Thiel Corporation is a globally diversified manufacturer with businesses in fluid power systems, electrical power quality, distribution and control, and automotive engine air management and fuel economy. It is considering an expansion into the hydrogen fuel cell business. It has been researching its move into the fuel cell industry over the past few years. To date it has spent $55 million in research and development on fuel cell technology and an additional $10 million in marketing and feasibility studies and hopes to recover these costs with the successful move into the industry. It is evaluating the project proposal over a nine-year time horizon.

You have been asked to collect the data to make an assessment and have summarized that data as follows:

• You estimate that it will cost Thiel $1.5 billion to establish its presence in this business. Of this amount, $1 billion will be spent right now (t = 0) acquiring the capital assets needed for the business with a second investment of $500 million made one year from now (t = 1). Beginning in year 2, additional capital expenditures of $30 million will be needed to maintain and enhance the equipment with that amount growing at a rate of 2% per year thereafter. The business will be operational at the beginning of the second year (t = 2). The entire initial investment of $1.5 billion is depreciable starting in the second year and will be depreciated using the MACRS schedule for a 5-year asset. For simplification, you may disregard any depreciation issues that could arise with the additional capital expenditures that begin in year 2.

• The total market for fuel cell technology products is currently estimated to be $6 billion but is expected to grow 20% per year for the next 4 years, with growth leveling off to 12% per year by the 8^th year and beyond (i.e., the growth rate will be 20% per year through year 4, 18% in year 5, 16% in year 6, 14% in year 7, and 12% per year in year 8 and beyond). Thiel is hoping to attain a 5% market share in the first year in which it enters the market (which is two years from now), a 6% market share in year 3, a 7% share in year 4, an 8% share in year 5, a 9% share in year 6, and a 10% share in year 7 and beyond.

• Thiel expects that its cost of sales will be 55% of its total fuel cell revenues in the first year of operations (t = 2). Production efficiencies will reduce this amount by 1 percentage point per year until the cost of sales levels off at 50% of total revenues in year 7 and beyond (i.e., the cost of sales as a percentage of sales will be 54% in year 3, 53% in year 4, 52% in year 5, 51% in year 6, and 50% in year 7 and beyond).

• Thiel will allocate 10% of its existing general and administrative (G&A) costs to the new division. Total G&A costs for the entire firm are currently $125 million and expected to grow at 2% per year over the long term. In addition, Thiel expects an additional increase of $50 million in G&A costs in year 2 when the operations begin generating revenues, and that these additional G&A costs will grow at the same rate as the firms growth in total fuel cell revenues after that.

• Thiel currently spends $90 million firm-wide in research and development costs and expects these expenditures to grow at 3% per year indefinitely. However, if the fuel cell division is added to the company, the expected growth rate in Thiels total R&D expenses is expected to be 25% per year beginning in year 1.

• While the new business will need distributional support, it is anticipated that Thiel can initially use excess capacity in its existing distribution network. Its existing businesses are currently using 50% of the firms distribution capacity, with anticipated growth of 10% per year going forward (e.g., it will use 55.0% of the distribution network next year, 60.5% the year after, and so on). Adding the fuel cell business would initially use up an additional 20% of the total capacity in year 2, the first year of revenue generation, and the increased use of the distribution system would track revenue growth in the fuel cell business beyond that point. Whenever Thiel runs out of distribution capacity, it will have to pay for an expansion of its distribution network in the year prior to it exceeding its total capacity. The current estimated cost of this expansion is $125 million, but this cost is growing at 3 percent per year. For simplification, you may disregard any depreciation charges associated with the investment necessary to expand the distribution system.

• The fuel cell division will create working capital needs, as estimated below:
  • The sale of fuel cells on credit to wholesalers and various industrial firms will create accounts receivable amounting to 34% of total revenues each year.
  • The purchase of inventory (of both raw material and finished goods) will be approximately 24% of the total cost of sales (not including depreciation, G&A, or R&D expenses).
  • The credit (i.e., accounts payable) offered by suppliers of inventory will be 15% of the total cost of sales (not including depreciation, G&A, or R&D expenses).

Any new investment in net working capital will be made at the beginning of each year in which the revenues are generated. Thus, the total amount of working capital investment needed for the second year will have to be made at the beginning of the second year (i.e., end of the first year), the incremental amount needed for the third year will be made at the beginning of the third year (i.e., end of the second year), and so on.

• The company faces a 25% tax rate and uses a weighted average cost of capital of 9.25% when analyzing similar projects.

1. Estimate the incremental cash flows from the proposed project. Although the project does not have a fixed termination date, for purposes of project valuation, cash flows associated with the project are expected to grow indefinitely at 3 percent per year after Year 9. Note that you will need to estimate total revenues and total cost of sales for year 10 to determine the amount of net working capital to be invested in year 9 to calculate the net cash flow for Year 9. The terminal or horizon value is then based on that amount growing t 3 percent per year thereafter. Calculate the expected net present value and internal rate of return of this project proposal. Given your results and any other considerations you might have, describe whether you would recommend accepting or rejecting this project and briefly explain/defend your recommendation.

2. Assume instead that the companys management is somewhat risk-averse and wishes to only commit to a 9-year time horizon. Rather than evaluating operations beyond year 9, Thiel has pre-arranged to sell the project at the end of year 9 to outside investors for the total amount of cash invested in the project. Thus, the project will have a salvage value at the end of year 9 equal to the total amount of capital and net working capital invested by the company over the 9 years. Assume the salvage value transaction would be nontaxable. Note that there would not be any investment in working capital made at the end of year 9 as it was in the original scenario. Calculate the expected net present value and internal rate of return given this change in assumption. Describe how the change in assumption could affect your recommendation of accepting or rejecting the project proposal.