The Capital Budgeting Automotive Specialties, Incorporated - Case Study Example

AUTOMOTIVE SPECIALTIES, INCORPORATED Table of Contents i. Process utilized in solutions and recommendations ii. Introduction iii. Theories, concepts, and principles iv. Problems in the case v. Consequence of persistent problems vi. Analysis of the data vii. Feasible solutions for each situation viii. Preferred solution ix. Assumptions for chosen alternative x. Summary for the Entire Learning Experience xi. Appendices xii. Work cited Process utilized in solutions and recommendations The utilized process entails the capital budgeting of a multinational organization. It involves the analysis of distinction between domestic, as well as offshore investments. The process incorporates risk assessment into the estimates of project cash flows. It separates the potential political risk with adjustments that would arise due to fluctuations in the exchange rate. This was done because political risks are often entirely separated from risk arising from exchange activities. Evaluation of parity conditions over the life of the project was carried out. This was however, made beneficial by incorporating the conditions into the forecasts of exchange rates. The forecasts were readily available as they were within the contact of managers. The case was expanded by including annual exchange relationships, as well as potential political events that indicated relations with exchange rate behavior. Although the process may seem to distract students, the simplifications utilized were essential for the provision of a sufficiently detailed analysis. The process also included a keen focus on the beneficial techniques, as well as financial aspects included in the case. Some issues were however over looked although an individual who reviews the analysis would easily reincorporate them. Political contemplations principal to investments were also initiated in the process. This was to help meet the requirements of a vast customer. Introduction Capital budgeting is the main subject matter of this case in regards to a multinational organization. Rudimentary comprehension of basic techniques in capital budgeting is essential in evaluation of the case (Bierman, Harold & Smidt, p. 382). However, some issues require advanced knowledge to analyze and the present resolution of the case. Automotive Specialties, Incorporated (ASI) is a multinational holding company classified as a domestic division. It has been delegated the role of building a new plant in Mesa Verde, a small country in South America by its largest customer. Jamie Miles an Assistant treasurer at ASI did the analysis and forecasts of the customer’s proposal. Uncertainty of the investment was done in collaboration with Fujimora Transport though the investment value was not determined. The management of ASI needed to consider some of the customer’s motives prior to commitment of finances in the implementation of the project. Theories, concepts, and principles This case indicates the fact that capital budgeting involving multinational organization is similar to the basic capital budgeting that students are familiar with. Development of annual income projection was done using the provided estimates of demand and supply. This concept was useful in determining the strength of royale against the dollar over the entire life of the project. Estimates of cost of goods sold were developed covering every SKU, operating expenses, as well as depreciation cost for the Mesa Verde project for every next six years. The straight line method of depreciation was used in accordance to the initial investment amount. A discounted cash flow analysis was conducted according to the budgeted figures obtained from previous calculations. This included the estimates of the projects net present value, as well as internal rate of return. Included also was the original royale rate of exchange scenario for the annual cash flow values (Bierman, Harold & Smidt, p. 382). A going concern method is used in the sale of the project in the final year. This included the relevant cash flow values in every period. The net present value and the internal rate of return are estimated using the terminal value, firms cost of capital, as well as the initial investment value. Net present value being greater than zero indicates that the project should be accepted. Problems in the case Incorporation of political risk in the analysis is a problem facing the case. This is in the determination of whether to consider the value of other markets. This brings the difficulty in determining the growth option of the firms purchase to invest in Mesa Verde. Determination of an accurate measure of net present value through the incorporation of the growth option was required. Another problem is the consideration potential value of leaving the project by putting on the market in the intervening years. This becomes a problem as it is beyond scope, as well as audience of the case. The other issue the Jamie needed to address was patent rights in the case of making recommendations to the