**Capital Budgeting Analysis **

**Group Assignment II **

Form a team of THREE (or two) members and select a coordinator for the team. Take the average of the **last digits **of team members’ 8-digit UMIDs and **use the average as your team’s discount rate factor **for the analysis. For example, if the three UMIDs’ last digits are, respectively, 0, 6 and 8, then your team’s discount rate factor will be (0+6+8)/3=4.67%.

**Our team: 0 +3+2 = 5/2=2.5% Team’s Discount Rate Factor**

**Real Discount Rate: 2.5+8= 10.5% compounded daily**

Your team is assigned to the Gadget Division of The FGM Corporation, the largest multinational automobile manufacturer in the world. Your team is asked to evaluate a project proposal regarding the production of a device, DEVICE, which applies the most advanced artificial intelligence technology to improve driving safety. This upgradeable built-in device gives warnings to drivers and assist them to stay in lane and avoid collision. The DEVICE will be marketed as an optional feature for FGM cars and trucks. A 2-year comprehensive market analysis on the potential demand for this device was conducted and completed last year at a cost of $10M, where M is for millions.

From the comprehensive market analysis, your team expects annual sales volume of DEVICE to be 6.0M units for the first year and will decrease by 5% and 10%, respectively, in the following two years. The unit price of the device is $895 (expressed in constant t=0 dollar, i.e., in real term). Due to the introduction of similar products by competitors at the end of Year 3, the expected annual sale volume will drop to 3.5M units and the unit price is expected to fall to $700 (expressed in constant t=0 dollar, i.e., in real term) in the years following the introduction of the competitive products. Unit production costs are estimated at $800 (expressed in constant t=0 dollar, i.e., in real term) 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 2.0% and 3.0%, respectively, over the life of the project.

In addition, the implementation of the project demands current assets to be set at 18% of the annual sale revenues, and current liabilities to be set at 14% of the 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 $35M (expressed in constant t=0 dollar, i.e., in real term) for the first three years, and $20M (expressed in constant t=0 dollar, i.e., in real term) afterwards.

The production line for DEVICE will be set up in a vacant plant site (land) purchased by FGM at a cost of 30M twenty years ago. This vacant plant site has a current market value of $45M, and is expected to be sold at the termination of this project for $52M in five years. The machinery for producing DEVICE has an invoice price of $475M, and its customization costs another $50M for meeting the specifications for the project. The machinery has an economic life of five years, and is classified in the MACR 7-year asset class for depreciation purposes. The sale price of the machinery at the termination of the project is expected to be 25% 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 5% of the book value of assets. Corporate overhead costs are not expected to change with the acceptance of this project. 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 with 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 this project can be used to write off taxable income of The FGM Corporation. The general inflation rate is 2.4%.

**Question 1: **

- In light of the appropriate objective of a firm, what would be your recommendation on the DEVICE Project based on the (base) scenario described above? Why?
- Would your recommendation be changed if the unit price of DEVICE only falls to $745 (expressed in constant t=0 dollar, i.e., in real term) upon the entrance of competitive products after three years into this project, i.e., the optimistic scenario? What would be your recommendation if the unit price falls to $650 (expressed in constant t=0 dollar, i.e., in real term) after three years, i.e., the pessimistic scenario? Why?

- In light of the appropriate objective of a firm, what should be your recommendation on the Project if there is 60% chance that the base scenario (as described in the introductory section) will occur, 18% chance that the optimistic scenario (as described in Q1B above) will occur, and 22% chance that the pessimistic scenario (as described in Q1B above) will occur? Why?
- Now your team completed the above analysis and presented your recommendation on the DEVICE Project based on the correct capital budgeting decision rule. The project manager, who is a senior engineer with no training in financial analysis, asks your team to base your recommendation on the (pure) payback period rule instead. In response, your team goes back to calculate the payback period for each of the three scenarios discussed above. What is your team’s recommendation on the Project under each scenario? Use your analysis to explain precisely (in a convincing manner) to the project manager why the payback period rule should not be used for decision making on the DEVICE Project. And why your team’s choice of capital budgeting method should be used instead!

**Question 2: **A potential solution to combat the competition is to regain the competitive edge by upgrading the DEVICE via upgrading the machinery and software technology at the end of the third year for a nominal cost of $300M. Assume that this upgrade is fully depreciated over its 2-year life according to the straight-line depreciation method, and it has zero value at the termination of the project. The upgraded DEVICE can be sold at $750 (expressed in constant t=0 dollar, i.e., in real terms) apiece. Would you recommend the upgrade of the machinery and the product? What is the value of this option to upgrade (relative to the base scenario)?

**Question 3: **An alternative solution is to back out from the DEVICE Project at the end of the third year for a NOMINAL penalty of $175M. Besides, the machinery will have a zero market value if the project is abandoned. And the plant site is estimated to be priced at $48M. Would you recommend the abandonment of the project? What is the value of this option to abandon (relative to the base scenario)?

**Question 4: **Since this is a major project for the Gadget Division, the Division Director is greatly concerned about the riskiness of this Project. Your team is asked to determine the MINIMUM unit price (expressed in constant t=0 dollar, i.e., in real terms) for DEVICE such that the Project will be acceptable according to the conceptually most correct capital budgeting method, basing on the information given in the base scenario.**(Hint: **Learn to use the Goal Seek function on Excel to solve for the minimum unit price!)

**Question 5: **Being diligent professionals, your team is not satisfied with the assumed discount rate in the base scenario that is given to you. From your team’s research, your team notes that The FGM Corporation issued three types of securities to finance its businesses. It has 6B shares of its common stock outstanding, which is priced at $28 per share. The stock beta is estimated at 1.50. In addition, the Corporation’s 8% coupon, $120B par, 15-year, B-rated semiannual coupon paying bonds are priced at a discount of 7% relative to its par. In addition, The FGM Corporation also finances its operation with 500M shares of its preferred stock, which pays annual DPS of $4 and is currently priced at $55 per share. Currently, the yields on long-term Treasury securities are around 2.0%. Your team references the stock market statistics reported in Chapter 10 of the text for the estimation of the market risk premium. Your team believes that the riskiness of the Project is compatible with that of other projects of the company. Based on your team’s analysis, you redo Q1, Q2 and Q4, and address the above issues by showing your work to your supervisor. Are there any differences in your recommendations? Why or why not?

**Question 6: **In anticipation of tightening government regulations that aim at mitigating adverse environmental impacts of business operations in the U.S., your team speculates that there would be an

environmental surcharge equivalent to 0.5% of the annual production costs applicable to the DEVICE Project. Hence, you redo the analysis in Q1C with the inclusion of the proposed environmental surcharge. What would be your recommendation on the DEVICE Project after accounting for the possible financial consequence of its environmental impact? If a green technology could help you eliminate the environmental impact of the Project and hence the corresponding environmental surcharge, what should be the maximum amount to be invested in this green technology for the Project?

Your team is required to turn in a report (in Word or PDF format) that addresses the six questions in this case. In addition, I expect your group to use Excel spreadsheet for your analysis, and submit your Excel spreadsheet along with your report for my grading. Besides, **you are required to do your analysis in NOMINAL term, and apply symmetry tax treatment on any gain or loss in operations and asset transactions**!

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