Importance of Energy Cost Situation - Tesca - Case Study Example

TESCA Works: Case analysis of Importance of energy cost situation In the present environment, energy has become one of the basic necessities for households as well as commercial sectors. The rapid growth of global economy has resulted in increase in the cost of energy as well as in the environmental regulations, which has caused companies to critically assess their energy requirements and analyze various methods of operational cost control. Given that energy cost is increasing steadily, the companies as well as household consumers are taking efforts to minimize energy consumption and exhibiting greater inclination towards energy efficient appliances and green technologies. One of the major drawbacks of energy, which has further drawn attention of consumers as well as of various governing officials, is environmental footprint. Hence, companies are being forced to manufacture products that are highly energy efficient (Lior, 2008). California is one of the largest cities of the United States (US) with a moderate climate. Owing to this fact, the state’s households consume about 31% less energy compared to the average consumption of the US. According to Energy Information Administration’s report, the household section comprises about 20% of total energy consumption of the state, but major energy is consumed by the commercial and industrial sectors, followed by the transportation sector. In addition, the EIA report suggest that about 75% households have one refrigerator, while the rest has more than two and about 20% consumers have separate freezer. The current study suggests that although consumers cannot minimize their need for the appliances, energy efficient appliances can further serve towards minimizing the consumption level (EIA, 2009). Furthermore, energy and its cost are important factors for industries and commercial units because of California’s heavy dependence on the non-renewable resources for energy. With growing number of environment regulations, it has become mandatory for companies to consume less energy in the production activities as well as to produce energy efficient products. Although the consumption of electricity in past two decades’ data may not show significant differences, the expenditure shows tremendous gap. Overall, it can be suggested that the energy cost analysis will prove beneficial for commercial as well as household sectors in California. The commercial sector will be benefitted by lower production cost and better profit margin, while household will have the advantage of utilizing technologies without paying high electricity bill (EIA, 2014). Calculation of cost of equity and discounting factor for the refrigerator project The cost of equity of a company primarily denotes the return that its shareholders seek from the fund they invested in the organization or its project (s). The cost of equity in the current paper will be calculated using the Capital Asset Pricing Model formula. The Cost of Equity is given by: Ke = Rf + (Rm-Rf)*β. Rf denotes the risk free return that Tesca earns from its investment in the 10-year Treasury notes. The interest rate of the treasury bills is 2.0%. Rm denotes the expected market return and Rm-Rf represent the market risk premium, which in case of Tesca is 11.0%. In addition, the value of beta, which represents the systematic risk, is 1.3. Table 1 (Source: Author’s creation) Thus, the calculated cost of equity of the company will be 16% for the given project. The discount rate denotes the minimum interest rate that is considered in discounted cash flow analysis of a particular project for determining the present value of all the future cash flows. In a number of organizations, the weighted average cost of capital is often considered as the appropriate discount rate because of risk profile of the given project being similar to that of the particular company. Nonetheless, when risk profile of the project is substantially different, the companies utilize the Capital Asset Price Model for calculating the project specific discount rate. The project specific discount rate is similar to the cost of equity as it considers market risk as well as risk free return for generating risk adjusted discount rate. In context of Tesca Works, it is appropriate to calculate the WACC so as to determine the appropriate discounting rate. In this context, the reason is that the organization has raised equity as well as debt capital for purpose of its capital requirements, which is why the total cost of capital will be the most suitable discounting factor for the company. WACC = cost of equity*equity percentage in total capital + cost of debt*debt percentage in total capital*(1-tax rate) Table 2 (Source: Author’s creation) The calculated discount rate for evaluating the refrigerator project of Tesca Works is 11.58% (Fama & French, 2004; Perold, 2004). Selection of a particular compressor and the reason behind it Tesca Works have two models of compressors, among which it has to select one compressor after analyzing the associated benefits and drawbacks. The two models that have been suggested for the given project are CM-004 and TS-L12. It was observed during the analysis that overall cost of the model CM-004 including installation cost is $280, whereas that of TS-L12 is $250. In addition, the cost of warranty that the company has to bear for initial 5 years is $40 and $50 respectively. When the total cost including installation and warranty cost was calculated for 1 year, the cost of CM-004 was found to be approximately 6.67% higher than that of TS-L12. However, as the aggregate costs were calculated for five years, the cost of CM-004 was found to be 4% less than that of TS-L12. The cost break-up has been represented in table 3: Table 3 (Source: Author’s creation) From the company’s perspective, it is clearly visible that the organization will benefit eventually if it installs the CM-004 model of compressor. While the installation cost is $30 more than that of TS-L12, it is mitigated against low warranty cost of about $40. In this context, it is also important to note that cost of warranty is generally