Simtel, a leading semi-conductor manufacturer, is contemplating investing in a new "Gigantium" chip manufacturing facility based on the encouraging market research report (which cost $10 million). It has already spent $250 million on a test run of manufacturing this chip. The plant and equipment used for chip manufacturing becomes worthless once the chip is obsolete. For the Gigantium project, Simtel would need to make an immediate investment of $1.6 billion in plant and equipment. Simtel plans to use the cash it has on hand to make this investment. Simtel is currently at its target capital structure. It expects the life of the Gigantium chip to be 8 years. The company plans to sell 10 million chips at a price of $80 per chip. The Cost of Goods Sold (COGS) (excluding depreciation) is estimated at 30% of sales while Selling & General Administration (SG&A) expenses are estimated at 10% of the sales. For calculating depreciation expense, the company has two options 1. The straight line method (i.e. $1.6 billion divided by 8 years of useful life) thus translating into an annual depreciation expense of 200 million each year 2. The Double Declining Balance (DDB) method for the first 3 years, followed by the straight line method for the last 5 years. a. Under the DDB method, first depreciation as a percentage of total assets is estimated since the life of the project is 8 years, this translates into 1/8 = 12.5%. b. Next, this fraction is doubled (2*12.5%=25%). The resulting fraction is multiplied by the remaining book value of the asset (also known as the depreciable base). i. For Gigantium, in the first year DDB depreciation would be 25%*1,600 million $400 million, I ii. In the second year, the depreciable base is only $1,200 million ($1,600- 400 1,200), thus the DDB depreciation is 25%*1,200= $300 million. e=0 Table 1 YEAR 1 2 3 5 6 7 8 Depreciation $200 $200 $200 $200 $200 $200 $200 $200 (SL) Depreciation $400 $300 $225 $135 $135 $135 $135 $135. (DDB) The Net Present Value (NPV) of any investment can be evaluated by finding the present value of all the Free Cash Flows (FCF). FCF in any particular year is defined as: FCF= EBIT*(1-Tax Rate) + Depreciation - Capital Expenditure - Increase in Operating NWC = 280 (1-0%) 200-1600-0 = 280+200-1600=480-1600 =(1220)480 430 41 42-48 Assignment Questions w 14 80+ 400-160-0 480-1600 47 2 1905300 34 253 +225 345+135 =480 =480 480 6. Suppose that Simtel currently has existing unused warehouse space. As a result of the company's growth, even without Gigantium it is expected that this unused capacity would be fully utilized by the end of year 4. Thus, Simtel is already planning to build a warehouse for $100 million in Year 4 (assume the full amount of the warehouse is spent at the end of year 4). However, if the Gigantium project is taken, the unused capacity will be fully utilized in only two years. Hence, the new warehouse would need to be built at the end of Year 2, requiring Simtel to spend the $100 million two years earlier. Regardless of when it is built, the warehouse will be depreciated over a 4 year life using the straight-line method. How does this change your NPV analysis? 7. The marketing department now believes that introducing Gigantium would cut into the "sales" of Pentium chips because some of the Gigantium customers would have otherwise purchased Pentium chips. The best estimate by the marketing group is that the amount of lost Pentium sales would be $200 million per year. You also learn that Simtel's market research shows that their competitor AMD is also working on a chip similar to Gigantium but it will take AMD two years to introduce their product. The introduction of the AMD chip will have the same effect on Pentium sales as the introduction of Gigantium (i.e. reduce Pentium sales by $200 million per year). Simtel enjoys an EBIT margin of 25% on Pentium chips. How does this change your NPV analysis? 8. The reduction in Pentium sales would make Simtel's San Mateo plant redundant. Assume all the sales lost ($200 million) are from this plant. The plant has been fully depreciated and can be sold to a potential real estate developer. The net amount from this sale after all taxes are paid is $20 million. If the Gigantium project is not undertaken, the plant would still become redundant after 2 years due to AMD's project launch but it is hard to estimate what price it can be sold for. Management believes that the offer from the real estate company is unlikely to be repeated in two years and thus assumes that this plant would have zero value. How does this affect your estimate of NPV for the Gigantium project? 9. The closure of San Mateo facility would also lead to a reduction in net working capital. Simtel estimates that the total net working capital tied up at the Sam Mateo facility is 15% of the facility's sales. If the plant were closed immediately, assume this net working capital can be recovered fully. If the Gigantium project is not undertaken, the San Mateo plant would still become redundant due to AMD's product launch in two years, but the working capital would be worthless due to obsolete material. How does this change your NPV of Gigantium Project? 10. Typically computer chips command high prices when they are introduced but the prices decline through time. Assume Simtel would continue to produce the same number of