In late 2016, the executive committee of Lotis Electronics, Inc., met to consider a significant change in the company's strategy. Lotis is a large, integrated producer of electronic components, computers, military electronic equipment, and office machines. Its products are considered to be of the very highest quality, and the company has the reputation of being competitive in all of its businesses. The firm specializes in large commercial applications, so none of its products has ever been designed for either the "home" or the very small business market. These two market segments have always been ignored because Lotis considered the demand by households and very small firms for the kinds of products it produces to be insufficient, so there would be little or no profit potential in serving them. Recently, though, several competitors have expanded into the home computer market, increasing their sales volume of certain electronic components that are also used in their commercial product lines. This has led to greater scale economies in production of these components, and hence to significantly lower unit costs. This challenge could have serious adverse competitive ramifications for Lotis' commercial products, so the executive committee now faces the issue of how to respond to the threat. At a series of earlier meetings, the executive committee had decided to explore the feasibility of entering the home and/or small business computer market. It was quickly verified that the company has no distinctive capabilities that would give it a competitive advantage in the home market segment. However, it might be possible to exploit one of the company's recent patents in the rapidly expanding business market for high performance portable lap-top computers. Lotis has recently patented a new process for making high resolution display panels. Flat displays employing this technology are substantially easier to read than those made with competing technologies, and the detail that these displays achieve is comparable to standard video display terminals (VDTS). Also, the new displays consume far less power than do alternative VDTs. The Engineering Department estimates that it will be possible to build and sell at a competitive price a portable computer with 8GB of random access memory (RAM), a 250 GB SSD, and 15.6-inch LED display. Using a stateof-the-art 4-cell lithium ion battery system and a solar cell power augmenter, the computer could be operated for approximately 24 hours without recharging the batteries. When indoors, 120 volt AC power can also be used to preserve battery charge. Based on initial engineering estimates of the capabilities of the computer and its production costs, the executive committee authorized a full-scale analysis of the project. Two potential strategies emerged from the first part of this analysis. The first, called by its advocates the "both feet" strategy, requires the company to enter the market with maximum dedication Gump in with "both feet") by building a large production facility that could serve potential needs for ten years. With this kind of effort, the market would perceive that the company had made a firm commitment to this new product. The second strategy, labeled the "tiptoe in the dark" strategy by its detractors, calls for the company to make a smaller investment in a facility that would have sufficient capacity to serve anticipated market requirements for only five years. Based on information that could be gained in the first few years about the market, the technology, acceptance of the product, and the reaction of competitors, another decision would then be made as to whether to increase production capacity, to maintain the original level of production, or to get out of the business. Hence, the firm would "tiptoe in the dark" and not make any substantial resource commitments until more light could be shed on the development of the market and the company's ability to compete in it. The vice-president for marketing, Doyle Carruthers, was the champion of the first strategy. He argued that by building the large plant immediately, Lotis would signal to the market its commitment to the business. This would help attract both customers and retail distributors. Also, by exploiting the learning curve and obtaining the economies of scale associated with high-volume production, the company could maximize its ability to compete aggressively. This argument seemed compelling to a majority of the executive committee members. However, Floyd Metzger, the vice-president for operations, believed that the second strategy had some desirable characteristics. First, given the projected growth rate in market demand and Lotis' share of that market, production capacity would not be reached with the smaller plant until after 2023. That is also the time a decision to expand would have to be made, so the company would not lose any future sales with the two stage investment. Second, if the sales projections turn out to be overly optimistic, Lotis would be in a much better position to "bite the bullet" and abandon the venture if a smaller amount of capital is at stake. As an example of a situation in which the more cautious approach should have been used, Metzger pointed to the serious excess capacity problem in the Semiconductor Division caused by over optimism. The third desirable