Middle River Automotive, LLC (MRA) is a company that was established in 2017 with the goal of designing, developing, manufacturing, and selling both hybrid and fully electric cars and light trucks. The company's corporate and design headquarters are in Baltimore, MD. In 2018, the company acquired several decommissioned assembly plants in nearby Middle River, MD, previously owned by Martin Marietta, Corp., an aerospace manufacturing company later acquired by Lockheed Martin. MRA has spent the past 18 months renovating and updating these facilities in anticipation of using them to manufacture electric vehicles. The cost of these renovations thus far has been approximately $1 billion. Scenario It is 2022 and MRA management is currently evaluating a proposal to move forward with plans to manufacture its first light pickup truck, the fully electric Pegasus EVX. The company has already conducted extensive research into both the manufacturing and marketing of this new vehicle and has developed the following estimates: The company expects that, upon the commencement of production, this new project will have an 8-year life. If the project moves forward, a further $250 million investment in Property, Plant, & Equipment will be required immediately. This capital expenditure will be fully depreciated using the straight-line method over an 8-year depreciable life. If given the green light, it will take one year to finish preparing the manufacturing facility, install the new equipment, and hire and train employees. Production and deliveries will commence during year 2 and run for 8 total years. Though operations will not have commenced in Year 1, the company will begin to recognize any depreciation expense in Year 1. The company expects to deliver 50,000 vehicles in the first year of production. The company expects the number of units delivered to increase by 25% in Year 2, 15% in year 3, with sales growth to fall by 5% each year thereafter for the remainder of the project's life. The company has estimated that the average selling price for the Pegasus will be $40,000 in its first year of availability. The company estimates that after this, the average selling price will fall by 2% per year as competition increases and consumers are presented with increasing options in the electric vehicle market. The company expects gross margin to be 5% in the first year of production, 10% in Year 2, and 20% every year thereafter. Gross margin can be calculated as: some sales of the Pegasus will be to customers who may have been planning on purchasing other MRA vehicles, such as their hybrid SUV launched last year. The company has determined that 10% of its annual Pegasus sales will fall into this category. Other vehicles manufactured by MRA have an average selling price of $35,000 and are produced at an average gross margin of 20%. For accounting purposes, except for any investment in CapEx, which will be recognized immediately (T=0), all revenues, expenses, and cash flows will be recognized at the end of the year during which they take place. An additional investment in inventory will need to be made in Year 1 in the amount of $50 million. This inventory will be maintained for the duration of the project's life and will be drawn down to $0 upon the termination of the project. Deliverable You are to prepare an incremental earnings and free cash flow forecast based on these assumptions. Middle River Automotive uses a cost of capital of 12% when evaluating new projects. Its marginal corporate tax rate is 28%. When completing your incremental FCF forecast and answering the following questions, please provide all dollar amounts in thousands of $USD. Meaning, for example, that if a certain raw value of $100 million, it would be represented in your spreadsheet as $100,000 (in effect, 100,000 thousand dollars). In addition to providing a complete incremental free cash flow forecast, please answer the following questions: 1. What is the NPV of this project using the base-case assumptions presented above? 2. Based on input from the marketing department, MRA has concerns about the uncertainty surrounding the first year's sales figures. Holding all other assumptions constant, including YoY sales growth estimates, what is the NPV of the Pegasus project if first year sales are 10% greater than anticipated? What is the NPV if first year sales fall 10% short of our base- case estimates? What is the NPV break-even level of first year sales? 3. In order to meet sales growth targets, MRA is aware that it may need to lower the price of the Pegasus in order to incentivize customers to choose their product over a competitor's. Management is fairly confident that it will be able to achieve the $40,000 average selling price forecast for year 1 of operations. However, they would like you to take a look at how the project's value is impacted if they need to be more aggressive in pricing the Pegasus beyond Year 1. What is the NPV of the Pegasus project if, after Year 1, the average selling price falls by 4% per year, instead of the 2% per year drop incorporated into our base-case Gross Margin = Revenue - COGS Revenue A summary of these baseline forecasts is provided below: Year of Operations Vehicle Deliveries YOY Delivery Average Growth Average Selling Price YoY Price Change Gross Margin 1 50,000 $ 40,000 5% 2 62,500 25% $ 39,200 -2% 10% 3 71,875 15% $ 38,416 -2% 20% 4 79,063 10% $ 37,648 -2% 20% 5 83,016 5% $ 36,895 -2% 20% 6 83,016 0% $ 36,157 -2% 20% 7 78,865 -5% $ 35,434 -2% 20% 8 70,979 -10% $ 34,725 -2% 20% Some further assumptions: The company expects operating expenses (SG&A) of $100 million per year, beginning in Year 1, and continuing for the life of the project. In addition, the company expects an additional $100 million investment in Research & Development in Year 1 in order to finalize the design of the vehicle and its groundbreaking battery technology. After Year 1, the company expects R&D expenses of $25 million per year for the remainder of the project. Furthermore, the company anticipates having to spend $40 million on marketing in Year 1, in advance of the launch of the Pegasus. Marketing expenses are expected to fall by 10% per year after Year 1. Final assembly of the Pegasus will take place in the Pershing Assembly Building. MRA currently leases a portion of this building to a third party for $25 million annually. If the Pegasus project moves forward, this third party will need to relocate its operations immediately and will no longer lease the space from Year 1 onward. Though the company is fully depreciating its equipment over 8 years, it has also estimated that it will likely be able to sell some of this equipment at the end of the project's life. You anticipate that the equipment could be sold for $60 million at the end of the project's life. The company expects that the vast majority of its sales will be to new customers making the transition from traditional, gas-powered vehicles. However, they also expect that A 1 Assumptions 2 Year 1 Vehicle Deliveries 3 Year 1 Average Selling Price 4 Long-term Gross Margin 5 Corporate Tax Rate B C D E F G H J In the table below, please forecast the incremental free cash flows that would result from an investment in this project using your base-case assumptions. At this point, do NOT include the impact of any alternative assumptions presented in questions 2-5. 6 Cost of Capital 7 CapEx 8 Price Drop After Year 1 9 10 11 Question 1 12 NPV of Pegasus Project 13 Question 2 14 NPV with +10% Year 1 Sales: 15 NPV with -10% Year 1 Sales: 16 NPV break-even level of Year 1 Sales: 17 Question 3 18 NPV with 4% YoY drop in selling price: 19 NPV break-even YoY price drop: 20 Question 4 21 NPV break-even gross margin for 22 Year 3 and beyond: 23 Question 5 24 NPV with updated depreciation plan: 25 Which depreciaition schedule should 26 MRA use? 27 Question 6 28 What is the IRR of Pegasus Project? Year Revenue Cost of Revenue (COGS) Gross Profit SG&A R&D Marketing Expenses Other Expenses Depreciation EBIT Income Tax Incremental Earnings PLUS: Depreciation LESS: CapEx LESS: Increase in NWC Salvaged Equip Cash Flow Free Cash Flows 0 1 2 3 Please provide all dollar values in thousands of $USD 29 30 31 32 33 34 35 L M K N You may make use of any formulas you'd like when filling in this table, but please do not insert/remove any cells, rows, and/or columns. Do not make any formatting changes. 5 6 7 8 9 P Q assumptions. What is the NPV break-even level of YoY drop in average selling price beyond Year 1. Again, hold all other assumptions constant. 4. MRA anticipates gross margin to increase from 5% in Year 1 of production to 20% by Year 3 of production due to efficiency gains in production processes as well as lower production costs. However, there is some concern that these estimates are too optimistic. Holding our gross margin estimates constant in the first 2 years of operations, what is the NPV break-even level of gross margin that must be achieved by Year 3 of operations and maintained for the remainder of the project's life. 5. In order to incentivize investment in "green" industry, the government has made additions to the corporate tax code that it hopes will encourage investment in these types of companies. Recently-passed legislation allows investments in electric vehicle production to utilize and benefit from an accelerated depreciation schedule. This legislation allows 50% of the cost of any capex investment to be depreciated in its first year (Year 1). The remaining 50% will be depreciated evenly over the original assumed depreciable life. What is the NPV of the Pegasus project using these updated depreciation assumptions? Despite this recently passed tax legislation, MRA still plans on using straight-line depreciation for all of its accounting. Which depreciation method should you utilize in your FCF and NPV analysis? 6. What is the IRR of this project? Provide your answer to 1 decimal place (0.1%).