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##### You are the principal financial analyst of the Gadget Division

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solution

**Question**

The Universal Direction Assistance (UDA) Project;Group Assignment;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 new voice-activated electronic;device Universal Direction Assistance (UDA). This upgradeable device, which;incorporates the most advanced computer and satellite wireless technology, provides;directions and real time traffic reports that guide automobile drivers in choosing the;preferred route to their destinations. This device can be used in any country with;specialized software that contains local geographical information and real time traffic;report (where technology is available) that are translated into the chosen language of the;driver. UDA will be sold as an option for the FGM cars and trucks. A comprehensive;market analysis on the potential demand for this device was conducted last year at a cost;of $4M.;From the comprehensive market analysis, you expect annual sale volumes of UDA to be;2.2M units for the first year and drop by 20% in the second year, with a unit price of;$650 (expressed in constant t=0 dollar). Due to the introduction of similar devices by;competitors at the end of the second year, the expected annual sale volumes will drop to;1.4M units and the unit price is expected to fall to $455 (expressed in constant t=0 dollar);for the final two years of this 4-year project. Unit production costs are estimated at $530;(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 2% and 3.5%, 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 14% of the annual production;costs. Besides, the introduction of UDA will increase the sales volume of cars and trucks;that leads to an increase in the annual after-tax cash flow of FGM by $7M (expressed in;constant t=0 dollar).;The production line for UDA will be set up in a vacant plant site purchased by FGM at a;cost of $30M twenty years ago. This vacant plant site has a current market value of;$24M, and is expected to be sold at the termination of this project for $20M in four years.;Alternatively, the vacant plant site can be used for supporting a competing project that is;expected to generate a NPV of $15M. The machinery for producing UDA has an invoice;price of $125M, and its modification costs another $10M for meeting the specifications;for the project. The machinery has an economic life of 4 years, and is classified in the;MACR 5-year class for depreciation purpose. The sale price of the machinery is;expected to be zero at the termination of the project.;The corporate handbook of The FGM Corporation states that corporate overhead costs;should be reflected in project analyses at the rate of 4% 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 this project is assumed to be 15%. The estimated;marginal tax rate of The FGM Corporation is 34%. The general inflation rate is 2.5%. It;is also assumed that taxable income from other parts of the company is sufficient to allow;for tax subsidy on losses incurred in this project.;Question 1;A.;In light of the appropriate objective of a firm, what would you recommend on the;UDA Project basing on the (base) scenario described above? Why?;B.;Would your recommendation be changed if the unit price of the UDA only falls to;$500 (expressed in constant t=0 dollar) upon the entrance of competitive products;after two years into this project, i.e., the optimistic scenario? What would be your;recommendation if the unit price falls to $400 (expressed in constant t=0 dollar);after two years, i.e., the pessimistic scenario? Why?;C.;What would be your recommendation on this UDA Project if there is 70% chance;that the base scenario (as described in the introductory section) will occur, 10%;chance that the optimistic scenario (as described in Q1B above) will occur, and;20% chance that the pessimistic scenario (as described in Q1B above) will occur?;Why?;Question 2;A potential solution to combat the competition is to regain the competitive;edge by upgrading the UDA via upgrading the machinery at the end of the;second year for a NOMINAL cost of $120M. 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 UDA can be sold at $570 (expressed in constant;t=0 dollar) while its production cost remains at $530 (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)?;Question 3;An alternative solution is to back out from the UDA Project at the end of;the second year for a NOMINAL tax deductible penalty of $50M.;Besides, the plant site and the machinery will have a zero market value if;the project is abandoned. 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. Hence, she asks;you to determine the MINIMUM unit price for the UDA device such that;this Project will be acceptable, basing on the base scenario information;that you used in your analysis for Q1A. (Hint: You are advised to use the;Goal Seek function in Excel to determine the unit price expressed in;constant t=0 dollar!);Question 5;Being a diligent professional, you are not satisfied with the assumed;discount rate of 15% that is given to you. From your own research, you;note that The FGM Corporation has 800M shares of its common stock;outstanding, which is priced at $35 per share. The stock beta is estimated;at 1.3. In addition, the Corporations 9%, $20B par, 10-year, B-rated;semiannual coupon paying bonds are priced at a discount of 12% from its;par. In addition, The FGM Corporation also finances its operation with;100M shares of its preferred stock, which pays annual DPS of $6 and is;currently priced at $90 per share. Currently, the yields on long-term;Treasury securities are around 3%. You reference the stock market;statistics reported in the Ibbotsons SBBI Yearbook (or Chapter 10 in your;text) for your estimation of the market risk premium. You believe that the;riskiness of the UDA Project is compatible with that of other projects of;the company. Base on your own analysis, you redo the above analyses;and address the above issues, i.e., Q1 ~ Q4 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., you;speculate that there would be an environmental surcharge equivalent to;5% of the annual production costs applicable to the UDA Project. Hence;you redo the analysis in Q1A with the inclusion of the proposed;environmental surcharge. What would be your recommendation on the;UDA 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 would be the maximum amount to be;invested in this green technology for the Project?

Paper#23300 | Written in 18-Jul-2015

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