characteristic Metzger noted is that portable computer technology is advancing rapidly, so the two-stage investment would permit a change to new production techniques, if they develop, at a far lower retrofitting cost. He admitted, though, that the total investment cost would be higher with the two-stage investment if the additional capacity does turn out to be needed. Most other members of the executive committee had to agree with Metzger that these were very real benefits. Carruthers, though, still remained convinced that the capital cost advantage of the large facility-and the signal it would give to the market about Lotis' intent-were dominant. After the executive committee had argued the merits of the two strategies for some time, Karen Michaels, executive vice-president and chief financial officer, observed that the best way to resolve the issue was to conduct a formal economic and strategic analysis of the two scenarios. Michaels also suggested that there might be still another possible alternative. Specilically. the Computel Corporation had recently announced a reorganization of the firm's operations. Now they were looking for a buyer for one of their manufacturing plants located in the same industrial park where Lotis would establish its facility. Michaels pointed out that it might be possible to purchase the Computel plant, which was roughly the same size as the one Lotis envisioned under the "tiptoe in the dark" scenario, at a very attractive price and on a turn-key basis. She suggested that her capital budgeting staff should be directed to conduct an economic analysis of this alternative, along with the other two, and to report their results to the executive committee in two weeks. This suggestion was accepted, and the committee turned to other business. The next morning Michaels called together her economic analysis staff to brief them on the task at hand. From the various engineering studies and market forecasts, she derived the following information. To date, Lotis has spent $12 million on R \& D, including design and market studies, on the new portable computer. Of the $12 million total, $6 million can be expensed immediately, while the remaining $6 million must be capitalized and amortized over five years. Assume that under an IRS ruling, $6 million of the expenditures is the maximum that can be expensed; the remainder must be capitalized and then amortized after the project becomes operational and begins to generate cash revenues. If the portable computer project is abandoned, though, these capitalized R \& D expenditures will have produced no information or designs for use in other divisions or by anyone else. In this case, they can and will be written off immediately. If the decision is made to build a new plant (either the small facility or the large one), a 20 acre site will have to be acquired on January 1,2017(t=0). The company currently owns a tract of land in the industrial park that would be suitable for the facility. However, this particular land is owned by the Semiconductor. Division, which acquired it for expansion purposes. The Semiconductor Division has not grown as rapidly as Lotis had forecasted, so the land is expected to remain idle until 2023 (or t=6 ). when the expansion is now envisioned. This tract cost $4mili, which is also its current market value; other similar sites are available at the same price in the park if the Portable Computer Division takes over the Semiconductor Division's tract. provisions will have to be made for a replacement. For a payment of $200,000 on January 1, 2017, the Semiconductor Division can obtain an option on a similar 20 -acre tract in the same park; exercise of the option would call for the payment of $5.25 million for the property on January 1,2023 . Michaels estimates that the tract will have a market value of $5.5 million in 2023 , so similar tracts should be available for that price in 2023. If Lotis were to build its own plant, most of 2017 would be spent obtaining approvals and so forth; land acquisition at t=0 would be the only material expenditure during 2017. Actual construction would occur during 2018. Looking first at the "tiptoe in the dark" strategy whereby Lotis would acquire the smaller facility, the cost would be $10 million. (Assume that the $10 million expenditure would occur on January 1,2018 , which is t=1.) The plant would be depreciated starting on January 1,2020 , according to the modified accelerated cost recovery system (MACRS) schedule for 311/2-year property. Although the depreciable life is 32 years, the plant would actually be used to produce portable computers for a maximum of ten years, from January 1,2020 through December 31,2028 (which is essentially the same as January 1,2029)(t=3 through t=12 ). It is estimated that the buildings would have a market value of $3.4 million at the end of 2028, an amount equal to the book value at the end of 2028, and the land would have an after-tax terminal value of $6 million at the same date. The necessary manufacturing equipment, under the build alternative, would be installed during 2018 at a cost of $15 million (assume payment would he made on January 1,2018 , which is t=1 ). The equipment would be classified as five-year property under the MACRS guidelines, and, at the end of 10 years, the removal cost would equal its scrap value. The production