Wheelz Ltd Case Study

Wheelz Ltd is a car manufacturing company that is based in the outer suburbs of Newcastle. The company has traditionally focused on manufacturing range of small to medium sized cars and scooters, which are targeted at young professionals. Management of the firm recently read an article that identified a huge recent growth in the four-wheel drive market, and they are considering whether it would make sense for the business to move into manufacturing these vehicles. You have been approached to provide advice regarding this investment decision.

The primary piece of machinery currently used by Wheelz Ltd to manufacture their sedans is called the Sedan-Fabricator. This existing machine is at the end of its useful life, so the firm would be required to buy a new machine immediately if they decide to proceed with manufacturing sedans. This machinery has a price of $9,500,000. The Sedan-Fabricatorhas an economic life of three years and will be sold at the end of that period for its scrap value of $500,000. The table below summarises the number of sedans this machine is able to produce each year across its useful life:

Year 1

Year 2

Year 3

4,000

3,500

3,200

The sedans produced by the Sedan-Fabricator have a variable cost of $12,000 per unit and the operating costs for the machine are $2,000,000 per annum. Each of the sedans manufactured using the Sedan-Fabricatorare sold for $14,000 and the cash flows from all sales is received at the end of each year.

If Wheelz Ltd decides to move into the four-wheel drive market, the machinery required to produce these vehicles is called the Construct4x4. Wheelz Ltd have already paid $500,000 to engage in exploratory market research, which determined that there is a viable market of potential sale of four-wheel drive vehicles. The Construct4x4machine costs $25,000,000 and has a useful life of four years, with a scrap value of $1,000,000 at the end of its useful life. The table below summarises the number of units this machine is able to produce each year across its useful life:

Year 1

Year 2

Year 3

Year 4

4,000

3,900

3,700

3,700

The Construct4x4machine has a variable cost of $22,000 per unit and a fixed cost of $4,500,000 per annum. Each four-wheel drive manufactured is expected to be sold for $26,000 and the cash flows from all sales is received at the end of each year.

The company manufactures all its motor vehicles at the factory, where it pays rent of $2,000,000 per annum. However, as the Construct4x4takes up significantly more floor space than the Sedan-Fabricator, Wheelz Ltd would need a larger factory if they decided to invest in this new machine. The landlord also owns an adjoining factory and has offered Wheelz Ltd to rent both premises for a combined cost of $2,500,000 per annum. The human resources department at Wheelz Ltd costs $3,000,000 per annum to run. The size of this department will not change regardless of whether Wheelz Ltd goes ahead with either project, but for accounting purposes $1,000,000 of HR related expenses will be allocated to each project.

Both machines are depreciated straight-line from their purchase price to their salvage value. Wheelz Ltd has an effective tax rate of 30%. You have estimated that the after-tax required rate of return on both of these projects is 15% p.a. All cash flows occur at the end of each year.

Using the information from the case study, answer the following questions:

Question 1 (16 marks)

a.Calculate the one-life NPV for the Sedan-Fabricatormachine.

b.Assuming the two projects are independent, discuss whether you would accept this project.

Question 2 (20 marks)

a.Calculate the one-life NPV for the Construct4x4machine.

b.Assuming the two projects are independent, discuss whether you would accept this project.

Question 3 (10 marks)

a.Calculate the internal rate of return (IRR) for one life of both machines and identify which machine you would invest in based on this approach assuming the two projects are mutually exclusive.

b.Discuss why your investment decision might be different when using the IRR compared with the NPV in the case of these two machines and explain how you might reconcile these results.

Question 4 (12 marks)

a.Calculate the payback period for one life of both machines.

b.Assuming the machines are mutually exclusive, identify which machine is superior based on this approach.

c.Discuss the weaknesses with using the payback period to evaluate the two machines.

Question 5 (10 marks)

Assume that the two machines are recurring and mutually exclusive. The investment cost and cash flows for all future life cycles is expected to remain constant.

a.Compare the two projects using the equivalent annual value approach and the lowest common life approach.

b.Briefly discuss your results.

Question 6 (10 marks)

The management team at Wheelz Ltd is worried that there may be some errors in the assumptions used to calculate the NPV of the project. Management is particularly concerned that the sales price and fixed costs may differ from their estimated values. The table below provides the best- and worse-case scenario for these inputs are provided in the table below:

Sedan-Fabricator

Construct4x4

Best Case

Worst Case

Best Case

Worst Case

Sales Price

$14,500

$13,500

$26,500

$25,500

Fixed Costs (p.a.)

$1,800,000

$2,250,000

$4,300,000

$4,700,000

a.Calculate how sensitive the one-life NPV of both projects is to these alternative estimates of the sale price and fixed costs

b.Briefly discuss the implications of the results from your sensitivity analysis.

Question 7 (12 marks)

An analyst working for Wheelz Ltd has proposed that as the firm is only financed with equity and all of the firm's projects have the same level of risk, the cost of equity capital should be used as the discount rate in NPV analysis. The analyst has estimated that the returns on Wheelz Ltd's stocks have a standard deviation of 25% per annum while the market portfolio returns have an expected standard deviation of 16% p.a. The covariance between the returns of Wheelz Ltd stocks and the market is 3.84%. The risk-free rate is 4% p.a. and the expected return on the equity market portfolio is 14%.

a.Use the CAPM to calculate Wheelz Ltd's cost of equity capital.

b.Using the cost of equity capital as the discount rate for cash flows, re-calculate the one-life NPV for both projects and evaluate the projects if they are mutually exclusive.

c.Discuss any reasons why your results from the NPV analysis using the cost of equity capital might be different from your analysis where the discount rate was assumed to be 15%.

Question 8 (10 marks)

Wheelz Ltd have decided to fund the new equipment by issuing bonds with a face value of $100,000 and a coupon rate of 12% p.a. payable semi-annually. The market yield on equivalent corporate bonds is 9.6% p.a., compounding semi-annually:

a.Calculate the number of bonds that would need to be issued to fund the initial investment required for the Sedan-Fabricatormachine.

b.Calculate the number of bonds that would need to be issued to fund the initial investment required for the Construct4x4machine.

c.Briefly explain the differences between a corporate bond and a term loan.