Question

Photovoltaic Rooftile Company
Background
Photovoltaic Brick Company (PVtile) is an emerging company manufacturing roof tiles that produce electricity. After extensive research and development, PVtile has recently developed its first product, Tile2.0, and must decide whether to make the investment to produce it in scale. The research and development costs so far have totalled $70 million. Tile2.0 would be put on the market at the beginning of next year (Year 1), and PVtile expects it to stay on the market for a total of four years (from Year 1 to Year 4). Test marketing costing $16 million has been spent (tax deduction on this test marketing cost cannot be claimed) and shown that there is a significant market for the new tile among people building new homes and renovating existing premises.
As the Chief Financial Officer at PVtile, Wanghong Zhang, has been asked by the board of directors to evaluate the Tile2.0 project and provide a recommendation on whether to go ahead with the investment. He was concerned with the discount rates used in the analysis, as well as various comments he had received from other executives at PVtile whom he had asked to review the proposal.
Mr. Zhang assumes that the initial investment will occur immediately (Year 0), and operational cash flows will occur at beginning of next year (Year 1). PVtile must initially invest $120 million in production equipment to make the Tile2.0 in Year 0. This equipment can be sold for $55 million at the end of four years (Year 4). PVtile intends to sell the Tile2.0 to two distinct markets, wholesalers and the retailers.
1) The new build market: The wholesale market consists primarily of the large suppliers of building supplies that buy Tile2.0 in bulk and sell to small building companies. In the new build market, the Tile2.0 is expected to sell for $9 per tile in Year 1. The variable cost to produce each tile is $6 in Year 1.
2) The renovation market: The retail market consists mainly of smaller hardware stores who will typically order Tile2.0 on behalf of homeowners and small builders. This market allows higher margins; PVtile expects to sell the Tile2.0 for $10 per tile in Year 1. Variables costs are the same as in the new build market.
PVtile intends to drop prices by 75 cents per year from year 2 to year 4 in the new build and renovation market; variable costs will increase at the inflation rate from Year 2 to Year 4 as well. In addition, the Tile2.0 project will incur $25 million in marketing and general administration costs in the first year (Year 1). This cost is expected to increase at the inflation rate in the subsequent years (Year 2 to Year 4).
PVtile’s corporate tax rate is 35 percent. Annual inflation is expected to remain constant at 2.0 percent over the life of the project. Construction analysts forecast 1 million new homes to be created in PVtile’s markets in Year 1 and construction rates will grow at 2.5% per year thereafter. The average home will need 2,000 tiles and PVtile expects the Tile2.0 to capture 5 percent of the wholesale rooftile market from year 1 to year 4.
Industry analysts estimate that renovators will replace 200,000 roofs in Year 1 and that the market will grow at 2 percent annually. The average roof renovated requires 1,500 tiles. PVtile expects the Tile2.0 to capture an 8% market share.
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The production equipment would be depreciated using the straight-line depreciation method over 4 years to a zero balance. The immediate initial working capital requirement is $11 million in Year 0. Thereafter, the net working capital requirements will be 25% of sales. At the end of year 4, the company (PVtile) will get all working capital back.
Last year PVtile used a 14% discount rate to evaluate a new project, NewTile. PVtile’s investment banker advised Mr Zhang that the normal discount rate for construction materials is 12% but because of the different characteristics of the photovoltaic market, the higher discount rate is appropriate.
Mr. Zhang has hired you as a financial consultant for PVtile. You are expected to answer the following questions and resolve any of his other concerns.
Report requirements:
Mr. Zhang requires you to prepare a capital budgeting analysis to show the directors in a meeting to be held soon. Based on the case study, please answer all of the following questions in your report.
1. Using the financial and qualitative information provided in the case, estimate the incremental free cash flow of this project in each year (from Year 0 to Year 4). Please show all your working.
2. The depreciation is a non-cash charge. Do you need to consider the depreciation in the capital budgeting process? Why? Explain.
3. Should PVtile use a different discount rate to other construction material companies? If so, why, and what discount rate should they use?
4. Mr. Zhang had been told that there are various techniques for valuation such as the NPV, payback period, and discount payback period, IRR, and PI which all could be used for this project. He wants you to use all of these techniques and help PVtile make this investment decision. PVtiles requires the payback period is less than 3 years and discounted payback period is less than 4 years. What can you conclude from the information these techniques provided? Based on your analysis, should PVtile accept this project? Show all your working.
5. Recently, Mr. Zhang received another project proposal, ‘PowerBrick’ which has the similar overall risk as the Tile2.0. This project is expected to generate NPV for PVtile $30 million in total and will operate for 10 years. If the Tile2.0 and PowerBrick are mutually exclusive projects, which project should PVtile choose?

Answer 1

Answer;

The project PVtile has negative NPV therefore it should not be accepted.