capacity of the plant is 75,000 units per year. An initial investment in net working capital equal to 30 percent of estimated first-year sales would be required in 2019 (assume the investment would be made on January 1,2019 , at t=2 ). Additions to net working capital in each subsequent year would be 30 percent of any expected increase in sales from the previous year. Assume that this investment would be made on January 1 of the year in which it is required; for example, any additional net working capital needed to support any projected 2020 sales increase would be paid for on January 1, 2020. Lotis' marketing department has projected total demand for portable lap-top computers at the level shown in Table 1. If Lotis builds the large facility, it is expected that the company can capture 60 percent of the market in its first year of operation and will be able to maintain this market share for the full ten years the plant is in operation. If either the smaller plant is built or the Computel facility is purchased, the first year market share will most likely be around 50 percent, as some potential buyers will not be too sure about Lotis' commitment to the venture. However, in all subsequent years of operation, the market share should be 60 percent. The sales price per unit is expected to be $1,675 in 2017, and, because of stiff competition, this price is expected to erode at about 6 percent per year. The Engineering Department has estimated manulacturing costs for the small plant as follows: Variable costs: 60 percent of sales Fixed costs: $10 million annually, excluding depreciation. The variable costs are expected to remain at 60 percent of sales for the entire ten-year period, and fixed costs other than depreciation are projected to increase with the rate of inflation, which is expected to be 4 percent per year. All operating cash flows are assumed to occur at the end of the year (which is equivalent to the beginning of the next year). The alternative large plant would involve a larger building which would cost 315 million in 2018 , and the equipment would require an outlay of $21 million. Variable costs would be a constant 50 percent of sales with the large plant. The initial fixed operating costs other than depreciation would be $15.75 million, and these costs would increase at 4 percent per year. The assumptions about working capital requirements and salvage value would be the same as for the small plant. If the already existing plant is purchased from Computel Corporation, it will be on a turn-key basis, with payment being made on January 1,2018 , which is t=1 in this analysis, and with Lotis immediately taking over the plant and starting to operate it. (The contract would call for Lotis to hire most of the Computel employees and to have access to the plant for training, as needed, prior to the January 1, 2018 closing.) This plant would have a net cost of \$22 million. Of this amount, \$2 million is for the land (transferred at book value), $8 million for the building, and the remaining $12 million for the equipment. The variable costs in this plant would be 70 percent of sales, and the fixed operating costs would be $7.5 million in the first year, increasing at the inflation rate of 4 percent per year. The working capital requirements under this alternative would be the same as for the construction alternative. The salvage value of the equipment is expected to equal the removal cost, but the building will have a value equal to its book value after ten years. The land will have an aftertax value expected to equal $6 million after ten years. Also, the cash flows as given include all tax effects associated with the $6 million of capitalized R&D costs. Lotis's effective federal-plus-state tax rate is 40 percent; its target debt ratio is 40 percent; its cost of new debt is 11 percent; its next expected dividend, D1, is $1.80; its current stock price, P0, is $45; and the firm's expected growth rate, g, is 10.37 percent. Lotis uses its overall weighted average cost of capital in evaluating average risk projects, and it adjusts this figure up or down by 2 percent for more or less risky individual projects. The plan to build the smaller plant is considered to be above average risk, while the acquisition of the Computel facility is considered to have average risk. The "both feet" strategy, whereby the company would build the large production facility, is considered to be the most risky of the alternatives, requiring an additional 1 percent premium on top of the standard 2 percent risk premium. 3. The correct after-tax cash flows for the three alternative projects have been derived by your analytical team. These are given in Table 4. What discount rate(s) is(are) appropriate for these alternatives? What discount rate is appropriate for the small addition alternative? Justify your measure. Compute their net present values, internal rate of return, and payback periods. Table 3 MACRS Depreciation Rates "Industrial buildings must be depreciated over a 31.5-year period using straight line with the one-half month convention. Actual depreciation varies depending on the. month property is placed in service, but for capital budgeting purposes we use as an approximation a frst year rate of (1/31.5)0.5=1.5873%, and fur the next 31 years a rate of 1/31.5=3.1746%. Table 4 After-Tax Cash Flow Projections