Question

Tesla is planning to open its first manufacturing plant (for the production of batteries) outside the US. You are one of the financial analyst that will help assessing the feasibility of the investment.

2. Tesla has commissioned one of the Big Four Consulting firm to provide some recommendations with regard to the current legal regulations in China. The consulting service fees will amount to 1 million dollars.

3. The Chinese government has in place a support scheme for foreign companies that invest in the manufacturing industry. The Chinese government will pay a 10% cash grant of the initial capital investment (this will be paid as a lump sum at the time of the investment).

4. Suppose that the life of the project is 10 years and the initial investment in the project today is 500 million dollars.

5. The plant will be depreciated to $0 book value over the 10 years and can be sold by Tesla in year 20 for 150 million dollars.

6. It has been estimated that Tesla would be able to generate gross revenues of 75 million dollars per year (starting at the end of the first year).

7. The new production of batteries in China will have a direct impact on the production of batteries in the US. The revenues generated in US are estimated to drop by 8 million dollars each year.

8. The annual variable costs are expected to be 25% of the “incremental annual revenues”.

9. The current weighted average cost of capital for Tesla is 12%, and the project has the same risk profile and financial structure of the company. The company tax rate is 30%.

What would happen to the WACC and NPV in the case Tesla would be using a higher proportion of debt to finance this project? Under what conditions the WACC can be used as a discount rate for the cash flows of a specific project?

Answer 1

First Calculated the vaibility of the project under same WACC @12%

We will do this under NPV Method.

Net Present Value = Present Value of Inflow - Outflow

Hence First Calculate the Annual Inflow for each year.

Gross Revenue from China Project = $75M

Less Drop In US Revenue = $8M

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Incremental Annual Revenue = $67M

Less Variable Cost = $16.75M (25% of $67M)

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Net Incremental Annual Revenue = $50.25M

Salvage Value of Project at 20th Year = $150M

Pre Tax WACC = 12%

Hence Post Tax WACC = 8.4% (12% x (1-0.30))

Discounting Annuity Factor for 8.4% for 10 years = 6.59

Discounting Factor for 8.4% for 20 Years = 0.20

Hence Present Value of Total Inflow:

($50.25M x 6.59) + ($150M x (1-0.30) x 0.20)

we get $340.15M

Outflow:

Initial Investment = $500M

Consulting Fees = $1M

Less Cash Grant = $50M

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Net Outflow = $451M

Hence NPV = $340.15M - $451M

we Get -$110.85M

In case the Debt proportion is increased the WACC would go high and as the companys expected return goes high the NPV would go down further.

so it is not advisable for the company to invest in the projet.

Incase the Firm Overall risk is same as that of the new project then WACC can be use as Discounting factor to evalute the present value of cash inflow of a specific project.