The requirements of the case study are detailed in the attachment. The free cash flow of each year of the project is required to determine NPV, IRR, and whether or not to accept the project.

MBA 720: Group Case Study Apple iCar Apple designs, manufactures, & markets mobile communication & media devices, personal computers, & portable digital music players, & sells a variety of related software, services, accessories, networking solutions, & third-party digital content. The company has had a very good run, both in terms of earnings and stock prices, over past decade. Based largely on the success of the iPhone, Mac and the iPad, the company has reported double digit growth in revenues and earnings over the last few years and its stock price has reflected this success. It is currently the most valuable company in the world though Google is fast closing in. It has a substantial cash balance and a good balance sheet. However, Tim Cook, CEO of Apple, is concerned that though iPhone 6 series has been an unprecedented success, Apple is too much dependent on iPhone revenues. Hence, it wants to diversify its product line to come up with something very different. The Proposal Apple has been working on an ambitious project called TITAN for the past few years. If the initial prototypes are successful it will consider entering the automobile market with an innovatively designed electric car, called the iCar, aimed at the premium end of the 1 automobile market. You have been asked to collect the data to make the assessment and have come back with the following information: 1. R&D Expenses: Apple has already spent (and expensed) $ 8 billion on research on the automotive technology and development of the commercial design of the electric car. None of that money can be recouped at this stage, if Apple decides not to go ahead with the iCar. 2. Introductory Costs; If Apple decides to go ahead with the iCar investment, it will have to spend $18 billion up front (in 2016) and $2 billion in installation costs to create a new production facility, lock in suppliers, distributors and retailers and to invest in infrastructure. The cost is depreciable over the next 10 years, down to a book value of $ 4 billion. Apple expects the salvage value to be equal to the book value. Apple expects to use straight-line depreciation. 3. Market Potential and Share: In the premium auto market (including all cars priced at or above $60,000) there were 5 million automobiles sold globally in the most recent year and the market is expected to grow approximately 5% a year for the next decade. Apple expects to gain a 2% market share next year (ie.,2017) if the iCar is introduced and increase that market share by 2% a year (4% in the second year, 6% in the third year and so on) to reach a target market share of 10% of the overall market by the fifth year. It expects to maintain that market share beyond year 6. 4. Pricing and Unit Costs: Apple expects to price its cars at $ 70,000 a unit next year (or 2017) and the price will keep pace with inflation after that. Based upon the costs of the materials used in the iCar currently, Apple expects the Gross margin on the iCar to be 39% and that rate is expected to be steady for the next 10 years 5. Marketing Options and Costs: Apple plans to use two different retailing options. In the first, it will sell the iCar through auto retailers and pay the retailers a commission of 15% of the price per unit sold (The retailers will have to follow Apple's fixed price schedule - no discounting allowed). In the second, it will sell the iCar through the Apple Auto Stores around the country. To do the latter, Apple will have to spend $5 billion right now in creating those stores; this expense will be depreciated straight line over the next 10 years to a salvage value of zero. It will also pay its sales people a 2 commission of 10% of the price per unit for every car sold at an Apple Auto store. Apple expects to generate 80% of its revenues from specialty retailers and 20% from Apple Auto Store sales each year for the next 10 years. 