In late 2016, the executive committee of Lotis Electronics, Inc., met to consider a significant change in the company's strategy. Lotis is a large, integrated producer of electronic components, computers, military electronic equipment, and office machines. Its products are considered to be of the very highest quality, and the company has the reputation of being competitive in all of its businesses. The firm specializes in large commercial applications, so none of its products has ever been designed for either the "home" or the very small business market. These two market segments have always been ignored because Lotis considered the demand by households and very small firms for the kinds of products it produces to be insufficient, so there would be little or no profit potential in serving them. Recently, though, several competitors have expanded into the home computer market, increasing their sales volume of certain electronic components that are also used in their commercial product lines. This has led to greater scale economies in production of these components, and hence to significantly lower unit costs. This challenge could have serious adverse competitive ramifications for Lotis' commercial products, so the executive committee now faces the issue of how to respond to the threat. At a series of earlier meetings, the executive committee had decided to explore the feasibility of entering the home and/or small business computer market. It was quickly verified that the company has no distinctive capabilities that would give it a competitive advantage in the home market segment. However, it might be possible to exploit one of the company's recent patents in the rapidly expanding business market for high performance portable lap-top computers. Lotis has recently patented a new process for making high resolution display panels. Flat displays employing this technology are substantially easier to read than those made with competing technologies, and the detail that these displays achieve is comparable to standard video display terminals (VDTS). Also, the new displays consume far less power than do alternative VDTs. The Engineering Department estimates that it will be possible to build and sell at a competitive price a portable computer with 8GB of random access memory (RAM), a 250 GB SSD, and 15.6-inch LED display. Using a stateof-the-art 4-cell lithium ion battery system and a solar cell power augmenter, the computer could be operated for approximately 24 hours without recharging the batteries. When indoors, 120 volt AC power can also be used to preserve battery charge. Based on initial engineering estimates of the capabilities of the computer and its production costs, the executive committee authorized a full-scale analysis of the project. Two potential strategies emerged from the first part of this analysis. The first, called by its advocates the "both feet" strategy, requires the company to enter the market with maximum dedication Gump in with "both feet") by building a large production facility that could serve potential needs for ten years. With this kind of effort, the market would perceive that the company had made a firm commitment to this new product. The second strategy, labeled the "tiptoe in the dark" strategy by its detractors, calls for the company to make a smaller investment in a facility that would have sufficient capacity to serve anticipated market requirements for only five years. Based on information that could be gained in the first few years about the market, the technology, acceptance of the product, and the reaction of competitors, another decision would then be made as to whether to increase production capacity, to maintain the original level of production, or to get out of the business. Hence, the firm would "tiptoe in the dark" and not make any substantial resource commitments until more light could be shed on the development of the market and the company's ability to compete in it. The vice-president for marketing, Doyle Carruthers, was the champion of the first strategy. He argued that by building the large plant immediately, Lotis would signal to the market its commitment to the business. This would help attract both customers and retail distributors. Also, by exploiting the learning curve and obtaining the economies of scale associated with high-volume production, the company could maximize its ability to compete aggressively. This argument seemed compelling to a majority of the executive committee members. However, Floyd Metzger, the vice-president for operations, believed that the second strategy had some desirable characteristics. First, given the projected growth rate in market demand and Lotis' share of that market, production capacity would not be reached with the smaller plant until after 2023. That is also the time a decision to expand would have to be made, so the company would not lose any future sales with the two stage investment. Second, if the sales projections turn out to be overly optimistic, Lotis would be in a much better position to "bite the bullet" and abandon the venture if a smaller amount of capital is at stake. As an example of a situation in which the more cautious approach should have been used, Metzger pointed to the serious excess capacity problem in the Semiconductor Division caused by over optimism. The third desirable