Write a research paper that goes into further detail about the three capital budgeting techniques.You are a financial consultant that helps companies evaluate capital budgeting decisions. One of your clients, ModCo, is a company that modifies trucks for specialized applications. ModCo can bid on a contract to customize and deliver 24 trucks over 5 years to a customer. However, they are struggling to make various capital budgeting decisions, and have retained you to help them. ModCo’s required rate of return for such projects is 20% and its marginal tax rate is 21%.
Part 1
In order to fulfil the contract, ModCo will have to purchase certain equipment. It is considering two different options.
Option 1 has a purchase price of $125,000 and will cost $10,000 per year to operate. It needs to be replaced every 6 years. At the end of its useful life, it has a salvage value of $5,000.
Option 2 has a purchase price of $140,000 and will cost $8,500 per year to operate. It needs to be replaced every 8 years. At the end of its useful life, it has a salvage value of $7,000.
It costs $5,000 to install either option.
The equipment ModCo plans to purchase qualifies for 5-year MACRS depreciation.
Question: Which option should ModCo purchase? Justify your decision based on comparison of the equivalent annual cost for each option. Assume that ModCo will continue to replace the option you recommend on an ongoing basis.
Part 2
ModCo would like to avoid the winner’s curse and wants you to help determine the minimum price per truck that it will submit as part of its bid. The company provides you with the following information:
The trucks are complicated to produce, and this is the first time ModCo will be modifying trucks for this application. Due to the learning curve associated with the process, ModCo estimates it will be able to produce one fewer truck the first year than in the remaining years.
Additionally, at the end of the five years, Option 1 equipment can be sold for $5,500, while Option 2 equipment can be sold for $8,000. For the purposes of Part 2, assume that ModCo will sell the equipment it purchased at the end of Year 5.
ModCo will set aside $25,000 for working capital needs at the start of the project. Thereafter, ModCo estimates that NWC will be equal to 15% of revenues. At the end of the project, the working capital used for the project will be recovered and re-deployed elsewhere.
ModCo can purchase the truck platforms it needs for $12,000 per platform in Year 1. Each truck also requires additional parts in addition to the truck bed. These parts are expected to cost $2,000 in Year 1. It also estimates that it needs office supplies of $500 per year and these office expenses are expected to remain fixed over the term of the project.
ModCo has an office and production facility that it rents for $10,000 per month but estimates that it will need more office space. Luckily, additional space adjoining ModCo’s existing facility is available for $2,000 per month for a 5-year lease. Existing Utility costs are $500 per month and are expected to grow proportionately with rent.
ModCo’s salaries and bonuses for its existing employees total $1,000,000 per year, including its CEO’s salary, which is $100,000. The CEO also earns a bonus equal to 1% of revenues. ModCo needs 4 additional technicians to produce the trucks. Salaries and benefits for these technicians is $40,000 per year, and these technicians are contracted on fixed, long-term contracts. However, there is a labor shortage and ModCo thinks that it can only find 3 qualified technicians. The good news is that one of ModCo’s existing employees can be reassigned to this project. This employee’s salary is $60,000 and he works on a product that generates EBIT of $500 per year.
Variable costs are expected to increase by 5% per year.
Hint: When setting up your model, set up the variable you are trying to solve for (i.e. the bid price per truck) as an input to the model. To begin with, enter any “dummy” amount into this cell and build your model based on that. Once you have completed building the model, you can use Goal Seek in Excel to solve for the variable.
Questions:
What is the minimum amount that ModCo should charge for the truck in order to make its required rate of return? Assume ModCo has 1,000 shares outstanding. What would be the change in ModCo’s share price if it won this bid at this price? Explain the basis for your answer for the change in the share price.
Assume ModCo bid $62,000 per truck and won the contract. Assume ModCo has 1,000 shares outstanding. What would be the change in ModCo’s share price if it won this bid at this price? Explain the basis for the your answer for change in the share price. What is the project’s IRR under this assumption? What is the Payback Period under this assumption? If ModCo had a PP cutoff of 2 years, would it have accepted the project?
Assume that ModCo doesn’t win the contract, but that the company that sent the contract out to bid approaches ModCo with a counter-offer. If ModCo is willing to build the trucks for $59,500 per truck, ModCo will be awarded the contract. Assume ModCo has 1,000 shares outstanding. What would be the change in ModCo’s share price if it won this bid at this price? Explain the basis for your answer for the change in the share price. Under this scenario, what is the Profitability Index for the project? Should ModCo accept the project?
[IMPORTANT] Instructions for Case 2
Your model for Part 1 should be on a single worksheet. Name the sheet “Part 1.” Answer the question for Part 1 at the bottom of the sheet that sheet.
For Part 2, you will need to submit three sheets. First, create your “Base Model” on one sheet. Name the sheet with the base model as Sheet 2a. Once you have created it and are satisfied it works, create two duplicates of that sheet. Name those sheets Part 2b and Part 2c, respectively. Your responses for Part 2, question A should be at the bottom of the sheet named Part 2a. Similarly, your responses to questions B and C should be at the bottom of sheets Part 2b and Part 2c, respectively. For questions B and C, feel free to change input/assumption variables as needed to answer the question. You may also need or want to add additional “modules” or calculations to your model to answer the questions. When doing so, avoid modifying the “Base Model” as it appears on Part 2a. Rather, add them at the bottom of the sheet (but before your answer to the questions).
We will only grade the 4 sheets labeled Part 1, Part 2a, Part 2b and Part 2c, so please label your work as instructed.
