Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 62

Solving for Unknowns; Strategy Because of increased consumer demand for fuel-efficient, alternative energy automobiles, Global Auto Company is considering investing in a new hybrid crossover vehicle. Development costs each year for a two-year period for this new vehicle are estimated as $750 million. Tooling and other set-up costs in year 2 are estimated at $1 billion. Actual production and sales are estimated to begin in year 3. It is anticipated that the plant being envisioned could produce vehicles for six years. Each vehicle sold is estimated to provide $3,500 of net cash flow (pre-tax). The estimated salvage value of the manufacturing plant after six years of operation is thought to be $250 million. Assume that all cash flows take place at year-end, and that the pre-tax WACC for Global Auto is 15 percent. Income-tax effects can be ignored in this problem.

Required

1. What is the minimum volume of car sales, per year, in the six-year life of the plant that is needed to make this proposed investment acceptable using NPV as decision criterion?

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2. How does your answer in (1) change if the company’s pretax WACC is 14 percent? 16 percent? Do you think the estimated NPV of this project is sensitive to the estimate of the company’s discount rate?

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3. What strategic considerations, including those related to risk management, would likely bear on this decision?

Step 1 of 6

NPV is a substantial method used in capital budgeting to evaluate the project. With help of NPV, the company can decide whether to accept or reject the project. NPV is the change between the present value of all the future cash inflows and the present value of all the cash outflows over some time.