Since last year, Clear View Energy Systems has divided its different product lin
ID: 2789061 • Letter: S
Question
Since last year, Clear View Energy Systems has divided its different product lines into separate divisions for accounting purposes. There are now four divisions consisting of the window film business, the vehicle film business, the roof film business, and the recently launched aerospace film business which produces solar film coatings for NASA, commercial satellites, and the growing aerospace industry (including companies such as SpaceX, Blue Origin, and Arianespace).
It’s budget time again and the various division managers have brought their proposals for next year’s capital spending program. Your job is to evaluate these proposals from a financial perspective and determine which projects meet the company’s criteria for investment.
Additional information: Based on your findings and suggestions regarding management of the company’s weighted average cost of capital, the company has decided to increase slightly it’s use of (less expensive) debt financing. The result is that the company’s new WACC is now approximately 10%.
However, you feel that the various divisions have different risk profiles, given their dependencies are very different industries. The window film business depends on both the commercial and residential construction industries, as well as the home improvement market; the vehicle film business depends on the automobile industry, the roof film business depends on the residential construction industry, but also on the energy (utilities) industry, as some some of the major projects for this division involve joint ventures with local and regional utilities companies; and the aerospace film business depends on the ups and downs of the aerospace industry and the political influences that affect NASA’s budgets and projects. These dependencies can cause the revenues (and profitability) for these divisions to fluctuate significantly over time, so you propose to use different discount values for evaluating the various divisional projects.
The construction industries (both residencial and commercial) are now recovering fairly smoothly from the earlier recession of 2008-2009, so you feel comfortable applying a discount rate to the window film division of 10%, which is equal to the company’s WACC. The automobile industry, though fairly robust, is still volatile. The level of vehicle sales has been fluctuating from year to year and this affects the vehicle film division’s sales, so you feel obliged to add a few percentage points to this division’s discount rate, to factor in this risk. The vehicle film division will use a 12% discount rate. The roof film division will utilize an 11% discount rate as it has a slightly higher risk than the window film business…due to the dependency on the utility companies, and their somewhat fickle support for energy saving projects. The aerospace business is perhaps the most risky due to the political nature of NASA budgets and the wild swings in that industry. The aerospace division will use a discount rate of 15% (which includes a 5% risk adjustment over the company’s WACC).
Proposal #1: The window film business is proposing to invest in some new production machinery that will save roughly $300,000 per year (EBT) over the 10-year productive life of this equipment. The cost of the equipment is estimated to be $2,260,000, and it will be depreciated using the straight-line method over its 10-year life. The tax rate = 35%.
Proposal #2: The vehicle film business proposes to invest in a new product that can be used with hybrid vehicles to directly hook up to the vehicle’s battery to help extend the time between required recharges. The cost to implement the corresponding production line and start-up costs for launching the product are estimated to be $2,800,000. The additional sales that this project would likely generate over the next 7 years (the estimated life of the product before becoming obsolete) are as follows:
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
2,500,000
3,250,000
4,250,000
6,000,000
9,000,000
12,000,000
10,000,000
The expected operating profit (EBT) for this product line is 7%. The tax rate for the company is 35%. The depreciation that corresponds to this product line would be approximately $400,000 each year over this seven year period.
(Hint: You should use an Excel spreadsheet to solve for the IRR and the NPV of this project, as the cash flows are different each year.)
Proposal #3: The roof film division proposes to invest in modifications to its residential roof tiles product being sold in the southwestern US states, especially in California and Arizona. These modifications would bring the product specifications (and more importantly, the hazardous waste disposal processes used in its manufacture) in line with new environmental standards likely to be implemented in California should a proposed referendum be approved by voters in the fall. The company currently produces these tiles in California, in a plant they acquired last year. They have not had problems to date with meeting the state’s stringent enviromentat regulations, but these regualations evolve over time, and failure to meet future standards could affect the potential to produce and/or sell the products in that state.
The investment in new processing equipment would cost about $481,000 but is expected to produce cost savings of around $50,000 per year (EBT) for the next 10 years. The company will used straight-line depreciation over the 10-year life of this equipment. The tax rate is 35%.