firm. The firm should be cautious regarding the recognition, as well as implementation of U.S laws regarding patent rights prior to investing. Evaluation of the weakening of royale using the expected net present value and the internal rate of return was needed. This was to be used in determining the impact it would have on the recommendation made by Jamie to the firm. There was also a need to reproduce an analysis on the initial estimates made by Jamie in order to indicate the weakening of Royale. This would be indicated in relation to the dollar over the planning horizon of the project. This would help in solving the problem of determining if a new plant needed to be built. There was also the problem of estimating the exchange rate of Royale to the dollar in order to produce a discounted cash flow. This would help in identifying if the project would be accepted or rejected. Consequence of persistent problems The main problems involved potential political risk and fluctuation. Without an estimate of trend of exchange rate, it would be hard to identify the economic benefit or cost that the small country would encounter. A review of the historical exchange rate would assist in curbing the problem of fluctuations in the exchange rate. Lack of identifying the potential political risk would lead to unexpected changes in the value of the currencies. This would potentially lead to deterioration of the currency. Thus, an estimation of the Royale was necessary to avoid the effects of persistent problems. Persistent of the problems would also lead to a rise in operating costs. This would then lead to a need for additional working capital outlay. The extra risk inherent would lead to a subjection to a hurdle rate to the cash flows. Knowledge of the political risk of investment was necessary to help in the adjusting of the annual cash flow. Analysis of the data Exhibit 1 Mesa Verde Proposal Annual Revenue Projections, appreciating Dec 31, 2006 to Dec 31, 2011, ‘000 Mesa Verde Other Markets SKU 517 SKU 453 SKU 367 Annual Totals 2006 R133,386 R154,155 R200,995 R488,536 2007 R139,423 R163,628 R209,854 R512,905 2008 R146,212 R174,073 R218,154 R538,439 2009 R153,217 R185,407 R227,444 R38,309 R46,354 R75,815 R726,546 2010 R160,877 R197,716 R237,765 R40,221 R49,429 R79,261 R765,270 2011 169,108 R211,230 R249,354 42,281 R53,524 R83,124 R808,622 Exhibit 2 Mesa Verde Proposal Annual Revenue Projections, appreciating Dec 31, 2006 to Dec 31, 2011, ‘000 COGS, SKU 517 453 367 Operating Expenses Depreciation Total 2006 R71,495 R86,327 R99,694 R63,510 R154,667 R475,692 2007 R74,731 R91,632 R104,088 R66,678 R154,667 R491,795 2008 R78,370 R97,481 R108,205 R40.383 R154,667 R479,104 2009 R102,658 R129,754 R150,417 R54,491 R154,667 R592,018 2010 R107,789 R138,401 R157,245 R57,395 R154,667 R615,497 2011 R113,305 R148,262 R164,909 R60,647 R154,667 R641,790 Exhibit 3 Mesa Verde Proposal Annual Cash Flows Dec 31 ST ‘06 to Dec 31 ’11, ‘000 2006 2007 2008 2009 2010 2011 Annual Revenue R488,536 R512,905 R538,439 R726,546 R765,270 R808,622 Total Costs R475,692 R491,795 R479,104 R591,018 R615,497 R641,790 Income before taxes R12,844 R21,111 R59,334 R134,528 R149,773 R166,832 Taxes (45%) R5,780 R9,500 R26,700 R60,538 R67,398 R75,075 Income after Taxes R7,064 R11,611 R32,634 R73,990 R82,375 R91,758 Plus: depr. Expense R154,667 R154,667 R154,667 R154,667 R154,667 R154,667 Annual Cash Flow R161,731 R166,278 R187,301 R228,657 R237,042 R246,424 Annual Cash Flow ($) $2,022 $2,132 $2,464 $3,090 $3,292 $3,520 Terminal Value $ 32,146 Total Cash Flow $2,022 $2,132 $2,464 $3,090 $3,292 $35,666 Exhibit 4 Mesa Verde Proposal Annual Revenue Projection Dec 31 ’06 to Dec ‘11 Mesa Verde Other 2006 2007 2008 2009 2010 2011 SKU 517 R133,386 R146,573 R161,603 R178,063 R196,623 R217,425 R44,512 R49,160 R54,362 SKU 453 R154,155 R172,020 R192,396 R215,473 R241,653 R271,582 R53,871 R60,413 R68,816 SKU 367 R200,995 R220,616 R241,118 R264,327 R290,602 R320,598 R88,109 R96,874 R106,874 Totals R488,536 R539,208 R595,116 R844,365 R935,329 R1,039,657 Exhibit 5 Mesa Verde Proposal Annual Cost Projections Dec ’06 t0 Dec ’11, ‘000 2006 2007 2008 2009 2010 2011 COGS,SKU 517 R71,495 R78,563 R86,619 R119,305 R131,742 R145,678 COGS,SKU 453 R86,327 R96,331 R107,742 R150,833 R169,157 R190,623 COGS,SKU 367A R99,694 R109,425 R119,594 R174,808 R192,188 R212,026 Operating Expenses R63,510 R70,097 R44,634 R63,327 R70,150 R77,974 Depreciation Expense R154,667 R154,667 R154,667 R154,667 R154,667 R154,667 Total Expenses R475,692 R509,083 R513,256 R662,940 R717,903 R780,968 Exhibit 6 Mesa Verde Proposal Annual Cash Flows Dec 31 ’06 to 31 ‘11 2006 2007 2008 2009 2010 2011 Annual Revenue R488,536 R539,208 R595,116 R844,365 R935,329 R1,039,657 Total Costs R475,692 R509,083 R513,256 R662,940 R717,903 R780,968 Income after taxes R5,780 R16,569 R45,023 R99,783 R119,584 R142,279 Plus: depr. Expense R154,667 R154,667 R154,667 R154,667 R154,667 R154,667 Annual Cash Flow R161,731 R171,235 R199,690 R254,450 R274,251 R296,946 Annual Cash Flow ($) 2,022 2,088 2,377 2,959 3,116 3,299 Terminal Value $30,128 Total Cash Flow 