Electrics, Inc. Introduction William Livingston has recently been hired as the CEO of Electrics, Inc. Previously he had been the marketing manager for a large manufacturing company and had established a reputation for identifying new consumer trends. Electrics Inc. is a California-based generator manufacturing company. The company is well known for manufacturing large, heavy-duty generators at a reasonable cost. One of its greatest achievements is that its generators can be easily modified or customized for different applications. The company is considering an expansion of its current product line to include an electric motors conversion kit for cars. Customers can use these kits to convert their cars from gas to electric drive systems. Mr. Livingston felt that due to high energy prices, consumers will be more willing to consider purchasing new conversion kits. Profile of Electrics Electrics, Inc. was established by the Smith brothers in 1910 as the Logging Saw Company. The firm started manufacturing large steam saws to serve the logging industry which processed lumber. Their customers were construction companies that provided housing for the population increase in California. The Smith brothers quickly realized that the times were changing. They started looking for the technologies that would keep them at the forefront of their field of business. In 1915, the Smith brothers decided that 2 they needed to make generators as replacements for the saws. They realized that the logging industry was not viable anymore and that generators were starting to serve the same purpose. The company started making generators in the early 1920s. Electrics then opted to produce large-commercial AC electric motors. It was an easy decision to make since the commercial AC electric motors would use common parts with the companys generators and the customers were local hospitals, schools, and governments. Starting in the 1950s the commercial AC motors business accounted for about 50% of Electrics revenues. The Car Conversion Kit Mr. Livingston arranged a meeting with the firms top management and the chief design and the chief manufacturing engineers to propose a new product. Mr. Livingston presented an argument that more individuals in the United State and Canada would be willing to purchase the conversion kit because people are becoming more environmentally conscious. Electric cars are more efficient and environmentally friendlier. Also, the recent increase in fuel costs seems to be long lasting. This is an opportunity to get people hooked on environmentally friendly appliances as he put it. The proposal under consideration is for the introduction of a new car conversion kit to convert gas cars into electric ones. To distinguish Electrics from other manufacturers, the proposal included details about the efficiency and quietness of operation of the motors that need to be developed. 3 Mr. Phillips and Mr. Lopez, the two engineers, enthusiastically and quickly pointed out that the needed technology could be based on the companys commercial AC motors. The framework currently used for building the commercial AC motors can be modified to work for smaller electric motors at a low cost. The marketing vice president, Mr. Chen, pointed out that the marketing analysis could be done quickly and at a reasonable cost. At this point, Mr. Livingston charged the participants in the meeting to produce a financial plan for the development and production of the electric motor. Customer Cars Most people purchase gas cars and keep them for a few years or until they stop working or a nicer new model is introduced. Recently, most states companies started educating people about the efficiency of electric cars and began offering rebates on the most efficient models. These approaches increased public interest. This renewed the publics interest in low fuel-consuming cars. The Decision Three weeks later, the vice presidents presented the sales and cost forecasts shown in the exhibits. The information presented contains the cost of production, financing information, and warranty cost estimates. In addition, there were two options for the controller of the electric motor in the conversion kits. The CTX 13 is more expensive to install but has a lower warranty cost. The MT 78 is cheaper to install but has a higher warranty cost. Which controller should be used? 4 The Analysis Mr. Livingston noticed that there is an abundance of enthusiasm about entering the electric car conversion kit building business, but his cautious nature made him seek a more neutral analyst. This is your responsibility. You have been hired by Electrics to analyze the proposal to build the electric motor and provide recommendations to Mr. Livingston. The issues that need to be addressed in your report are the following: 1. How much importance should be given to the energy cost situation? 2. What is the projects cost of equity? What is the Cost of Debt? 3. Is the Weighted Average Cost of Capital the appropriate discount factor to use for evaluating the electric motor project? Could other costs be used in the analysis? 4. Which of the two controllers should be used in the conversion kit if you decide to go ahead with the project and why? 5. Use the appropriate capital budgeting techniques to evaluate the project. 6. Use the average demand scenario to evaluate the sensitivity of the projects NPV with respect to sale price of the electric motor and the cost of the controller. With percent deviations +/- 10%, 20%, 30%. 7. Based on the scenario and sensitivity analysis you performed above, comment on the overall riskiness of the project. 8. Would you recommend that Electrics accept or reject the project? What is the basis for your recommendation? 5 Question review and analysis in APA format. WACC, Capital Budget analysis and Risk analysis in spreadsheet format. Rubric is provided. Files posted to Blackboard by Midnight Sunday December 17. This work represents 25% of your course assessment grade. 6 Exhibit 1 Sales forecasts: The forecasts are based on projected levels of demand. The firm could face weak, average, and strong demand. All the numbers are expressed in todays dollars. The forecasted average inflation per year is 4.0%. Demand level Weak Average Strong Probability 25% 45% 30% Price per electric motor $9,100 $9,200 $9,250 Units sold per year 40,000 40,500 40,750 Labor cost per electric motor $4,250 Parts $2,500 Selling General & Administrative $9,500,000 Average warranty cost per year per electric motor for the first five years is $75. The present value of this cost will be used as a cost figure for each electric motor. Afterwards, the electric motor owners will become responsible the repairs. The electric motors can be produced for eight years. Afterwards, the designs become obsolete. Exhibit 2 Controller costs: Controller choices: Controller model number CTX 13 MT 78 Price per controller and installation $1280 $1260 Average annual warranty cost per year for five years. Afterwards, the electric motor owner will become responsible the repairs*. $90 $100 The chosen controller will be installed in every electric motor and will become a cost figure for each unit produced. * The controller manufacturers are not providing Electrics with any warranty. However, Electrics will provide a warranty to its customers. After the initial five years, the electric motor owners may purchase extended warranty from any insurance company that offers such packages. 7 Exhibit 3 Investment needs: To implement the project, the firm has to invest funds as shown in the following table: Year 0 Year 1 $17 million Production and selling of commercial appliances begins MACRS depreciation will be used. Project life is eight years, zero salvage value. To facilitate the operation of manufacturing the electric motors, the company will have to allocate funds to net working capital (NWC) equivalent to 10% of annual sales. The investment in NWC will be recovered at the end of the project. Exhibit 4 Financing The following assumptions are used to determine the cost of capital. Historically, the company tried to maintain a debt-to-equity ratio equal to 1.50. This ratio was used because lowering the debt implies giving up the debt tax shield and increasing it makes debt service a burden on the firms cash flow. In addition, increasing the debt level may cause a reduced rating of the companys bonds. The marginal tax rate is 25%. All the numbers are expressed in todays dollars. The forecasted average inflation per year is 4.0%. Cost of debt: The companys bond rating is roughly at the high end of the BBB range. Surveying the debt market yielded the following information about the cost of debt for different rating levels: Bond rating AA A BBB Interest cost range 4.5% ~ 5.5% 5.25% ~ 6.5% 6.5% ~ 9% The companys current bonds have a rating of BBB. Cost of equity: The current 10-year Treasury notes have a yield to maturity of 4.00% and the forecast for the S&P 500 market premium is 9.5%. The companys overall is 1.25