Question

Cash Flow Analysis Case Study

World Market designs, manufactures, & markets furniture, magnets and other interesting trinkets. The company has had a very good run, both regarding earnings and stock prices, over the past decade, notwithstanding the wild ride during the ongoing pandemic. Based largely on the success of the furniture and magnet the company has reported double-digit growth in revenues and earnings over the last few years, and its stock price has reflected this success and in summer 2018 it became the first Trillion-dollar company. There was a brief downward shift as World Market reported lower revenue for the first time in years against a backdrop of flagging magnet demand in summer 2019 over last year. Part of the problem is a shifting Chinese market, the Trump tariffs, but it's also due to the fact that people are simply taking longer to refresh their furniture.

Though the store seems to be a rousing success, CEO of World Market, has been concerned on the fact that World Market is too much dependent on furniture revenues and have taken steps to move the company into its next phase. World Market has always been an evolving company. While it never really invented any product categories, it always seemed to make those product categories work better and smarter. It also found a way to make us want them, even when they were more expensive. Hence, it wants to diversify its product line to come up with something very different. 2017, World Market CEO spoke publicly about World Market's work on autonomous driving software, confirming the company's work in a rare candid moment. World Market doesn't often share details on what it's working on, but when it comes to the car software, it's harder to keep quiet because of regulations. The CoolCar has the potential to be World Market's "next star product" with World Market able to offer "better integration of hardware, software and services" than potential competitors in the automotive market.

Questions (please show all work):

Cash Flow Analysis

1. Estimate the after-tax incremental cash flows from the proposed CoolCar investment to World Market over the next 10 years.

If the project is terminated at the end of the 10th year, and both working capital and investment in other assets can be sold for book value at the end of that year, estimate the Net Present Value and the Internal Rate of Return of this project to World Market.

Based on Expected NPV, would you recommend World Market to take this project? Explain your answer in detail.

The Proposal

World Market has been working on an ambitious project for the past few years. If the initial prototypes are successful it will consider entering the automobile market with an innovatively designed electric car, called the CoolCar, aimed at the premium end of the automobile market. World Market believes that the Pandemic will have very little effect on the demand for Electric cars, so though they revised their estimates to reflect some near term effects of Pandemic, they are confident that 2 years down the line, the world would be back to its pre-Pandemic normal. You have been asked to collect the data to make the assessment and have come back with the following information:

1. R&D Expenses: World Market has already spent (and expensed) $ 10 billion on research on the automotive technology and development of the commercial design of the electric car. None of that money can be recouped at this stage if World Market decides not to go ahead with the CoolCar.

2. Introductory Costs: If World Market decides to go ahead with the CoolCar investment, it must spend $20 billion up front (in 2020) and $2 billion in installation and shipping to build new production facility, lock in suppliers, distributors, and retailers and to invest in infrastructure. The cost is depreciable over the next ten years, down to a book value of $4 billion, and World Market expects to use straight-line depreciation. World Market expects to sell this production facility at the book value at the end of the project.

3. Market Potential and Share: In the premium auto market (including all cars priced at or above $60,000) there were 6.0 million automobiles sold globally in the most recent year, and the market is expected to grow approximately 5% a year for the next decade. World Market expects to gain a 2% market share next year if the CoolCar is introduced and increase that market share by 2% a year (4% in the second year, 6% in the third year and so on) to reach a target market share of 10% of the overall market by the fifth year. It expects to maintain that market share beyond year 6.

4. Pricing and Unit Costs: World Market expects to price its cars at $ 89,500 a unit next year (or 2021), and the price will keep pace with inflation after that. Based upon the costs of the materials used in the CoolCar currently, World Market expects the variable production cost per unit to be $70,400 next year and grow at the inflation rate after that.

5. Marketing Options and Costs: World Market plans to use two different retailing options. In the first, it will sell the CoolCar through specialty auto dealers and pay them a commission of 10% of the price per unit sold (The retailers will have to follow World Market's fixed price schedule - no discounting allowed). In the second, it will sell the CoolCar through the World Market Auto Stores around the country. To do the latter, World Market will have to spend an extra $4 billion right now in creating those stores; this expense will be depreciated straight line over the next ten years to a book value of zero. It will also pay its salespeople a commission of 6% of the price per unit for every car sold at an World Market Auto store. World Market expects to generate 80% of its revenues from specialty car dealers and 20% from World Market Auto Store sales each year for the next ten years.

6. Production Facilities and Costs: World Market will be building a manufacturing facility in China to produce the CoolCar. The facility will allow World Market to produce 775,000 cars each year. It is expected that World Market will operate below capacity in the initial years, but if the capacity limit is reached, World Market will have to invest a substantial amount to build new facility of equivalent capacity. With the experience of Pandemic, World Market wants to diversify its supply chain and would like to build its second facility in India. The current estimate of the cost of building a new facility in India is $ 6 billion (this cost is part of the introductory costs), but this cost will grow at the inflation rate. You can make any reasonable assumption on how to depreciate the new facility.

7. Advertising Expenses: World Market spent $ 2.5 billion on advertising in the most recent year. If World Market does not invest in the CoolCar, it expects this cost to increase 5% a year for the next ten years. If the CoolCar is introduced, the total advertising expenses each year, from years 1 to 10, are expected to be 20% higher than they would have been without the CoolCar division.

8. Working Capital: The CoolCar will create working capital needs in the following way

Accounts Receivable will be at 9% of sales, Inventory will be at 12% of the Variable costs (or Cost of Goods Sold), and Accounts Payable will be at 10% of the Variable costs. All these working capital investments will have to be made at the beginning of each year in which goods are sold.

9. Risk Measures: The beta for World Market is 1.17, calculated using monthly returns over the last five years against the S&P 500 Index returns. However, management believes that the appropriate beta should be the average beta for the car industry that is 1.85. The current stock price for the firm is $ 319 per share with 4.378 Billion shares outstanding.

10. Bonds: World Market expects to finance the CoolCar division using the same mix of debt and equity (in market value terms) as it is using currently in the rest of its business. World Market's currently has $116.8 billion in market value of interest-bearing debt (with a weighted average maturity of 10 years). The World Market bonds are currently rated AA+. The AA+ bonds have a credit spread of 3.17% over 10-year Government Bonds.

11. Taxes: World Market's effective tax rate is about 26%.

12. Macro data: The current long-term nominal US Treasury bond rate is 0.66%, and the expected inflation rate is 2.5%. The expected Market Risk Premium is 6.00%.

Answer 1

Market value of equity
Shares outstanding (mn)	4,378
Price per share	319
Market value of equity (millions)	1,396,582
Market value of debt (millions)	116,800
Total market value	1,513,382
% Equity	92%
% Debt	8%
Risk free rate	0.66%
Expected inflation	2.50%
Expected market risk premium	6.00%
Expected beta	1.85
Expected credit spread	3.17%
Cost of equity	11.76%	=0.66%+(6%*1.85)
Cost of debt	4.68%	=(0.66%+3.17%+2.5%)*(1-0.26)
WACC	11.21%	=(92%*11.76%)+(8%*4.68%)
	11%
It is advisable to go ahead with the project as the NPV is positive at WACC for the project.
The IRR is 11.49% as NPV at that rate is zero. It is calculated using goal seek in excel.