How much importance should be given to the energy cost situation?
With the rapid development of competitive global economy, energy prices are soaring, and environmental regulations are increasing. Therefore, it is more critical for companies to acquire the ability to timely analyze and control operating costs. In order to achieve the goal of reducing cost and increasing profit, everyone is looking for effective ways to lower energy Costs, reduce Consumption and minimize their Carbon and environmental impact. In this case, Tesca Works Inc. is not the exception which disagree the importance of reducing energy cost and environmental pollution. Therefore, according to the situation presented in this case, there are two aspects that Tesca Works Inc. should consider about.
First, given one aspect of consumer, the lower energy cost is, the more benefits customers get. As far as we can see, because of current recession’s impact, consumer confidence declines, and they are willing to cut down their spending and purchase new efficient appliances which are energy-saving and environmentally friendly. The reason that lowering energy cost is benefit for consumers is that energy cost or price of electricity is increasing. In the following section, there are two figures which show electricity costs per kilowatt hour from 1990 to 2009, and then forecasted at two rates to the year 2025 in U.S.
Figure 1 shows the cost per KWH in the overall US from 1990 to 2009, and projected into 2025 using the average rate increase over the 20 years from 1990-2009.
Figure 2 shows a slightly accelerated rate of KWH cost based on the rate increases across the US from 2005 to 2009. Even greater rate increases can be expected as fossil fuels are depleted and demand due to population growth increases.
Figure 1. The electricity costs based on the average rate increases from 1990-2009 (SOLAR vs NON RENEWABLE ENERGY COSTS COMPARISON ,2009).
Figure 2. The electricity costs based on slightly accelerated rate increases from 2005- 2009 (SOLAR vs NON RENEWABLE ENERGY COSTS COMPARISON ,2009).
Second, because of consistent population growth, continuing rapid urbanization and industrialization, mismanagement of nature resources, the issue of environmental protection is becoming more important in current society. Therefore, more and more companies focus on adopting comprehensive response to the environmental issues by developing in a sustainable way and maintaining their competitive advantage in the global economy (Welford, R. 2004). Thus, it is necessary for Tesca Works Inc. to consider its social responsibility by avoiding mismanaging energy and polluting environment. In addition, by producing and marketing efficient and environmentally friendly appliances, they also can take advantage of its competitive advantage and stand out from its competitors. In summary, it is very important for Tesca Works Inc. to think about the energy cost situation from customer perspective and environmental protection issues.
What is the project’s cost of equity? What is the appropriate discount factor to use for evaluating the refrigerator project?
We use pure play method to estimate the β coefficient because Tesca Works Inc. has a portfolio of products. By using this method to calculate the β coefficient, we can just compute the industry business β, which is equal to the business β of Tesca Works Inc..
According to the original case, the current bonds of Tesca Works Inc. have a rating of A, and the Interest cost range of A is from 6.25percent to 7.5 percent. We decide to use the average Interest rate in the rating A, it is 6.875 percent.
Revenue Percentage from Selling Generators
The percentage of income from generator is 50 percent. Therefore, the other half of income is generated from selling other appliances. However, we find the revenue percentage from selling generators is too low compared with other companies’ data. We decide the minimum percentage of revenues from selling generators is 85 percent, and we gather information of four companies, which are General Generators, Universal Power, Generators Inc., and International Generators, used as the original data in the calculation. β for the Appliance Business
The equation is as follows.
……………………. ………………………………………………..(1-1) therefore, …………………………………………………………………………(1-2) We use equation (1-2) to calculate the industry business β. General Generators, ;
Universal Power, ;
Generators Inc., ;
International Generators, ;
After calculating the four companies’ , we can compute the sum of the total and then get the average industry.
The average industry .
Hence, we assume that our βGenerator Business is 1.11.
According to Table 1, we can see that Tesca Works Inc. has a Debt/ Equity ratio is 40 percent and the tax rate is also 40 percent. Then, Tesca Works Inc. has a βGenerator, which is Tesca Works Inc. .
We find our business β for the entire company without debt and without taxes starting with our β of 1.3. We can calculate Tesca Works Inc.’s β without debt and taxes, which is
Tesca Works Inc.’s β is a portfolio of the generator β and another appliances β
Finally, we can get the beta for appliances, which is βAppliances=0.99. Therefore, after debt and tax adjustment, .
Project’s Cost of Equity
According to the case described, the current 10-year Treasury notes have a yield to maturity of 6 percent and the forecast for the S&P 500 market risk premium is 6.5 percent. Therefore, we can decide that the Risk-free rate is 6 percent, Market risk premium is 6.5 percent, and Beta of Tesca Works Inc. is 1.23. Based on the data given above, we can calculate the required return
on Tesca Works Inc.
Therefore, the cost of equity of Tesca Works Inc. is 13.995 percent.
As question asked, we should calculate the discount factor to use for evaluating the refrigerator project. As we see it, the discount factor is equal to the weighted average cost of capital (WACC). Therefore, we will calculate the WACC in the following equation (1-4). ………………………………………………………(1-4)
Because Tesca Works Inc. does not offer preferred stock, we just use the data about debt and common equity in the calculation. As described in the original case, Tesca Works Inc. has a Debt/Equity ratio of 40 percent. Therefore, we can get the target weights of debt (Wd) and target weights of equity (Ws). The interest rate (Rd) on the new debt of Tesca Works Inc. is 6.875 percent, the tax rate is 40 percent, and the cost of equity (Rs) is 13.995 percent. ,
Therefore, we can get that Debt=0.4×Equity;
Because Debt + Equity = 1, we can get Wd=29% and Ws=71%.
Therefore, the appropriate discount factor to use for evaluating the refrigerator project is 11.13 percent.
