CASE I: PACCARS BUY or BUILD DECISION

Paccar, a local truck manufacturer, is considering upgrading the technological capabilities of their two major lines of trucks: PeterBilt and Kenworth. Applications of this technology may include email and vehicle diagnostic and maintenance as well as other vehicle information. The decision whether to invest in this new technology is complicated by the realization that Paccar could buy the technology for an outside firm or could attempt to develop the technology in house.

If Paccar chooses to buy the rights to the technology from an outside firm, it would cost them $25 million. Additionally, some new operating equipment would be required at a cost of $150 million (assume both costs occur at time 0). The technology rights have a depreciable life of 3 years but a useful life of 5 years, the new operating equipment has a depreciable life of 10 years but also has a useful life of 5 years. Both assets will have no salvage value at the end of 5 years. Additionally, there will be an increase in maintenance expenses associated with this new technology contracted at $5 million in the first year of operation. The contracted annual increase in maintenance expense is 3% per year over the five years of its use. The increase in revenue if Paccar buys the technology is expected to equal $300 million in year one and is expected to grow at 5% per year over the next two years (years 2 and 3) and at 3% per year in the following two years (years 4 and 5).

If Paccar chooses to develop the software in house, the expected development costs would equal $50 million and the some new operating equipment would be required at a cost of $150 million. The time to develop the technology is expected to take one year and the operating equipment would be purchased at the end of the year (assume both costs to occur at the end of year 1). The development costs have a depreciable life of 3 years but a useful life of 5 years, while the new operating equipment has a depreciable life of 10 years and a useful life of 5 years. Neither asset would have any salvage value at the end of 5 years of use. Additionally, there will be an increase in maintenance expenses associated with this new technology estimated to equal $7 million in the first year of operations. The expected annual increase in maintenance expense is 3% per year over the five years of its use. The increase in revenue if Paccar develops the technology in house is expected equal $350 million in the first year the new technology was available (we are assuming that if we develop the technology in house it will be better suited for our customers leading to higher expected sales in year 1). The increase in sales revenue is expected to grow at 5% per year over the next two years (years 2 and 3) and at 3% per year in the following two years (years 4 and 5).

Historically, Paccars cost of goods sold is typically 80% of revenue and their working capital needs are 6% of their revenue. Paccars WACC is approximately 5.5% and their expected tax rate is 21%. Paccar uses the MACRS method of depreciation and depreciation expense will start in the year the firm begins selling trucks with the new technology.

Your task: John Harquest, an assistant to the CFO, has asked you (a financial analyst at Paccar) to analyze this new technology project and write a short report (maximum of 2 typed pages, double spaced, font size 12, one inch margins all around) describing the project, your procedures, your results, and your recommendation. John is expecting you to apply the traditional performance measures used at Paccar (NPV, IRR, and the payback period) for each alternative to obtain the new technology (buy and build). Additionally, John recently has heard someone mention another performance measure called the modified internal rate of return (MIRR) and would like you to learn about it and apply it to this analysis realizing that the decision makers at Paccar are not familiar with this measure. Based on your financial analysis (four performance measures) would you recommend: buy, build, or pass on the new technology? Additionally, Mr. Harquest would like you to identify any non-quantifiable issues that maybe relevant to this decision and describe how they would affect your original recommendation that was based solely on the quantitative analysis.

MARCS: Recovery Allowance Percentages for Property

OwnershipYear 3-Year 5-Year 7-Year 10-Year

1 33% 20% 14% 10%

2 45% 32% 25% 18%

3 15% 19% 17% 14%

4 7% 12% 13% 12%

5 11% 9% 9%

6 6% 9% 7%

7 9% 7%

8 4% 7%

9 7%

10 6%

11 3%

100% 100% 100% 100%

Depreciation Expense in year t = Initial Outlay * Recovery Allowance Percentage in year t.

Note: there is no adjustment for salvage value in the calculation of depreciation expense using the MACRS method of depreciation.

Also Note: This MACRS schedule assumed a June 30 acquisition of the asset and, therefore, year 1s allowance and the last years allowance are already adjusted to reflect depreciation expense for the half year.