You have recently been hired as the CFO of bus manufacturing company.The company is well known for manufacturing large and reliable bus at a reasonable cost.

The Decision

The president presented the sales and cost forecasts shown in the attached exhibits.The information presented contains the cost of production, financing information, and warranty cost estimates.The proposals also contained three engine options for the engines: The Athens engine, the Detroit engine, and the Marcus engine.The Detroit engine was more expensive to install, but had a lower warranty cost.The Marcus engine was less expensive to install, but had a higher warranty cost, and the Athens engine is in between. This begged the question:Which engine should be used?

Issues and Analyses

You sought to analyze the proposed project and provide your recommendations directly to CEO.The issues you want to address in your analysis and report are the following:

1)What are the project's cash flows for the next 20 years?

2)What is the company's cost of capital?

3)If you decide to go ahead with the project, which of the three engines should be used in the bus, and why?

4)Would you recommend accept or reject the project, based on NPV and IRR criteria?

Exhibit 1:Sales and Cost Forecast

The sales forecast is based on projected levels of demand.

Price per bus

$220,000

Units sold per year

12,000

Labor cost per bus

$31,000

Components & Parts

$86,000

Selling General & Administrative

$200,000,000

NOTE:Average warranty cost per year per bus for the first five years is $1,500.The present value of this cost will be used as a cost figure for each bus.Afterwards, the bus operator will become responsible the repairs on the buses.

The buses can be produced for 20 years.Afterwards, the designs become obsolete.

Engine choices

Engine

Athens engines

Detroit engines

Marcus engines

Price per engine, including installation

$18,250

$18,750

$17,250

Average annual warranty cost per year for 5 years.Afterwards, the bus operator will become responsible for the repairs on the buses. *

$1,400

$1,250

$1,450

The chosen engine will be installed in every bus and will become a cost figure for each bus.

Exhibit 2:Investment Needs

To implement the project, the firm has to invest funds as shown in the following table:

Year 0

Year 1

Year 2

Year 3

$500 Million*

$250 Million*

$250 Million*

$175 Million*

Production and selling of buses starts

Straight line depreciation will be used for the sake of simplicity.

Assume that the factory and equipment will have $0 residual value at the end.

Exhibit 3: Financing Assumptions

The following assumptions are used to determine the cost of capital.

Historically, the company tried to maintain a debt to equity ratio equal to 0.50.The marginal tax rate is 35%.

Cost of debt:

The company's current bonds have a yield to maturity of about 6.00%.

Cost of equity:

The current 10-year Treasury notes have a yield to maturity of 3.15% and the forecast for the S&P 500 market premium is 8.00%.The company's overall b is 1.40.

Project Guidance

Below is a list of items you need to identify and quantify to complete the case

A.For Each Year

1.Revenue

2.Variable costs

a.Labor cost per bus

b.Parts cost per bus

c.Engine costs per bus (2 options)

3.SG&A costs

4.Warranty costs

a.Bus

b.Engine (3 options)

5.Depreciation