Your team is assigned to the Gadget Division of The FGM Corporation, the

largest multinational automobile manufacturer in the U$.$S$.$ Your team is asked to

evaluate a project proposal regarding the production of a device, DEVICE, which

applies the artificial intelligence technology to improve driving experiences and

safety. This upgradeable built$-$in device gives warnings to drivers and assists

them to stay in lane and avoid collision. The DEVICE will be marketed as an

optional feature for FGM cars and trucks. A $15-$month comprehensive market

analysis on the potential demand for the device was conducted and completed

last year at a cost of $$18\mathrm{.}0$M$,$ where M is for millions.

Based on the comprehensive market analysis, your team expects annual sale

volume of DEVICE to be $5\mathrm{.}0$M units for the first year and will decrease by

$500,000$ units annually in the following two years. The REAL unit price of the

device is $$985($expressed in constant t$=0$ dollar$).$ Due to the introduction of

similar products by competitors at the end of Year $3,$ the expected annual sale

volume will drop to $3\mathrm{.}0$M units for the project$$s remaining $2-$year life. And the

REAL unit price is expected to fall to $$785($expressed in constant t$=0$ dollar$)$ in

the year following the introduction of the competitive products. The REAL unit

production costs are estimated at $$895($expressed in constant t$=0$ dollar$)$ at the

beginning of the project, and will not be impacted by the change in competition.

Annual nominal growth rates for unit prices and unit production costs are

expected to be $3\mathrm{.}0\%$ and $4\mathrm{.}5\%,$ respectively, over the entire life of the project.

In addition, the implementation of the project demands current assets set at $18\%$

of contemporaneous annual sale revenues, and current liabilities set at $13\%$ of

contemporaneous annual production costs. Besides, the introduction of DEVICE

will increase the sales volume of cars and trucks that leads to an increase in the

annual after$-$tax operating cash flow of FGM by $$30\mathrm{.}0$M $($expressed in constant

t$=0$ dollar, i$.$e$.,$ in real term$)$ for the first three years, and $$15\mathrm{.}0$M $($expressed in

constant t$=0$ dollar, i$.$e$.,$ in real term$)$ afterwards.

The production line for DEVICE is built on a vacant plant site $($land$)$ purchased by

FGM at a cost of $$50\mathrm{.}0$M thirty years ago. The vacant plant site has a current

market value of $$40\mathrm{.}0$M and is expected to be sold at the termination of the

project for $$55\mathrm{.}0$M in five years. The machinery for producing DEVICE has an

invoice price of $$120\mathrm{.}0$M$,$ and its customization costs another $$10\mathrm{.}0$M for meeting

the specifications for the project. The machinery has an economic life of five

years, and is classified in the MACR $5-$year asset class for depreciation purpose.

The sale price of the machinery at the termination of the project is expected to be

$12\%$ of its initial invoice price.

The corporate handbook of The FGM Corporation states that corporate overhead

costs should be reflected in project analyses at the rate of $3\mathrm{.}6\%$ of the book value

of assets. The acceptance of the project has no impact on the corporate

overhead costs. However, financial analysts at the Headquarters believe that

every project should bear its fair share of the corporate overhead burden. On the

other hand, the Director of the Gadget Division disagrees to this view and

believes that the corporate overhead costs should be left out of the analysis.

The marginal tax rate of The FGM Corporation is $21\%.$ And any tax loss from the

project can be used to write off taxable income of The FGM Corporation. The

general inflation rate is $3\mathrm{.}2\%.$

Question $1$:

A$.$ In light of the appropriate objective of a firm, what should be your

recommendation on the DEVICE Project based on the $($base$)$ scenario

described above? Numerically justify your recommendation according to

the conceptually most correct capital budgeting method.

B$.$ Would your recommendation be changed if the real unit price of DEVICE

only falls to $$805($expressed in constant t$=0$ dollar$)$ upon the entrance of

competitive products after three years into this project, i$.$e$.,$ the optimistic

scenario? What would be your recommendation if the real unit price falls

to $$740($expressed in constant t$=0$ dollar$)$ after three years, i$.$e$.,$ the

pessimistic scenario? Why?

C$.$ What would be your recommendation on the Project if there is $65\%$

chance that the base scenario $($as described in the introductory section$)$

will occur, $20\%$ chance that the optimistic scenario $($as described in Q$1$B

above$)$ will occur, and $15\%$ chance that the pessimistic scenario $($as

described in Q$1$B above$)$ will occur? Explain precisely numerically.

D$.$ Now your team completed the above analysis and presented your

recommendation on the DEVICE Project based on the correct capital

budgeting method. The project manager, who is a senior engineer with no

training in financial analysis, asks your team to base your

recommendation on the discounted payback period or the internal rate of

return instead. In response, your team goes back to calculate the

discounted payback period and internal rate of return for EACH of the three scenarios discussed above. What are the recommendations?