could rise at a pace equal to the inflation rate, or half the inflation rate, or may not rise with inflation. He wonders how accounting for inflation will affect the project's analysis. Although Tim will be the one who makes the final recommendation to the firm's top-management, he explicitly asks you to explain in your written report whether in your opinion Auto Safety should invest in the new trigger mechanism project or not 6