characteristic Metzger noted is that portable computer technology is advancing rapidly, so the two-stage investment would permit a change to new production techniques, if they develop, at a far lower retrofitting cost. He admitted, though, that the total investment cost would be higher with the two-stage investment if the additional capacity does turn out to be needed. Most other members of the executive committee had to agree with Metzger that these were very real benefits. Carruthers, though, still remained convinced that the capital cost advantage of the large facility-and the signal it would give to the market about Lotis' intent-were dominant. After the executive committee had argued the merits of the two strategies for some time, Karen Michaels, executive vice-president and chief financial officer, observed that the best way to resolve the issue was to conduct a formal economic and strategic analysis of the two scenarios. Michaels also suggested that there might be still another possible alternative. Specilically. the Computel Corporation had recently announced a reorganization of the firm's operations. Now they were looking for a buyer for one of their manufacturing plants located in the same industrial park where Lotis would establish its facility. Michaels pointed out that it might be possible to purchase the Computel plant, which was roughly the same size as the one Lotis envisioned under the "tiptoe in the dark" scenario, at a very attractive price and on a turn-key basis. She suggested that her capital budgeting staff should be directed to conduct an economic analysis of this alternative, along with the other two, and to report their results to the executive committee in two weeks. This suggestion was accepted, and the committee turned to other business. The next morning Michaels called together her economic analysis staff to brief them on the task at hand. From the various engineering studies and market forecasts, she derived the following information. To date, Lotis has spent $12 million on R \& D, including design and market studies, on the new portable computer. Of the $12 million total, $6 million can be expensed immediately, while the remaining $6 million must be capitalized and amortized over five years. Assume that under an IRS ruling, $6 million of the expenditures is the maximum that can be expensed; the remainder must be capitalized and then amortized after the project becomes operational and begins to generate cash revenues. If the portable computer project is abandoned, though, these capitalized R \& D expenditures will have produced no information or designs for use in other divisions or by anyone else. In this case, they can and will be written off immediately. If the decision is made to build a new plant (either the small facility or the large one), a 20 acre site will have to be acquired on January 1,2017(t=0). The company currently owns a tract of land in the industrial park that would be suitable for the facility. However, this particular land is owned by the Semiconductor. Division, which acquired it for expansion purposes. The Semiconductor Division has not grown as rapidly as Lotis had forecasted, so the land is expected to remain idle until 2023 (or t=6 ). when the expansion is now envisioned. This tract cost $4mili, which is also its current market value; other similar sites are available at the same price in the park if the Portable Computer Division takes over the Semiconductor Division's tract. provisions will have to be made for a replacement. For a payment of $200,000 on January 1, 2017, the Semiconductor Division can obtain an option on a similar 20 -acre tract in the same park; exercise of the option would call for the payment of $5.25 million for the property on January 1,2023 . Michaels estimates that the tract will have a market value of $5.5 million in 2023 , so similar tracts should be available for that price in 2023. If Lotis were to build its own plant, most of 2017 would be spent obtaining approvals and so forth; land acquisition at t=0 would be the only material expenditure during 2017. Actual construction would occur during 2018. Looking first at the "tiptoe in the dark" strategy whereby Lotis would acquire the smaller facility, the cost would be $10 million. (Assume that the $10 million expenditure would occur on January 1,2018 , which is t=1.) The plant would be depreciated starting on January 1,2020 , according to the modified accelerated cost recovery system (MACRS) schedule for 311/2-year property. Although the depreciable life is 32 years, the plant would actually be used to produce portable computers for a maximum of ten years, from January 1,2020 through December 31,2028 (which is essentially the same as January 1,2029)(t=3 through t=12 ). It is estimated that the buildings would have a market value of $3.4 million at the end of 2028, an amount equal to the book value at the end of 2028, and the land would have an after-tax terminal value of $6 million at the same date. The necessary manufacturing equipment, under the build alternative, would be installed during 2018 at a cost of $15 million (assume payment would he made on January 1,2018 , which is t=1 ). The equipment would be classified as five-year property under the MACRS guidelines, and, at the end of 10 years, the removal cost would equal its scrap value. The production