6. Production Facilities and Costs: Apple will be building a manufacturing facility in Taiwan to produce the iCar. The facility will allow Apple to produce 650,000 cars each year. It is expected that Apple will operate below capacity in the initial years but if the capacity limit is reached, Apple will have to invest a substantial amount to create a new facility of equivalent capacity. The current estimate (for 2016) of the cost of building a new facility is $ 8 billion, but this cost will grow at the inflation rate. 7. Advertising Expenses: Apple spent $ 2 billion on advertising in the most recent year. If Apple does not invest in iCar, it expects this cost to increase 15% a year for the next 10 years. If the iCar is introduced, the total advertising expenses each year, from years 1 to 10, are expected to be 20% higher than they would have been without the iCar division. 8. Working Capital: The iCar will create working capital investments that are to be made at the beginning of each year, which you have estimated as follows: The sale of iCars to retailers will create accounts receivable amounting to 8% of revenues each year. Inventory (of both the input material and finished iCars) will be approximately 10% of the variable production cost (which does not include depreciation, or advertising expenses). Accounts payable will be 9% of the variable production cost (not including depreciation, marketing costs, or advertising expenses). 9. Risk Measures: The beta for Apple is 1.477, calculated using monthly returns over the last 3 years and against the S&P 500 Index. But management believes that the appropriate beta should be the average beta for the car industry which is 1.95. The current stock price for the firm is $ 100 and there are 5,753.42 million shares outstanding. 10. Bonds: Apple expects to finance the iCar division using the same mix of debt and equity (in market value terms) as it is using currently in the rest of its business. Apple's 3 currently has $62.99 billion in market value of interest bearing debt. Apple is rated A1/A+. This rating currently has a default spread on a 10 year US Treasury bond of 0.9%. 11. Taxes: Apple's effective tax rate is 26.4%. 12. Macro data: The current long-term nominal US Treasury bond rate is 2%, and the expected inflation rate is 2 %. The expected Market Risk Premium is 5.75%. Questions on the Project 1. Cash Flow Analysis Estimate the after-tax incremental cash flows from the proposed iCar investment to Apple over the next 10 years. If the project is terminated at the end of the 10th year, and both working capital and investment in other assets can be sold for book value at the end of that year, estimate the net present value of this project to Apple. 2. Sensitivity Analysis Estimate the sensitivity of your numbers to changes in at least two of the key assumptions underlying the analysis. Based upon your analysis, and any other considerations you might have, tell me whether you would accept this project or reject it. Highlight any assumptions you make. Submit an Excel report by June 19th. Name your Excel file with the last name of one of your group members. On the first sheet, it should show the names of your Group members, the NPV, IRR and the Accept/Reject Decision for the Base case scenario 4 Solution Chapter: Problem: 8/13/2015 11 18 Estimating Cash Flows and Analyzing Risk Webmasters.com has developed a powerful new server that would be used for corporations' Internet activities. It would cost $10 million at Year 0 to buy the equipment necessary to manufacture the server. The project would require net working capital at the beginning of each year in an amount equal to 10% of the year's projected sales; for example, NWC0 = 10%(Sales1). The servers would sell for $24,000 per unit, and Webmasters believes that variable costs would amount to $17,500 per unit. After Year 1, the sales price and variable costs will increase at the inflation rate of 3%. The company's nonvariable costs would be $1 million at Year 1 and would increase with inflation. The server project would have a life of 4 years. If the project is undertaken, it must be continued for the entire 4 years. Also, the project's returns are expected to be highly correlated with returns on the firm's other assets. The firm believes it could sell 1,000 units per year. The equipment would be depreciated over a 5-year period, using MACRS rates. The estimated market value of the equipment at the end of the project's 4-year life is $500,000. Webmasters' federal-plus-state tax rate is 40%. Its cost of capital is 10% for average-risk projects, defined as projects with a coefficient of variation of NPV between 0.8 and 1.2. Low-risk projects are evaluated with a WACC of 8%, and high-risk projects at 13%. a. Develop a spreadsheet model, and use it to find the project's NPV, IRR, and payback. Input Data (in thousands of dollars) Equipment