Which of the two compressors should be used in the refrigerator if you decide to go ahead with the project and why?
In order to decide which compressor is suitable in the refrigerator, we need to evaluate two kinds of compressor costs by calculating net present value (NPV) of each compressor model. According to the data in exhibit 2 of compressor costs, we know the price per compressor and installation costs about two models: CM-004 and TS-L12, and we also need to consider annual warranty cost per year for five years. Therefore, we use the formula of NPV to decide which compressor is more cost-saving: NPV=CF0+CF1/(1+r)1+ CF2/(1+r )2+…….+ CFN/(1+r)N
As the result we got in the second question, WACC is 11.13%. Thus, by using
calculator, we get NPV of compressor CM-004 is negative 427.35, and NPV of compressor TS-L12 is negative 444.19. Since both model’s compressor costs are negative, the smaller NPV is, the more economical compressor is. Thus, we should install compressor CM-004 in every refrigerator to save manufacturing cost for Tesca Works Inc.
Forecast the project’s cash flows for the next eight years. What assumptions did you use?
To forecast the project’s cash flow for the next eight years, we first need to use some assumptions: Tesca uses straight line depreciation method so that depreciation costs keep the same in the next eight years. Furthermore, interest expense will not be considered in the analysis because the cost of capital is a combination of the cost of debt and the cost of equity; depreciation does not reflect actual cash outflow, so we added the depreciation back to get free cash flow. In this project, the forecasts are based on projected levels of demand which has three situations: weak, average and strong. According to the data in exhibit 1sales forecasts, three different demand levels caused different levels of sales and expenses and net cash flows. In weak demand condition, net cash flow is negative in year 0 which is (17,600,000) and is positive 4,870,000 and 2,110,000 in year 1 and 2 and will become negative again from year 3; in average demand condition, net cash flow also is negative in year 0 and positive from year 1 to year 4 and become negative from year 5 to year 7 and finally positive in year 8; net cash flows in strong demand condition are as similar as average condition.
Use the appropriate capital budgeting techniques to evaluate the project.
To evaluate capital budgeting there are some methods to use: net present value (NPV), internal rate of return, payback period, profitability index, accounting return. Since NPV is the best method to evaluate capital budgeting, we use NPV method. We already know the cost of capital is 11.13% and net cash flows in the next eight years. By calculating NPV in three demand level, we can see that in weak demand, NPV is negative 33,452,491.14, which is smaller than 0. Thus, in this condition, the project is not acceptable. Also, NPV in average demand is negative 704,878.09 which is not acceptable. By contrast, NPV in strong demand is positive which is 3,488,264.64. Accordingly, we can say that the project is acceptable only when Tesca Work Inc. faces in strong demand.
Use the average demand scenario to evaluate the sensitivity of the project’s NPV with respect to sale price of the refrigerator and the cost of the compressor. As described in question 5, we get the net present values when the WACC is 11.13% and the demand level is weak, average, or strong. When the demand level is weak, sales price per unit is $1,375 and units sold per year is 40,000, we get NPV is negative 33,452,491.14. When the demand level is average, sales price per unit is $1,575 and units sold per year is 42,500, we get NPV is negative 704,878.09. When the demand level is strong, sales price per unit is $1,600 and units sold per year is 43,000, we get NPV is 3,488,264.64. Depends on the probabilities for these three demand level, we can get the expected NPV which is negative 7,633,838, the average price which is $ 1,533, and the average units sold per year which is 42,025.
In the sensitivity analysis, we analyze data based on the average demand level, in which level sales price per unit is $1,533, cost of compressor is $280, and WACC is 11.13%. In this analysis, we set these as factors that can affect the NPV. Therefore, we use sales price, cost of compressor, and WACC as three factors, and calculate NPV when they individually changes a certain percentage, 10 percent, 15 percent, negative 10 percent, and negative 15 percent. In Table 1, we can see the results when these factors change individually.
Table 1 Results of NPV when factors change individually
Based on the results show in the table, we can get a chart to show how sensitive of the NPV when these three factors change individually. From Chart 1, we can point out that sales price per unit is the most sensitive factor, and WACC is the worst sensitive factor. That means when sales price changes, the NPV changes rapidly; when WACC changes, the NPV changes in a very small amount.
Chart 1 Sensitivity Analysis
Based on the scenario and sensitivity analysis you performed above, comment on the overall riskiness of the project.
Table 2 Scenario analysis
We can see from table 2, the riskiness of the project is tightly connected with economic environment. In scenario analysis, we time the probability of each demand level and get the weighted expected NPV is negative 7,633,838, because only when the company faces the strong economic environment the NPV is positive which probability is only 30%. That means, 70% probability that the company will faces the riskiness of this project. As mentioned before, based on the sensitivity analysis we know that sales price is the most sensitive factor which impact NPV of the project. That means, if there are some competitors in the market which reduce the sale price the NPV will reduce a lot even from positive to negative.
Would you recommend that Tesca Works accept or reject the project? What is the basis for your recommendation?
Above all, the probability of this project to be accepted is too small so that we recommend the Tesca Works Inc. reject the project. There are many reasons that resulted to this decision. First, the cost of the project is too high. We use the sales revenue less total expenses which include operating expense, cost of compressor to get the net cash flow. In this project the cost of compressor of each refrigerator and the warranty cost are too high which reduce the net cash flow. That proves the energy cost is very important to the company which we mentioned in Question 1. Second, sales price is too sensitive to NPV which means the company has to remain the sales price in a high level which is less competitiveness in the market. Third, the project needs a strong economic environment to earn money which probability is too small. Therefore, we recommend the company to reject the project.