capacity of the plant is 75,000 units per year. An initial investment in net working capital equal to 30 percent of estimated first-year sales would be required in 2019 (assume the investment would be made on January 1,2019 , at t=2 ). Additions to net working capital in each subsequent year would be 30 percent of any expected increase in sales from the previous year. Assume that this investment would be made on January 1 of the year in which it is required; for example, any additional net working capital needed to support any projected 2020 sales increase would be paid for on January 1, 2020. Lotis' marketing department has projected total demand for portable lap-top computers at the level shown in Table 1. If Lotis builds the large facility, it is expected that the company can capture 60 percent of the market in its first year of operation and will be able to maintain this market share for the full ten years the plant is in operation. If either the smaller plant is built or the Computel facility is purchased, the first year market share will most likely be around 50 percent, as some potential buyers will not be too sure about Lotis' commitment to the venture. However, in all subsequent years of operation, the market share should be 60 percent. The sales price per unit is expected to be $1,675 in 2017, and, because of stiff competition, this price is expected to erode at about 6 percent per year. The Engineering Department has estimated manulacturing costs for the small plant as follows: Variable costs: 60 percent of sales Fixed costs: $10 million annually, excluding depreciation. The variable costs are expected to remain at 60 percent of sales for the entire ten-year period, and fixed costs other than depreciation are projected to increase with the rate of inflation, which is expected to be 4 percent per year. All operating cash flows are assumed to occur at the end of the year (which is equivalent to the beginning of the next year). The alternative large plant would involve a larger building which would cost 315 million in 2018 , and the equipment would require an outlay of $21 million. Variable costs would be a constant 50 percent of sales with the large plant. The initial fixed operating costs other than depreciation would be $15.75 million, and these costs would increase at 4 percent per year. The assumptions about working capital requirements and salvage value would be the same as for the small plant. If the already existing plant is purchased from Computel Corporation, it will be on a turn-key basis, with payment being made on January 1,2018 , which is t=1 in this analysis, and with Lotis immediately taking over the plant and starting to operate it. (The contract would call for Lotis to hire most of the Computel employees and to have access to the plant for training, as needed, prior to the January 1, 2018 closing.) This plant would have a net cost of \$22 million. Of this amount, \$2 million is for the land (transferred at book value), $8 million for the building, and the remaining $12 million for the equipment. The variable costs in this plant would be 70 percent of sales, and the fixed operating costs would be $7.5 million in the first year, increasing at the inflation rate of 4 percent per year. The working capital requirements under this alternative would be the same as for the construction alternative. The salvage value of the equipment is expected to equal the removal cost, but the building will have a value equal to its book value after ten years. The land will have an aftertax value expected to equal $6 million after ten years. Also, the cash flows as given include all tax effects associated with the $6 million of capitalized R&D costs. Lotis's effective federal-plus-state tax rate is 40 percent; its target debt ratio is 40 percent; its cost of new debt is 11 percent; its next expected dividend, D1, is $1.80; its current stock price, P0, is $45; and the firm's expected growth rate, g, is 10.37 percent. Lotis uses its overall weighted average cost of capital in evaluating average risk projects, and it adjusts this figure up or down by 2 percent for more or less risky individual projects. The plan to build the smaller plant is considered to be above average risk, while the acquisition of the Computel facility is considered to have average risk. The "both feet" strategy, whereby the company would build the large production facility, is considered to be the most risky of the alternatives, requiring an additional 1 percent premium on top of the standard 2 percent risk premium. 3. The correct after-tax cash flows for the three alternative projects have been derived by your analytical team. These are given in Table 4. What discount rate(s) is(are) appropriate for these alternatives? What discount rate is appropriate for the small addition alternative? Justify your measure. Compute their net present values, internal rate of return, and payback periods. Table 3 MACRS Depreciation Rates "Industrial buildings must be depreciated over a 31.5-year period using straight line with the one-half month convention. Actual depreciation varies depending on the. month property is placed in service, but for capital budgeting purposes we use as an approximation a frst year rate of (1/31.5)0.5=1.5873%, and fur the next 31 years a rate of 1/31.5=3.1746%. Table 4 After-Tax Cash Flow Projections