cost Net operating working capital/Sales First year sales (in units) Sales price per unit Variable cost per unit (excl. depr.) Nonvariable costs (excl. depr.) Market value of equipment at Year 4 Tax rate WACC Inflation in prices and costs Estimated salvage value at year 4 $10,000 10% 1,000 $24.00 $17.50 $1,000 $500 40% 10% 3.0% $500 Intermediate Calculations Units sold Sales price per unit (excl. depr.) Variable costs per unit (excl. depr.) Nonvariable costs (excl. depr.) Sales revenue Required level of net operating working capital Basis for depreciation Annual equipment depr. rate Annual depreciation expense Ending Bk Val: Cost - Accum Dep'rn Key Results: NPV = IRR = Payback = 0 1 2 3 4 20.00% 32.00% 19.20% 11.52% $10,000 $10,000 Page 1 Salvage value Profit (or loss) on salvage Tax on profit (or loss) Net cash flow due to salvage $500 Cash Flow Forecast Sales revenue Variable costs Nonvariable operating costs Depreciation (equipment) Oper. income before taxes (EBIT) Taxes on operating income (40%) Net operating profit after taxes Add back depreciation Equipment purchases Cash flow due to change in NOWC Net cash flow due to salvage Net Cash Flow (Time line of cash flows) 0 1 Years 2 3 4 0 1 Years 2 3 4 0 1 Years 2 3 4 Key Results: Appraisal of the Proposed Project Net Present Value (at 10%) = IRR = MIRR = Payback = Discounted Payback = Data for Payback Years Net cash flow Cumulative CF Part of year required for payback Data for Discounted Payback Years Net cash flow Discounted cash flow Cumulative CF Part of year required for discounted payback b. Now conduct a sensitivity analysis to determine the sensitivity of NPV to changes in the sales price, variable costs per unit, and number of units sold. Set these variables' values at 10% and 20% above and below their basecase values. Include a graph in your analysis. % Deviation from Base Case -20% -10% SALES PRICE Base NPV $24.00 Note about data tables. The data in the column input should NOT be input using a cell reference to the column input cell. For example, the base case Sales Price in Cell B95 should be the number $24.00 you should NOT have the formula =D28 in that cell. This is because you'll use D28 as the column input cell in the data table and if Excel tries to iteratively replace Cell D28 with the formula =D28 rather than a series of numbers, Excel will calculate the wrong answer. Unfortunately, Excel won't tell2 you that there is a problem, so you'll just get the Page wrong values for the data table! Note about data tables. The data in the column input should NOT be input using a cell reference to the column input cell. For example, the base case Sales Price in Cell B95 should be the number $24.00 you should NOT have the formula =D28 in that cell. This is because you'll use D28 as the column input cell in the data table and if Excel tries to iteratively replace Cell D28 with the formula =D28 rather than a series of numbers, Excel will calculate the wrong answer. Unfortunately, Excel won't tell you that there is a problem, so you'll just get the wrong values for the data table! 0% 10% 20% % Deviation from Base Case -20% -10% 0% VARIABLE COST Base NPV $17.50 % Deviation from Base Case -20% -10% 0% 10% 10% 20% 20% Page 3 1st YEAR UNIT SALES Base NPV 1,000 Deviation NPV at Different Deviations from Base from Sales Variable Base Case Price Cost/Unit Units Sold -20% $0 $0 $0 -10% $0 $0 $0 0% $0 $0 $0 10% $0 $0 $0 20% $0 $0 $0 Range c. Now conduct a scenario analysis. Assume that there is a 25% probability that best-case conditions, with each of the variables discussed in Part b being 20% better than its base-case value, will occur. There is a 25% probability of worst-case conditions, with the variables 20% worse than base, and a 50% probability of base-case conditions. Page 4 Scenario Best Case Base Case Worst Case Probability Sales Price Unit Sales Variable Costs 25% 50% 25% $28.80 $24.00 $19.20 1,200 1,000 800 $14.00 $17.50 $21.00 NPV Expected NPV = Standard Deviation = Coefficient of Variation = Std Dev / Expected NPV = d. If the project appears to be more or less risky than an average project, find its risk-adjusted NPV, IRR, and payback. CV range of firm's average-risk project: Low-risk WACC = 8% WACC = 10% High-risk WACC = 13% 0.8 to 1.2 Risk-adjusted WACC = Risk adjusted NPV = IRR = Payback = e. On the basis of information in the problem, would you recommend that the project be accepted? Page 5 1,000 $24.00 $17.50 Page 6 Page 7 Page 8 Page 9 Page 10