The Energy Cost Situation in Tesca Works - Case Study Example

The Energy Cost Situation in Tesca Works 1) How much importance should be given to the energy cost situation? The energy cost situation is very important for Tesca Works because what developments in the energy sector could materially affect many industry in the economy. The energy cost situation will cause people to conserve energy and look for product that would maximize the utility of their resources. Thus the prediction in the case facts that consumers will more than willing to consider buying new efficient appliances would be more likely to happen than not. This would give Tesca Works the advantage as it has the capacity to respond to the situation since it is able to produce durable goods. Be expanding therefore its product line to include the manufacture of refrigerator, the company must be acting strategically towards a direction that could give the company a better return for its investments. Given that its manufacturing processes are adjustable or adaptable to making durable goods, its decision to go into refrigerator and consumer appliances implies making use of its strengths to take advantage industry opportunities as the industry where it belongs evolved as brought about by the increasing energy cost. This energy cost situation can be considered as an external event by Tesca Works that must be responded do at the strategic level if the company has to maximize wealth for its stockholders and sustain the long-term financial health of the organization. The evolution of the industry where the company belongs is evident with how the company has evolved over time. It has started as a manufacturer of steam saws in 1880 to serve the logging industry where there were still many logs and trees to process. The owners’ realization of changing times was therefore providential as they needed to look for new ways of doing things for them to come earlier to the market than their competitors. From the saws, they shifted to making generators sometimes in 1915 when the owners realized the lack of the viability of the making saws. The generators were then just serving the same purpose as saws as they make the work of people easier. So the owners were able to see the need to make things faster are the level of knowledge improves. About 25 years later, the company has gone into commercial appliances and it was easy for the company to do the same since appliances consist of parts as that of the generators being made by Tesca Works. While they originally targeted only the governments, schools and hospitals as customers, commercialization of the appliance needed to come as the economy and technology evolve and this has contributed to great part of their revenues. The history of the company in fact also leave traces of conquered problems of energy cost stated differently, which the company responded to by changing or shifting its products to ones that would serve people or customers better by conserving their energy. The need for appliance was still evident for the company but the change for more better ones has to come because of the changing environment which much also be addressed. Products that are efficient and environment friendly could only describe the products that would have to be made if they to survive the changing needs of the market. Thus the increasing electricity cost is very much connected to energy cost problem so that the company needs to address by adopting its processes to new products needed by the market. The rest of the paper will therefore discuss about the proposal to introduce the energy star refrigerator. In making it product different from competitors, the proposal included added value like large shelves in the doors and convenience. The product would also allow high volume of water ice dispenser while operating quietly and with efficiency. 2) What is the project’s cost of equity? What is the appropriate discount factor for evaluation the refrigerator project? The project’s cost of equity could be estimated by using the Capital Asset Pricing Model (CAPM) (Brigham and Houston, 2002). To compute for the appropriate discount factor, Tesca Works requires knowledge about is cost of capital. The said cost of capital approximates the concept of opportunity cost in economics, which can guide whether the investor is earning below or above. The said cost of capital is normally used as discount rate in discounting cash flows for the company using the CAPM model. The formula is: Required (or expected) Return = RF Rate + (Beta * (Market Return - RF Rate)). RF means for risk free rate and the rest of the formula is the market risk premium. Applying the formula would show that Tesca Works would have an estimated cost capital of 14.45% as computed below: Required (or expected) Return = RF Rate + Beta (Market Return - RF Rate) = 6% + 1.30 (6.5%) = 14.45%. The appropriate discount factor for evaluating the project however cannot be based simply on the project cost of equity as the project could also be finance through debt and this would necessitate the need to compute for the weighted cost of capital (WACC). This cost of equity of 14.45% needs to be adjusted with the cost of debt because the company has been maintaining capital structure with to debt to equity ratio of 0.40. Given the 40% marginal tax rate and cost of long-term debt based on higher end of interest on bonds on 6.5%, the company’s WACC could be estimated at 15.10 after adding the inflation rate of 3.5% annually. See Appendix C. 3) Which of the two compressors should be used in the refrigerator if you decide to? go ahead with the project and why? The compressor model CM-004 should be used over that of TS-L12 in the proposed refrigerator assuming that the project should be pursued because of its lower cost when the present values of their total cash outlays are computed. It was observed TS- L12 model has lower cash outlay at the start but has a higher warranty cost and while the CM-004 model has a higher cash outlay but lower warranty costs for the coming years. To evaluate which is better, there is need to discount at and assumed discount rate of 10%, the possible cash outflows from the options and choose which will yield a lower NPV, which means that would be equivalent to the less cost when spent at present. TS- L12 came out better. See Appendix A. 4) Forecast the project’s cash flows for the next twenty years. What assumptions did you use? The forecasted cash flows for the next twenty are those shown in Appendix B supporting schedules. The assumptions used are the following: Annual growth of revenues will be a rate of 5% based on volume. The cost of sales which include parts, cost of compressor, warranty cost for five years, labor cost and overhead. Since prices and cost are expected to increase also due to inflation, the forecasted cash flows just included the effect of inflation in the discount factor so that prices and cost are at base prices from Year 3 when the refrigerator will be produced and sold to the market for the next 20 years and therefore the forecast ends at Year 22. Years 0 to Year 2 included cash capital outlays totaling to $11 million and which will be depreciated over a 20 year period. The amount of depreciation was considered part of the overhead for purpose of computing the cost of sale and for computing the net profit year after operating expenses are deducted. After deducting taxes at 40% of