You are a team of financial analysts 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 $10M.
According to the results of the market analysis, the expected annual sale volumes of UDA are 1.8M units for the first two years, and drop to 1.5M units for the final two years of this 4-year project. Unit prices are expected to be $600 for the first two years, and then fall to $450, due to the introduction of similar devices by competitors, afterwards. Unit production costs are estimated at $500 in the first year of the project. The growth rate for unit production costs are expected to be 4% per year over the remaining life of the project.
In addition, the implementation of the project demands current assets to be set at 12% of the annual sale revenues, and current liabilities to be set at 8% 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 $21M.
The production line for UDA will be set up in a vacant plant that was built by FGM at a cost of $30M twenty years ago. This fully depreciated plant has a current market value of $20M, and is expected to be sold at the termination of this project for $12M in four years. The machinery for producing UDA has an invoice price of $120M, and its modification costs another $15M. The machinery has an economic life of 4 years, and is classified in the MACR 3-year class for depreciation purpose. The machinery is expected to have zero salvage value at the termination of the project.
The cost of capital (or discount rate) for this project is assumed to be 15%. The estimated marginal tax rate of The FGM Corporation is 30%.
Questions:
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 $550 2 upon the entrance of competitive products after two years into this project? What would be your recommendation if the unit price falls to $350 after two years? Why?
C. What would be your recommendation on this UDA Project if there is 75% chance that the base scenario (i.e., unit price falls to $450 after two years) will occur, 20% chance that the optimistic scenario (i.e., unit price only falls to $550 after two years) will occur, and 5% chance that the pessimistic scenario (i.e., unit price falls to $350 after two years) will occur? Why?