2,022 2,088 2,377 2,959 3,116 33,427 Feasible solutions for each situation This result indicated that the royale would appreciate against the dollar over the life of the project annually. This would start with an expected rate of exchange in 2002 and 2003 with R80 for every dollar. This is an expense projection for the Mesa Verde project under the assumption of the original rate of exchange. It indicated a 53.6%, of unit price for cost of goods sold. A fall in operating expenses from 13% to 7.5% of total revenues was experienced. The annual cash flow value for the country under original rate of exchange scenario annually is shown. At the beginning of 2006, a cash flow of $1.2 million would be needed as additional working capital. The end of 2005 indicates a committed initial investment. Annual cash flow at the end of the six years capitalized by the firms cost of capital indicates the terminal value of the project. The relevant cash flow value in each period is indicated in the last line. This is shown in the going concern, in the last year. This will however not recover the working capital contribution. Sunk cost would be represented by the cost of engineering report. This results show that the projects should be adopted since it has a positive net present value. Projection of revenues, expenses, as well as annual cash flows, is indicated under the assumption that Royale depreciates against the dollar annually by R2. Relevant cash flow values are shown in each period since the project is indicated by a full operation in the final year. Prior cost in the period is shown as sunk cost. The net present value is seen to be greater than zero using the cost of capital not forgetting internal rate of return. This result would not cause a change in the recommendation made by the analyst. Preferred solution The most preferred solution is for the country to buy the plant. This is because it seen to be beneficial to the country’s economy. It also has substantial returns in where the costs incurred are less compared to the revenue gained. Since the country’s currency is strong, it is of importance that the small country invests in the plant. From the analysis, the net present value from investing is seen to be positive thus it should be taken. Assumptions for chosen alternative It is assumed that the multinational way of capital budgeting is similar to the usual way of capital budgeting. Adjustments are also assumed to have been made in regards to the analysis that potential political risk is made in accordance to the prevailing exchange rate. It was also assumed that Royale would strengthen against the dollar annually over the life of the project by R2. The rate of exchange is also seen as constant and equivalent to the original exchange rate. Summary for the Entire Learning Experience From the analysis, it is true to say the capital budgeting does not change in regards to where it is carried out/ The annual cash flow value for the country under original rate of exchange scenario annually is shown. At the beginning of 2006, a cash flow of $1.2 million would be needed as additional working capital. The end of 2005 indicates a committed initial investment. Annual cash flow at the end of the six years capitalized by the firms cost of capital indicates the terminal value of the project. The relevant cash flow value in each period is indicated in the last line. This is shown in the going concern, in the last year. This will, however, not recover the working capital contribution. Sunk cost would be represented by the cost of engineering report. This results show that the projects should be adopted since it has a positive net present value. Projection of revenues, expenses, as well as annual cash flows, is indicated under the assumption that Royale depreciates against the dollar annually by R2. Relevant cash flow values are shown in each period since the project is indicated by a full operation in the final year. Prior cost in the period is shown as sunk cost. The net present value is seen to be greater than zero using the cost of capital not forgetting internal rate of returns. This result would not cause a change in the recommendation made by the analyst. Appendices Table 1 Product 2006 2007 2008 2009 2010 2011 SKU 517 Mesa Verde other markets 155.10 160.60 167 173.70 43.43 181.07 45.27 189.18 47.30 SKU 453 Mesa Verde other markets 172.51 179.76 187.74 196.51 49.13 206.16 51.54 216.78 54.93 SKU 367a Mesa Verde other markets 121.55 125.78 129.65 134.10 139.22 46.41 145.10 48.37 Table 2 Product 2006 2007 2008 2009 2010 2011 SKU 517 US Price Mesa Verde $10.75 R860 $11.13 R868.14 $11.52 R875.52 $11.92 R882.08 $12.34 R888.48 $12.77 R893.90 SKU 453 US Price Mesa Verde $11.17 R89.60 $11.67 R910.26 $12.20 R927.20 $12.75 R943.50 $13.32 R959.04 $13.92 R974.40 SKU 367a US Price Mesa Verde $20.67 R1653.60 $21.39 R1668.42 $22.14 R1682.64 $22.92 R1695.08 $23.72 R1707.84 $24.55 R1718.50 Work Cited Bierman, Harold, and Seymour Smidt. The Capital Budgeting Decision: Economic Analysis of Investment Projects. London: Routledge, 2006. Print. Read More