directly proportional to the chances of failure of the equipment. As a result, the warranty cost increases with a riskier component. If the statement is considered true, then chances of failure of TS-L12 is 25% higher than that of CM-004. Additionally, compressor is one of the most important equipments in a refrigerator and its failure with a few years of purchase will affect brand image of the company, even if it is liable for repairing or replacement cost. Keeping in view the high market reputation of Tesca Works, it is advisable that the company installs CM-004 model of compressors in its refrigerators. The other advantages of having reduced warranty cost and installing high quality equipments are improved reliability, higher quality control, effective management of warranty, prevention of fraud by effective monitoring and optimum services (Yeh & Lo, 2001). Cash flow forecasting for next 20 years Table 4 (Source: author’s creation) In calculation of the cash flow from the refrigerator project in Tesca works, the various assumptions made in the paper are as follows. The initial investment has been considered as the primary outflow, which consists of investment of $3 million, $5million and $3 million for first three years respectively. The next investment amounts (outflow) have been calculated considering various operational and non-operational costs. On the other hand, the inflows have been calculated purely based on revenue that the sale will generate. In the above table of 20-year projection, a period of 23 years have been taken in consideration because production and selling activities of the company starts from the fourth year and the product has 20 years shelf life-time before becoming obsolete. Initially, the outflow was calculated by adding various fixed and variable costs associated with the product, followed by addition of warranty cost for 5 years. One of the important assumptions made in the current paper is that the revenue is not constant. To have a realistic approach, a mixed structure of demand has been taken in consideration. For the initial as well as for last 3 years of production, the demand is expected to be low. In the initial years, the demand is taken as low because the product will be new in the market and naturally consumers will be buying less of it. On the other hand, in last phase of the project, the demand will be low because it will shift towards obsolescence and new products will enter the market. The time span between fourth and eighth year is expected to witness moderate demand as the product will be gradually earning familiarity in the consumer market. In addition, another reason of the product to gain popularity is brand image of the company. As per the case, the company is well-known for its creativity, reasonability of product cost and quality. So, by the half-shelf life of the product, the demand is expected to gain momentum. From the ninth year to seventeenth year, the product is expected to observe high demand. The rationale underlying this consideration is that by ninth year, the product will attain stability in its life cycle and will have a competitive market share. This is because of the company’s reputation as well as quality and related services. The various phases and the relevant cash inflows have been exhibited in table 5. Table 5 (Source: author’s creation) In the outflow calculation, the fixed cost comprises various general, administrative and selling expenses, which are not influenced by the number of product that Tesca produces. The variable costs that have been considered while calculating the total cost are labor cost, cost of various parts of the refrigerator (including cost of compressor) and average warranty cost for five years on each refrigerator. Another cost considered is the net working capital that, as per the case, is equivalent to 15% of the annual sales (DeFond & Hung, 2003). Capital budgeting techniques for evaluating the project Capital budgeting is a process of long-term investment decision making, where a firm evaluates various financial projects from different perspectives in order to determine the most profitable one. There are a number of capital budgeting techniques that are implemented in an organization, which are discounted as well as non-discounted in nature. Presently in Tesca, the project that requires evaluation is whether or not the organization should start manufacturing refrigerators. For this purpose, the project has been evaluated using net present value method, internal rate of return method, profitability index and payback period method (Bierman Jr & Smidt, 2012). Table 6 (Source: author’s creation) The net present value method is a discounted cash flow technique, where the firm will evaluate all its present cash flows as well as its future cash flows for the purpose of considering the time value of money. In this project, apart from the initial investment, it was observed that continuous inflow as well as outflow of fund has taken place. So, while calculating the net present value, only the net inflow has been taken into account. In this context, it is important to note that the cash flows are forecasted and not actually earned, which is why inflation rate has not been applied. It was calculated that at the weighted average cost of capital as discounting rate, the net present value of the project is positive. As per the acceptance rule of NPV, a project should be accepted if it has value exceeding zero. Hence, on basis of NPV method, the project should be accepted (Bierman Jr & Smidt, 2012; Tirole, 2010). A number of companies employ the internal rate of return method as well, when the investment is high and the management is not satisfied with the NPV method. The IRR denotes the minimum amount of positive return that the company must earn from a project for continuing the same. In financial terms, the IRR is calculated at the point, where the NPV of the project is zero. Another important factor that needs due consideration is while evaluating a project from IRR perspective, the internal rate should be higher than the discount rate. The IRR for the refrigerator project has been calculated using the concept