Automaton, Incorporated (Automaton) is a small, U.S. publicly-traded software company that manufactures quantum micro-processors to be used in the production of Artificial Intelligence-enabled (AI) computational devices.Over 90 percent of Automaton's revenues are derived from one product: AI CalcPro IV, which is used exclusively in scientific calculators.Automation experienced double-digit revenue growth in the ten years since it was founded in 2005.In recent years, however, its revenue growth rate has averaged eight percentage points.The future is looking even less profitable:Wall Street analysts estimate Automaton's revenue growth rate will decline to five percent, on average, over the next five years, and one percent thereafter.Furthermore, analysts' consensus 12-month price target for Automaton is $105, down from its most recent price of $159.82

Fierce competition, including from foreign companies, is behind the decline in Automaton's revenues.In particular, competition from U.K-based AI-CHIP, which was founded less than five years ago by Automaton's ex-Chief Scientist, Alfred Mathias Nzewi.AI-CHIP uses a more efficient manufacturing process to develop AI-enabled micro-processors that perform as well as Automaton's, but cost about 20 percent less.Automaton's market share in the AI-enabled micro-processor industry has declined from over 90 percent in 2010 to a little under 35 percentage points in 2018.

DEFCON V Alert

At a recent management meeting, Automaton's CEO, Sara Hwang, spoke of the need to innovate, reduce costs, and improve profitability.Specifically, she encouraged the senior management team to "think outside the box" in considering projects Automaton could undertake to stem its revenue declines and loss of market share.She said emphatically "...with the support of the Board, I am willing to spend whatever it takes to increase our profitability."Following the meeting, the general feeling among Automaton's senior managers was: if we do not make significant changes to bolster our operations, Automaton may go out of business within the next few years.

In the following days, Automaton's Chief Financial Officer (CFO) and Chief Operating Officer (COO) each proposed two projects: (1) an expansion project, and (2) a cost reduction project.

Incoming Kofi Johnson, MBA, CFA

Kofi Johnson was recently hired by Automation in part to evaluate the two projects identified by Automaton's senior managers.He intends to assess both projects using a combination of Payback Period, Net Present Value (NPV), and Internal Rate of Return (IRR).He makes the following mental note: "Payback Period accounts for Time Value of Money but does not consider cash-flows that occur after the initial cash outlay is recouped.Therefore, it is effectively useless as a project evaluation tool."In addition, as senior management is willing to fund multiple value-added projects, Kofi makes a second mental note: "Ms. Hwang mentioned that Automaton has soft capital constraints.Therefore, if both projects have a positive NPV, I will recommend that we accept the one with the highest IRR"

Automaton's Weighted Average Cost of Capital

Kofi's manager, Marilyn-Jo Peters, advises him to begin his analysis by first computing Automaton's Weighted Average Cost of Capital (WACC).To help, she gives Kofi an exhibit with formulas and data needed to compute Automaton's WACC. Kofi makes a third mental note: "If a company has no debt and is thus 100 percent equity financed, its WACC (i.e., cost of capital) must be equal to its Cost of Equity."

Project 1: Expanding Existing Capabilities

The first project is to increase Automaton's manufacturing capacity for five years.Automaton's Chief Financial Officer, Patrick McCabe believes doing this would boost Automaton's market share in the long run.

To facilitate this temporary expansion, Automation will purchase new equipment for $1,500,000.The additional micro-processors will be manufactured in a building Automaton purchased eight years ago for $4,200,000.The building will be retooled for the new project at a cost of $500,000, which includes building permit fees of $25,000.

The purchased equipment will be depreciated using Modified Accelerated Cost Recovery System (MACRS) depreciation schedule (see exhibits), and sold for $250,000 in year 5.

The projected revenue for year 1 is $550,000.Subsequent year's revenues will increase by eight percent of the preceding year's revenues (i.e., year 2 revenues equals 1.08 * $550,000).This expansion project will result in an annual loss of revenues from an existing manufacturing operation of $100,000.Operating expenses (excluding depreciation and amortization) is estimated at 20 percent of net revenues.

Operating net working capital will rise by $250,000 and $300,000 in years 1 and 2, respectively.This investment in operating net working capital fully reverses in the final year of the project.Annual interest expense is fixed at $35,000.

Questions

1. Is Kofi's first mental note accurate?Discuss briefly.
2. Is Kofi's second mental note accurate?Discuss briefly.
3. Is Kofi's third mental note accurate?Discuss briefly.
4. What is Automaton's cost of capital?
5. What is the project's net income for years 1 through 5?
6. What is the project's initial cash outlay in year 0?
7. What is the project's Free Cash Flows (FCF) for years 1 through 5?
8. What is the NPV and IRR of this project?
9. Kofi is concerned that the estimated cost of capital for Automaton is too high.He adjusts Automaton's Beta () and computes a new cost of capital of 5%.Using this discount rate, what is the project's NPV and IRR?

Project 2: Trimming the Fat to Boost Profitability

To reduce production costs, Automaton's COO, Christine Brady, suggests replacing one of its manufacturing equipment with a newer, more efficient model.This four-year project will result in reduced manufacturing costs which, in turn, would allow Automation to reduce the price of its flagship AI CalcPro IV.Christine believes reducing the cost of the processor will better position Automation to compete with AI-CHIP.

The current equipment, a MAC-98, can be sold today for $1,000,000 net.A brand-new MAC-100 retails for almost $3,250,000; however, Christine believes she can purchase it for $3,000,000 today.She will fund this purchase in part with proceeds from the sale of the MAC-98.In addition, accounts payable are expected to increase by $1,500,000 today, and fully reverse in year 4.

The new equipment will be in operation beginning in year two.As the old equipment will be offline in year 1, Christine forecasts lost revenues of $550,000 in year 1 arising from the idled equipment.The cost savings in years 2, 3 and 4 are estimated at $600,000, $950,000, and $1,000,000, respectively.Automaton's cost of capital and tax-rate remain unchanged. The equipment is depreciated using straight line depreciation (i.e., Equipment Cost - Salvage Value) / Useful Life).

Kofi is particularly excited about this project and goes about evaluating it.He is a bit unclear about how changes in depreciation impact FCFs, and seeks guidance from Christine.Christine makes the following two statements: "All else equal, higher depreciation expenses will result in larger FCF and lower net income.The specific impact of changes in depreciation expenses on FCFs can be discerned by multiplying the incremental depreciation expense by the tax rate."

Questions

1. What is the initial cash outlay for this project (i.e., year 0 cash flows)?
2. What is this project's FCF for years 1 through 4?
3. What is this project's NPV and IRR?
4. Kofi (again) is concerned that the estimated cost of capital for Automaton is too high.He adjusts Automaton's Beta and computes a new cost of capital of 5%.Using this, what is this project's NPV?
5. Is Christine's comment on the relationship between depreciation and FCFs and net income accurate?Discuss briefly.
6. Is Christine's second comment accurate?Discuss briefly.

Exhibits

MACRS 3 Schedule

Year 1: 33.33%

Year 2: 44.45%

Year 3: 14.81%

Year 4: 7.41%

Cost of Capital

WACC =

Cost of Equity = Risk-Free Rate + *(Equity Risk Premium)

After-Tax Cost of Debt = (1-Tax Rate) * Pre-Tax Cost of Debt

Risk-Free Rate (10-Year U.S. Treasury) = 3%

The Equity Risk Premium = 4.5%

Tax Rate: 40%

Automaton's beta () = 1.2

Automaton's Market Value of Equity / Total Capital ratio = 100%

Automaton's Market Value of Debt / Total Capital = 0%