net income before tax, the depreciation charges are added to get the net cash flows. Deducted further is the increase in net working capital of 12% of sales per year. At Year 22, total increase in net working capital per year is recovered. Note the net working capital is affected by the 5% annual increase in volume sales. What happens in the future is really difficult to project but a look at the future can also be based on assumptions with some justifications as provided for in the case facts. It is provided in the case facts that the refrigerator will only last for 20 years and after that period the demand for refrigerator with the said appropriate technology would have slowed down since technology would have changed then. It was then just enough to estimate a conservative 5% increase in volume. This is justified by the case fact the designs would become obsolete after 20 years. Note also the cost of parts as given do not yet include the price of compressor and warranty cost so that the same are added. Since there are two compressor models to choose from, the one with lower present value was the chosen one with its cost as part of production cost as done in the projected cash flows. 5) Use the appropriate capital budgeting techniques to evaluate the project. The appropriate capital budgeting techniques that could be used to evaluate the project include the use of NPV and the IRR. Under the NPV method, the proposal to make refrigerator produces a positive NPV and this would make the same as an acceptable stronger investment option even under weak demand level assumption. This means that the result of the cash flows as discounted using a discount rate of 15.10% (including the 3.5% annual inflation rate) is a better option than not accepting the proposal. This time the time value of money is considered by discounting the future values from Years 1 to 22 to their present values or at Year 0 or today. As computed the net present value of the proposal at the average level of demand is $52.8 million. Without the 3.5% inflation rate added to the computer cost of capital, the NPV was also positive. As the discount rate is increase the tendency is to decrease the net present value. Thus, the risk of accepting of the proposal is very low considering that even at the weak demand level assumption using the highest estimated WACC of 15.10%; the proposal could produce a positive net present value. See Appendix B. It may be noted that all of the demand levels are acceptable using their positive NPV generated. This therefore makes the need to make appropriate recommendations on the not much difficult. This does not necessarily mean however the business has no risk whatsoever. Capital investment decisions maintain for what will maximize wealth for the organization (Brigham and Houston, 2002). Among given options, that which would maximize wealth for the company should be chosen. Since not deciding to proceeding or accepting the proposal presupposes alternative use of the resources, the competing option should be able to provide an advantage. It is therefore assumed that if the company does not accept the proposal it has the readily alternative way of earning its profits at given cost of capital at 15.10% or the one used as discount rate. Note that the discount rate or cost of capital is assumed at 15.10% based on computation from case facts is significant in evaluating proposals. This could be difficult to estimate and understating the same or overstating the same may also result to wrong decisions since it is a factor in the computation. Finance models providing how to estimate the cost of capital are just based on theories and they should be treated management plans for the future based on estimate. This cost of capital is highly affected by developments or events external to the company such as economic factors. NPV method has its limitation also as to the estimates made in the cash flows which could be wrong. Despite these limitations, the use of NPV is still the better method even that of the internal rate of return (IRR) which can wrongly assumed that earnings are reinvested at said rate even when it is not the cost of capital as computed using the NPV (Brigham and Houston, 2002) 6) 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. The average demand scenario would be referring to the most like to happen among the possible demand levels and to use the same to evaluate the sensitivity of the project with respect to the viability of the proposal on the generated NPV would be to compare its results with the NPV when the demand level is weak or strong. By using the average demand the most probable to happen compared to the strong and weak level of demand, it can be seen that the NPV would is positive at $52.8 million using the computed cost of capital of 15.10%. In case of strong demand level, the NPV is at $57.3 million while in case of weak demand level, the NPV is at $21.8 million. See Appendix B. The analysis of the three levels of demand does not show much risk in accepting the proposal as would be discussed next. 7) Based on the scenario and sensitivity analysis you performed above, comment on the overall riskiness of the project. The overall riskiness of the project could be evaluated in terms of the chances of being unsuccessful in the project and its cost in relation to its success. The riskiness of the project would depend on the generated NPV could produce using the average scenario as the most likely to happen. Comparing the NPV of the three levels of demand, it would appear that the project would have a positive NPV even at the weak level. This would mean that the proposal is already acceptable at that level. With more reason to accept the project at the average and strong level of demand. Thus the overall riskiness level of the proposal is still calculated and manageable. In n business, the presence of risk is always assumed and the what can be done would be a question of how to manage the same and its significance must be studied so that things could be decide upon like to accept, to prevent or minimize the same. Since the level of risk in failing to realize increase wealth is low the risk would just have to be accepted by the acceptance of the proposal to make energy efficient and environment friendly refrigerator. 8) Would you recommend that Tesca Works accept or reject the project? What is the basis of your recommendation? This paper recommends acceptance the project since the result of the analysis using the NPV method shows that there is positive NPV of the proposal on all three level of demand – that is weak, average or strong The basis of the recommendation is the result of the NPV valuation and the assessment of the riskiness level. There is basis to accept on the basis of the positive NPV based on what most likely would happen as to level demand which will materially affect the level of revenues and because the overall riskiness of the same justifies the same. Not taking the risk is just like forfeiting the chance to earn or to become wealthier as the result of the proposal. The other option of not to accept the proposal would tie the company to say in its old business which may no longer justify the opportunity cost of money. Appendices See Supporting Schedules in Appendix B-1 1 References Case Study – Tesca Works Brigham, E. and Houston, J. (2002) Fundamentals of Financial Management, London: Thomson South-Western Read More