Problem 3. GM's Driverless Cars
The management of General Motors is considering building a plant to produce driverless cars. If it accepts this project today, management will begin building the plant 5 years from today (in project year 0). year. Plant construction will take one year. Six years from today, management will equip the factory with new equipment and some equipment GM already owns. For analytical purposes, management assumes it will operate the plant for five years before selling it. GM's opportunity cost of capital is 15% and its marginal tax rate is 40%.
If it accepts the project, management will spend $200m five years from now (year 0 of the project's life) to construct a new plant. Once the plant becomes operational, management will depreciate the plant ot zero over 10 years using straight-line depreciation. Management estimates that the market value of the plant at the end of the project's life will be $110m.
Six years from now (year 1 of the project's life) management will spend $300m to equip the plant. The equipment falls into the 5-year MACRS life class with the following (rounded) depreciation percentages: year 1, 20%; year 2, 30%, year 3, 20%; years 4-6, 10% each. Management estimates that this equipment will have zero market value at the end of the project's life.
To finance plant construction and equipment purchases, management will borrow $500m six years from now by selling bonds paying 5% annual interest, resulting in an annual interest expense of $25m.
At the same time it equips the plant, management will transfer to the plant equipment from another plant it will be closing then. This equipment, which will have a book value of $200m and five years of depreciable life left, is being depreciated using straight-line depreciation. Management believes it could sell this equipment for $250m at the time of transfer and for $10m at the end of the project's life.
The worksheet shows estimates of numbers of driverless cars sold, unit prices, and direct production costs per car (exclusive of depreciation). Initially, sales of driverless cars will have little impact on sales of GM's conventional cars but soon thereafter car buyers will begin switching from conventional cars to driverless cars, reducing revenues from the former. As this happens, management will scale back production of conventional GM cars, saving production costs and recapturing some investment in net working capital. The worksheet also shows numbers of conventional cars not produced and sold, unit prices and direct production costs per car.
Shortly after Google announced it was developing a driverless car in 2010, GM's management decided go step up the pace of development of its own driverless car. GM has already spent $75m on development costs and is committed to spending another $25m between now and the time plant construction begins. GM's comptroller has suggested spreading this $100m cost evenly over the first five years the plant is in operation (i.e., a development cost of $20m per year).
To produce driverless cars or conventional cars, GM must hold net working capital equal to 12% of coming-year direct production costs. Management must make the initial investment in net working capital to support production of driverless cars at project year 1; this investment will be recaptured at the end of the projects life. Management will reduce holdings of net working capital for conventional cars as it reduces production of these cars.
Once the plant is operational it will become part of GM's North American Operations. The VP of NA Ops will hire several mid-level executives to manage day-to-day plant activities at an annual cost of $10m.
Compute free cash flow for each year in the project's life, then compute the project's net present value (NPV) at two different points of time: right before the project is undertaken (5 years from now at project year 0) and today (year 0). Should GM produce driverless cars?
Project Year	0	1	2	3	4	5	6
Years from Now	5	6	7	8	9	10	11
Data
Number of driverless cars sold (m)			0.005	0.10	0.20	0.20	0.20
$ price per driverless car			$50,000	$50,000	$45,000	$40,000	$38,000
$ of direct cost per driverless car			$37,000	$32,000	$27,000	$27,000	$27,000
Number of conventional cars not sold (m)			0	0.05	0.15	0.18	0.20
$ price per conventional car			$35,000	$35,000	$32,000	$32,000	$30,000
$ of direct cost per conventional car			$25,000	$25,000	$26,000	$26,000	$26,000
MACRS %, robotic equipment
Project Year	0	1	2	3	4	5	6
Years from Now	5	6	7	8	9	10	11
Pro Forma Income Statement ($ mil)
Sales
Driverless cars
Conventional cars
Total
Costs (excl. Depreciation)
Driverless cars
Conventional cars
Total
Depreciation
Plant
New equipment
Used equipment
Total
Development Cost
Executive Salaries
=EBIT
Interest expense
Tax (40%)
= Net Income
Project Year	0	1	2	3	4	5	6
Years from Now	5	6	7	8	9	10	11
Pro Forma Balance Sheet -- Asset side ($ mil)
Net Working Capital
Driverless cars
Conventional cars
Total
Net Fixed Assets
Plant
New equipment
Used equipment
Memo: After-tax Cash Flow = MV (MV BV)T
	Year	MV	BV	T	ATCF
Used equipment
Plant
New equipment
Used equipment
Project Year	0	1	2	3	4	5	6
Years from Now	5	6	7	8	9	10	11
Project Free Cash Flow Worksheet ($ mil)