Question

Exhibit 1:   Sales and Cost Forecast

The sales forecast is based on projected levels of demand. All the numbers are expressed in today’s dollars. The forecasted average inflation per year is 3.0%

Price per bus	$220,000
Units sold per year	11,000
Labor cost per bus	$50,000
Components & Parts per bus	$95,000
Selling General & Administrative (fixed)	$250,000,000
NOTE: Average warranty cost per year per bus for the first five years is $1,000. The present value of this cost will be used as a cost figure for each bus. Afterwards, the bus operator will become responsible the repairs on the buses.
The buses can be produced for twenty years. Afterwards, the designs become obsolete.

Engine choices

Engine	Los Angeles engines	California engines
Price per engine, including installation	$25,000	$18,000
Average annual warranty cost per year for five years. Afterwards, the bus operator will become responsible for the repairs on the buses.*	$500	$2,000
The chosen engine will be installed in every bus and will become a cost figure for each bus. NOTE: The engine manufacturers are not providing California Best Trucks with any warranty. However, California Best Trucks will provide a warranty to its customers. After the initial five years, the bus operators may purchase an extended warranty from any insurance company that offers such packages.

Exhibit 2: Investment Needs

To implement the project, the firm has to invest funds as shown in the following table:

Year 0	Year 1	Year 2
$1 billion*	$100 million*	$100 million*
* California Best Trucks estimated that it would cost a total of $1 billion to build the factory and purchase the necessary equipment to produce the buses. The other $200 million investment, divided equally in years 1 and 2, is for non-depreciable labor training costs. Such investment is treated as regular business expenses.

Straight line depreciation will be used for the sake of simplicity.

To facilitate the operation of manufacturing the transit buses, the company will have to allocate funds to net working capital (NWC) equivalent to 15% of annual sales. The investment in NWC will be recovered at the end of the project.

The equipment will be sold for salvage at about $25,000,000 at the end of the project.

Exhibit 3: Financing Assumptions

The following assumptions are used to determine the cost of capital.

Historically, the company has maintained a debt ratio is 50%. This ratio was used, because lowering the debt implies giving up the debt tax shield, and increasing it makes debt service a burden on the firm’s cash flow. In addition, increasing the debt level may cause a reduced rating of the company’s bonds. The marginal tax rate is 30%. All the numbers are expressed in today’s dollars. The forecasted average inflation per year is 3.0%.

Cost of debt:

The company’s bond rating is roughly at the high end of the A range. Surveying the debt market yielded the following information about the cost of debt for different rating levels:

Bond rating	AA	A	BBB
Interest cost range	5.5% ~ 6.5%	6.25% ~ 7.5%	7.5% ~ 9%

The company’s current bonds have a yield to maturity of about 6.5%.

Cost of equity:

The current 10-year Treasury notes have a yield to maturity of 3.00% and the forecast for the S&P 500 market premium is 9.50%. The company’s overall b is 1.25.

• Spreadsheet showing

• Operating Cash Flows
• Incremental Cash Flows, including investment and salvage
• Warranty costs
• WACC
• NPV, IRR, Payback, and Profitability Index

Answer 1

PNL calculation
Unit sold (A)	11,000
Price per bus (B)	220,000
Gross sales (S=A*B)	2,420,000,000
Less costs
Labor	50,000
Material	95,000
Total direct cost per bus (C')	145,000
Annual direct cost (DC= C*A)	1,595,000,000
SG&A (D)	250,000,000
Warranty cost (PV of $1000 over 5 yrs.)	4,580
Annual warranty cost (E')	50,376,779
Operating profit (P=S-DC-D-E)	524,623,221
Depreciation (1 Bn/ 20 years) (R)	66,666,667
EBIT (O=P-R)	457,956,554
Tax (T @30%)	137,386,966
PAT (M=O-T)	320,569,588

Warranty costs
Engine choices
Engine	Los Angeles engines	California engines
Price per engine, including installation	$25,000	$18,000
Annual warranty cost	$500	$2,000
PV of warranty cost over 5 years	$2,289.85	$9,159.41
Total cost of engine	$27,289.85	$27,159.41

WACC calculation
Cost of debt
Interest on higher quality A rated bonds	6.50%
tax rate	30%
After tax cost of debt	4.55%
Cost of equity
CAPM (=3%+1.25*9.5%)	14.88%
Weight of debt	50.00%
Weight of equity	50.00%
WACC	9.713%

Cash flow calculation
Year	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15	16	17	18	19	20
Investment	(1,000,000,000)	(100,000,000)	(100,000,000)																		25,000,000
EBIT (growth @inflation)		457,956,554	471,695,251	485,846,108	500,421,492	515,434,136	530,897,161	546,824,075	563,228,798	580,125,662	597,529,431	615,455,314	633,918,974	652,936,543	672,524,639	692,700,378	713,481,390	734,885,831	756,932,406	779,640,379	803,029,590
EBIT * (1- Tax)		320,569,588	330,186,676	340,092,276	350,295,044	360,803,896	371,628,012	382,776,853	394,260,158	406,087,963	418,270,602	430,818,720	443,743,282	457,055,580	470,767,247	484,890,265	499,436,973	514,420,082	529,852,684	545,748,265	562,120,713
Depreciation		66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667	66,666,667
Change in WC (15% of sales)		363,000,000
FCFF = EBIT*(1-T) + depreciation - investments in WC		24,236,255	396,853,342	406,758,943	416,961,711	427,470,562	438,294,679	449,443,519	460,926,825	472,754,630	484,937,269	497,485,387	510,409,948	523,722,247	537,433,914	551,556,932	566,103,640	581,086,749	596,519,351	612,414,932	628,787,380
Net cash flow	(1,000,000,000)	(75,763,745)	296,853,342	406,758,943	416,961,711	427,470,562	438,294,679	449,443,519	460,926,825	472,754,630	484,937,269	497,485,387	510,409,948	523,722,247	537,433,914	551,556,932	566,103,640	581,086,749	596,519,351	612,414,932	653,787,380
PV of cash flow	(1,000,000,000)	(69,056,621)	246,620,810	308,012,808	287,787,370	268,921,581	251,321,435	234,899,636	219,575,102	205,272,508	191,921,862	179,458,116	167,820,803	156,953,706	146,804,548	137,324,706	128,468,947	120,195,187	112,464,261	105,239,713	102,403,383
NPV of project	2,502,409,859
IRR of project	18.13%
Payback of project	3.11
PI of project (1+ (NPV/net investment))	3.0853