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 (One for Los Angeles Engine and another one for California Engine) showing

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

Additional Note:

The warranty cost per unit is for every unit produced and sold throughout the project life of twenty years. This cost is determined by two factors: (1) the per year for five years cost of the warranty and (2) the discount rate being the cost of capital.

Answer 1