Question

Climate Magic, Inc., is headquartered in Houston, Texas. It describes itself as “a global manufacturer of dehumidification systems to companies across the globe.” The following was taken from the management discussion and analysis (MD&A) section of a recent annual report:

Climate Magic, Inc. The company has invested approximately $40 million in a metal compressor manufacturing facility in Detroit, Michigan. After experiencing setbacks in developing a commercially acceptable compressor, the Company is currently developing and testing a new line of compressor products. The Company is not able to determine when it will offer a compressor for commercial sale, but it does foresee that reaching volume production will require a large additional investment in the infrastructure. Given such additional investment and current market conditions, management is currently reviewing its options with respect to quality, product improvement, cost reductions, viable substitutes, acquisitions, and joint ventures.

Discuss relevant issues the company should consider and techniques the company should use to determine whether to pursue this project or not. What factors should be considered? What capital budgeting techniques should be used? What benchmarks should be utilized? What relevant costs and assumptions should be included? Explain your findings and include any related assumptions.

Answer 1

Given such additional investment, the following are the broad factors to be considered :

• Is it practically feasible to develop a commercially viable product with the additional money and time spend in R&D? Does the company have the capability or should a technology partnership/joint venture be considered?
• Is there a cheaper substitute available in the market, or can a cheaper substitute be acquired by acquiring a company which has already developed the technology. Can the technology be leased from an existing company which already has the technology?
• As $40 million has already been invested, what is the estimated payback period?
• The estimated sales and expenses should be estimated, and cash flows should be projected. Based on this, NPV and IRR techniques can be used to determine if the project is viable
• The benchmarks to utilize can be taken from companies within the same industry. In case of unavailable data or information, benchmarks can be taken from companies in a similar industry, such as heavy industry or heavy machinery manufacturing companies.
• The amount already spent in R&D is an irrelevant cost and should not be considered in capital budgeting analysis. It is a sunk cost