Question

Tesla’s product line current consists of the Model S sedan. Tesla is deciding whether to introduce the Model X SUV. If Tesla does introduce the Model X, it will sell 10,000 Model X annually in years 1-10 and 15,000 Model S annually in years 1-10. However, if Tesla does not introduce the Model X, it will sell 20,000 Model S annually in years 1-10. Moreover, Tesla can use its existing plant and equipment to produce the Model S. To manufacture the Model X, Tesla must spend $500 million in plants and equipment in year 0, which will be depreciated straight line to a book value of $0 in years 1-10 (i.e., depreciation is $50 million per year in years 1-10). Each Model X will sell for $80,000 and cost $70,000 to produce. Each Model S will sell for $60,000 and cost $55,000 to produce. Assume that the corporate tax rate is 35%, and that the appropriate nominal discount rate is 8.0% per year.

(a) What are Tesla’s after-tax cash flows in years 0-10 if it does not introduce the Model X to its product line?

(b) What are Tesla’s after-tax cash flows in years 0-10 if it does introduce the Model X to its product line?

(c) What are Tesla’s incremental after-tax cash flows in years 0-10 if it does introduce the Model X to its product line? (Hint: Subtract Tesla’s aftertax cash flows in years 0-10 without the Model X from Telsa’s after-tax cash flows in years 0-10 with the Model X.)

(d) What is the NPV of the incremental after-tax cash flows that you calculated in part (c)? Should Tesla introduce the Model X or not?

Answer 1

a). After-tax cash flows if model X is not introduced:

	Model S:
	Initial investment	0
	Units (u)	20,000
	Selling price/unit (s)	60,000
	Cost/unit (c)	55,000
Formula	0-10 year figures (/year):
(u*s)	Selling price (S)	1,20,00,00,000
(u*c)	Cost ('C)	1,10,00,00,000
(S-C)	Operating profit (P)	10,00,00,000
(P*35%)	Tax @35% (T)	3,50,00,000
(P-T)	After-tax cash flows	6,50,00,000

After-tax cash flows in years 0-10 are 65,000,000 /year

(b). After-tax cash flows if model X is introduced:

	Model S:			Model X:
	Initial investment	0		Initial investment	500mn
	Units (u)	15,000		Units (u)	10,000
	Selling price/unit (s)	60,000		Selling price/unit (s)	80,000
	Cost/unit ('c)	55,000		Cost/unit ('c)	70,000
				Dep/year (d)	50mn
Formula	Model S:			Model X:
(u*s)	Selling price (S1)	90,00,00,000	(u*s)	Selling price (S2)	80,00,00,000
(u*c)	Cost ('C1)	82,50,00,000	(u*c)	Cost ('C2)	70,00,00,000
	1-10 year figures (/year):
(S1+S2)	Total sales (S)	1,70,00,00,000
(C1+C2)	Total cost ('C)	1,52,50,00,000
(S-C)	EBITDA	17,50,00,000
	Depreciation (D)	5,00,00,000
(EBITDA - D)	EBIT	12,50,00,000
(EBIT*35%)	Tax @35% (T)	3,12,50,000
(EBIT-T)	Net income (N)	9,37,50,000
	Add: depreciation	5,00,00,000
(N+dep.)	After-tax cash flow	14,37,50,000

After-tax cash flow for Year 0 = -500 million + 65 million (cash flow from model S, as calculated in part (a)) = -435,000,000

After-tax cash flow for years 1-10 = 143,750,000/year

(c). Incremental cash flows and (d) NPV of incremental cash flows:

Formula	Year (n)	0	1	2	3	4	5	6	7	8	9	10
(a)	After-tax cash flow (without X)	6,50,00,000	6,50,00,000	6,50,00,000	6,50,00,000	6,50,00,000	6,50,00,000	6,50,00,000	6,50,00,000	6,50,00,000	6,50,00,000	6,50,00,000
(b)	After-tax cash flow (with X)	-43,50,00,000	14,37,50,000	14,37,50,000	14,37,50,000	14,37,50,000	14,37,50,000	14,37,50,000	14,37,50,000	14,37,50,000	14,37,50,000	14,37,50,000
(c = b-a)	Incremental cash flow	-50,00,00,000	7,87,50,000	7,87,50,000	7,87,50,000	7,87,50,000	7,87,50,000	7,87,50,000	7,87,50,000	7,87,50,000	7,87,50,000	7,87,50,000
1/(1+d)^n	Discount factor @ 8%	1.000	0.926	0.857	0.794	0.735	0.681	0.630	0.583	0.540	0.500	0.463
(c*discount factor)	PV of incremental cash flow	-50,00,00,000	7,29,16,667	6,75,15,432	6,25,14,289	5,78,83,601	5,35,95,927	4,96,25,858	4,59,49,869	4,25,46,175	3,93,94,606	3,64,76,487
	NPV	2,84,18,910.17

Incremental NPV is positive so Tesla should introduce model X.