Question 6 only:

Real Discount Rate: 14.0% compounded daily

Your team is assigned to the Gadget Division of The FGM Corporation, the largest multinational automobile manufacturer in the U.S. Your team is asked to evaluate a project proposal regarding the production of a device, DEVICE, which applies the artificial intelligence technology to improve driving experiences and safety. This upgradeable built-in device gives warnings to drivers and assists them to stay in lane and avoid collision. The DEVICE will be marketed as an optional feature for FGM cars and trucks. A 15-month comprehensive market analysis on the potential demand for the device was conducted and completed last year at a cost of $18.0M, where M is for millions.

Based on the comprehensive market analysis, your team expects annual sale volume of DEVICE to be 5.0M units for the first year and will decrease by 500,000 units annually in the following two years. The REAL unit price of the device is $985 (expressed in constant t=0 dollar). Due to the introduction of similar products by competitors at the end of Year 3, the expected annual sale volume will drop to 3.0M units for the projects remaining 2-year life. And the REAL unit price is expected to fall to $785 (expressed in constant t=0 dollar) in the year following the introduction of the competitive products. The REAL unit production costs are estimated at $895 (expressed in constant t=0 dollar) at the beginning of the project, and will not be impacted by the change in competition. Annual nominal growth rates for unit prices and unit production costs are expected to be 3.0% and 4.5%, respectively, over the entire life of the project.

In addition, the implementation of the project demands current assets set at 18% of contemporaneous annual sale revenues, and current liabilities set at 14% of contemporaneous annual production costs. Besides, the introduction of DEVICE will increase the sales volume of cars and trucks that leads to an increase in the annual after-tax operating cash flow of FGM by $30.0M (expressed in constant t=0 dollar, i.e., in real term) for the first three years, and $15.0M (expressed in constant t=0 dollar, i.e., in real term) afterwards.

The production line for DEVICE is built on a vacant plant site (land) purchased by FGM at a cost of $50.0M thirty years ago. The vacant plant site has a current market value of $40.0M and is expected to be sold at the termination of the project for $55.0M in five years. The machinery for producing DEVICE has an invoice price of $120.0M, and its customization costs another $10.0M for meeting the specifications for the project. The machinery has an economic life of five years, and is classified in the MACR 5-year asset class for depreciation purpose. The sale price of the machinery at the termination of the project is expected to be 12% of its initial invoice price.

The corporate handbook of The FGM Corporation states that corporate overhead costs should be reflected in project analyses at the rate of 3.6% of the book value of assets. The acceptance of the project has no impact on the corporate overhead costs. However, financial analysts at the Headquarters believe that every project should bear its fair share of the corporate overhead burden. On the other hand, the Director of the Gadget Division disagrees to this view and believes that the corporate overhead costs should be left out of the analysis. The marginal tax rate of The FGM Corporation is 21%. And any tax loss from the project can be used to write off taxable income of The FGM Corporation. The general inflation rate is 3.2%.

Only Question 6:

Question 1:

A. In light of the appropriate objective of a firm, what should be your recommendation on the DEVICE Project based on the (base) scenario described above? Numerically justify your recommendation according to the conceptually most correct capital budgeting method.

B. Would your recommendation be changed if the real unit price of DEVICE only falls to $835 (expressed in constant t=0 dollar) upon the entrance of competitive products after three years into this project, i.e., the optimistic scenario? What would be your recommendation if the real unit price falls to $715 (expressed in constant t=0 dollar) after three years, i.e., the pessimistic scenario? Why?

C. What would be your recommendation on the Project if there is 65% chance that the base scenario (as described in the introductory section) will occur, 20% chance that the optimistic scenario (as described in Q1B above) will occur, and 15% chance that the pessimistic scenario (as described in Q1B above) will occur? Explain precisely numerically.

D. Now your team completed the above analysis and presented your recommendation on the DEVICE Project based on the correct capital budgeting method. The project manager, who is a senior engineer with no training in financial analysis, asks your team to base your recommendation on the discounted payback period or the internal rate of return instead. In response, your team goes back to calculate the discounted payback period and internal rate of return for EACH of the three scenarios discussed above. What is your teams recommendation on the Project under each scenario according to the discounted payback period? Use your analysis to explain precisely (in a convincing manner) to the project manager why the discounted payback period should not be used for decision making on the DEVICE Project. Discuss precisely and concisely the challenge your team faced in your attempt to calculate the internal rate of return for each scenario.

Question 2: A potential solution to combat the competition is to regain the competitive edge by upgrading the DEVICE via upgrading the machinery and software technology at the end of the third year for a nominal cost of $350M. Assume that the upgrade is fully depreciated over the projects remaining 2-year life according to the straight-line depreciation method, and it has zero value at the termination of the project. The upgraded DEVICE can be sold at a real unit price of $875 (expressed in constant t=0 dollar). Would you recommend the upgrade of the machinery and the product? How much is the value of the option to upgrade (relative to the base scenario)?

Question 3: An alternative solution is to back out from the DEVICE Project at the end of the fourth year for a NOMINAL (non-deductible) penalty of $360M. Besides, the machinery will have a zero market value if the project is abandoned. And the plant site is estimated to be priced at $50M then. Would you recommend the abandonment of the project? How much is the value of the option to abandon (relative to the base scenario)?

Question 4: Since this is a major project for the Gadget Division, the Division Director is greatly concerned about the riskiness of this Project. Your team is asked to determine the MINIMUM real unit price (expressed in constant t=0 dollar) for DEVICE such that the Project will be acceptable according to the conceptually most correct capital budgeting method, based on the information given in the base scenario. (Hint: Learn to use the Goal Seek function on Excel to solve for the minimum unit price!)

Question 5: Being diligent professionals, your team is not satisfied with the assumed discount rate in the base scenario that is given to you. From your teams research, your team notes that The FGM Corporation issued three types of securities to finance its businesses. It has 2B shares of its common stock outstanding, which is priced at $65 per share. The stock beta is estimated at 1.55. In addition, the Corporations 11% coupon, $40B par, 20- year, B-rated semiannual coupon paying bonds are priced at a premium of 6% relative to its par. In addition, The FGM Corporation also finances its operation with 80M shares of its preferred stock, which pays annual DPS of $6.50 and is currently priced at $75 per share. Currently, the yields on long-term Treasury securities are around 3.0%. Your team references the stock market statistics reported in the Ibbotsons SBBI Yearbook (highlighted in Chapter 10 of the assigned text) for the estimation of the market risk premium. Your team believes that the riskiness of the Project is compatible with that of other projects of the company. Base on your teams analysis, you redo the above analyses and address the above issues, i.e., Q1 ~ Q4, by showing your work to your supervisor. Are there any differences in your recommendations? Why or why not?

Question :6 In anticipation of tightening government regulations that aim at mitigating adverse environmental impacts of business operations in the U.S., your team speculates that there would be an environmental surcharge equivalent to 0.8% of the annual production costs applicable to the DEVICE Project. Hence, you redo the analysis in Q1C with the inclusion of the proposed environmental surcharge. What would be your recommendation on the DEVICE Project after accounting for the possible financial consequence of its environmental impact? If a green technology could help you eliminate the environmental impact of the Project and hence the corresponding environmental surcharge, how much is the maximum amount to be invested in this green technology for the Project?