Proposal #4: The aerospace film division is proposing investment in a new variation of its product which could be used on the international space station and on commercial satellites, including a new system of telecommunications satellites that Virgin Satellite is planning to launch in the next few years, if it receives permission from the Federal Communciations Commission (FCC) for this new system. The space station deal also includes some risk as the various countries involved must approve the components used on the joint station. Michael Yoder, the division manager estimates that there’s a 75% chance of success for each of the two major deals. However, even if both deals fell through there would still be some residual sales to other satellite projects (the residual sales will happen in any scenario). The potential sales for this product over the next seven years, if all goes well, are as follows:
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Virgin Satellite
1,000,000
1,500,000
2,000,000
3,000,000
3,250,000
3,250,000
3,250,000
Space Station
900,000
1,200,000
1,800,000
2,400,000
2,700,000
2,700,000
2,700,000
Residual Sales
750,000
1,000,000
1,500,000
2,000,000
2,250,000
2,250,000
2,250,000
Michael estimates that the operating profit margin (EBT) would be a whopping 12% on this lucrative business. The initial investment required for this project would be $2,975,000. The yearly depreciation associated with this investment would be $425,000 per year over this period. (The tax rate of course is 35%).
Your team’s assignemnt is as follows:
Calculate the IRR and NPV for each of these proposals. Are there any other criteria that should be included in the decision-making process?
If access to funding was not an issue, which project(s) would you recommend for inclusion in next year’s budget? Why?
If CVES had limited access to capital for these projects…let’s say they only had $4,000,000 in available capital…which project(s) would you choose, and why?
If CVES used the same discount rate for each division (in this case, its WACC), how would this affect your selection of projects?
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
2,500,000
3,250,000
4,250,000
6,000,000
9,000,000
12,000,000
10,000,000
Explanation / Answer
1) Calculation of NPV and IRR of each proposal Proposal 1- Initial investment 2260000 Annual savings 300000 Depreciation per year 2260000/10 226000 Tax Rate 35% Discount rate of window firm business 10% NPV - EBT 300000 less - Depreciation 226000 74000 Less - Tax @ 35% 25900 EAT 48100 Depreciation 226000 CFAT 274100 Annuity fator for 10years @ 10% 6.1446 Pv of cash flows 1684225.844 Initial Investment 2260000 NPV -575774.1563 IRR - IRR formula in excel year CF 0 -2260000 1 274100 2 274100 3 274100 4 274100 5 274100 6 274100 7 274100 8 274100 9 274100 10 274100 IRR(Select Above Values) 3.6715% Proposal 2- Vehicle firm discount rate 12% Year Add. Sales EBT 7% EAT Dep. Tax Savings(DTS) CFAT (Given) (EBT x (1-t) (Dep. X t) (EAT+DTS) 0 0 0 0 0 -2800000 1 2500000 175000 113750 140000 253750 2 3250000 227500 147875 140000 287875 3 4250000 297500 193375 140000 333375 4 6000000 420000 273000 140000 413000 5 9000000 630000 409500 140000 549500 6 1200000 84000 54600 140000 194600 7 10000000 700000 455000 140000 595000 Using NPV Formula = NPV(Select Last column i.e.CFAT) (excluding initial investment) 1635352.65 Less ; Initial investment - 2800000 NPV = -1164647.35 IRR using IRR formula -1.429% (select last column) Proposal 3 Initial investment 481000 Annual savings 50000 Depreciation per year 2260000/10 48100 Tax Rate 35% Discount rate of window firm business 11% NPV - EBT 50000 less - Depreciation 48100 1900 Less - Tax @ 35% 665 EAT 1235 Depreciation 48100 CFAT 49335 Annuity fator for 10years @ 10% 5.8892 Pv of cash flows 290545.2613 Initial Investment 481000 NPV -190454.7387 IRR - IRR formula in excel year CF 0 -481000 1 49335 2 49335 3 49335 4 49335 5 49335 6 49335 7 49335 8 49335 9 49335 10 49335 IRR(Select Above Values) 0.4636% Proposal 4- Aerospace firm discount rate 15% Secanario 1 - If all goes well (Prob - 0.75) Year Add. Sales EBT 12% EAT Dep. Tax Savings(DTS) CFAT (Add all 3 ) (EBT x (1-t) (Dep. X t) (EAT+DTS) 0 0 0 0 0 -2975000 1 2650000 318000 206700 148750 355450 2 3700000 444000 288600 148750 437350 3 5300000 636000 413400 148750 562150 4 7400000 888000 577200 148750 725950 5 8200000 984000 639600 148750 788350 6 8200000 984000 639600 148750 788350 7 8200000 984000 639600 148750 788350 Using NPV Formula = NPV(Select Last column i.e.CFAT) (excluding initial investment) 2453618.11 Less ; Initial investment - 2975000 NPV = -521381.89 IRR using IRR formula 9.704% (select last column) Other criteria that can be used are Payback period, Profitability Index 2) All Proposals give negative NPV or IRRRelated Questions
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