of NPV being zero. It was observed that internal rate of return of the project is 30.27%, which is higher than the discount rate as well. Hence, Tesca can accept the project. The profitability index is also known as profit investment ratio. It helps in ranking projects in terms of their profitability. The acceptance criterion of profitability index is the ratio of net inflow and initial outlay should be more than 1. In the proposed project of Tesca, the profitability index is 10, which is comparatively high given the general standards. Consequently, the project can be accepted. The payback period denotes the time period within which the net inflow should be able to recover the initial outlay or investment made in a project. In the refrigerator project of Tesca, it was observed that the initial inflow was negative; however, high inflow was witnessed in the following years and overall, the initial project cost was recovered in 1.55 years (Martin, Petty & Scott, 2002). Scenario and sensitivity analysis Scenario analysis is the process of determining the way in which NPV is affected under different cash flow scenarios. In the current paper, three such scenarios have been considered, namely weak, average and strong; weak being the worst case and strong being the best case scenario. At this point, it important to note that although these scenarios are not exactly probable, it is possible for the firm to face them. With respect to Tesca, the sensitivity of NPV will be evaluated in relation with cost of both models of compressors and the scenario will be analyzed for 3 years. Table 7 (Source: Author’s Creation) In the sensitivity analysis, two different costs of the refrigerator have been calculated as that of both the compressors is significantly different. The other costs included in the total cost are labor cost, parts cost and insurance costs. Two assumptions made in this section are; firstly, the insurance cost has been considered as $75/ year for five years and insurance cost of respective compressors has not been taken in consideration. Secondly, it has been assumed that the parts cost is exclusive of the cost of compressor. However, in other questions, due to absence of sufficient information, it has been assumed that the parts cost include that of the compressor. It was observed that the change in cost of compressor has significant impact on sensitivity of the NPV as for compressor model CM-004, the value is comparatively less. It is a generally notion that if NVP exhibits high volatility with respect to the specific variable, then the forecasting risk associated with the particular variable, in this case cost of compressor, will increase significantly. The sensitivity analysis shows that the NPV is not highly volatile, given different costs of compressor (Saltelli, Chan & Scott, 2000). Overall riskiness of the project Sensitivity and scenario analysis are very common measures of risk assessment with respect to a particular project. The given project at Tesca involves long-term investment as well as a new venture for the company. Hence, it is important to evaluate potentials of the project from different aspects. The sensitivity analysis measures the impact of different variables on viability of the project, in this case, on its net present value. Compressor is an important component of the refrigerator and is available at different costs and in different quality. The dilemma that has been faced by the management is whether to install low cost compressor with high maintenance or otherwise. The sensitivity analysis was primarily conducted with the aim to determine impact of the cost of two different compressors on NPV of the project. The analysis was conducted for three years and it was observed that the NPV did not exhibit extreme variability in context of the two components. The primary deduction made from this observation is that the volatility of NPV of the project is low, which is why the forecasting risks associated with the project are comparatively low. In addition, the scenario under which the sensitivity analysis was conducted was assumed to be the base or average one with a probability of 45% chances of occurrence. Another important deduction that was realized from the sensitivity analysis is that since little variability in NPV was observed, the company can easily switch to the better compressor (Ross, Westerfield & Jordan, 2008; Saltelli, Chan & Scott, 2000). Recommendations regarding the project Based on the facts available in the case and the analyses conducted in the paper, it can be recommended to Tesca that the project is acceptable. Given the life span of the project of 20 years, there are certain risks associated with product quality, demand and profitability; but these constraints are manageable and can be controlled by the firm. The primary factor that the company needs to focus upon is to create a product that is energy efficient. Given the increasing cost of energy in California and other states of the US and the environmental consequences of excessive consumption of energy, energy efficient products are facing high demand in the market. Additionally, the company will also enjoy reduced production cost on implementing sustainability in its product. The second factor that the organization need to focus upon is that between two models of compressors, the best selection will be the one that reduces overall cost and not substantial cost. During the warranty cost analysis, it was observed that CM-004 is a better model with reduced overall cost. The company should install this compressor as it will provide better service over the years. In addition, the same was supported by sensitivity analysis of the project. Another important recommendation is that while forecasting its cost, Tesca should consider the three pre-mentioned scenarios and not merely one, so that the project is neither overvalued nor undervalued. 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The capital asset pricing model. The Journal of Economic Perspectives, 18(3), 3-24. Ross, S. A., Westerfield, R., & Jordan, B. D. (2008). Fundamentals of corporate finance. New York: Tata McGraw-Hill Education. Saltelli, A., