What would be the approach and formulas to answer the two questions below?
You are the principal financial analyst of the Gadget Division of The FGM Corporation, the largest multinational automobile manufacturer in the world. You are 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 comprehensive market analysis on the potential demand for this device was conducted last year at a cost of $20M.
From the comprehensive market analysis, you expect annual sale volumes of DEVICE to be 5M units for the first year and will decrease by 10% in the second year, with a unit price of $1,000 (expressed in constant t=0 dollar). Due to the introduction of similar products by competitors at the end of the second year, the expected annual sale volumes will drop to 3M units and the unit price is expected to fall to $750 (expressed in constant t=0 dollar) for the final two years of this 4year project. Unit production costs are estimated at $900 (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 3.0% and 2.5%, respectively, over the life of the project.
In addition, the implementation of the Project demands current assets to be set at 20% of the annual sale revenues, and current liabilities to be set at 12% 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 $15M (expressed in constant t=0 dollar) for the first two years, and $8M (expressed in constant t=0 dollar) afterwards.
The production line for DEVICE will be set up in a vacant plant site (land) purchased by FGM at a cost of $50M thirty years ago. This vacant plant site has a current market value of $40M, and is expected to be sold at the termination of this project for $45M in four years. Alternatively, the vacant plant site can be used for supporting a competing project that is expected to generate a NPV of $30M instead of selling it at the market price today. The machinery for producing DEVICE has an invoice price of $145M, and its customization costs another $15M for meeting the specifications for the project. The machinery has an
economic life of 4 years, and is classified in the MACR 7-year asset class for depreciation purpose. The sale price of the machinery at the termination of the project is expected to be 30% 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 to this view and believes that the corporate overhead costs should be left out of the analysis.
The (nominal) discount rate for the Project is assumed to be 14%, compounded daily. The estimated marginal tax rate of The FGM Corporation is 35%. The general inflation rate is 2.8%.
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 second year for a nominal cost of $200M. 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 $800 (expressed in constant t=0 dollar) 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)?
An alternative solution is to back out from the Project at the end of the second year for a nominal tax deductible penalty of $100M and zero salvage value for the plant and the machinery. Would you recommend the abandonment of the project? If yes, what is the value of this option to abandon (relative to the base scenario)?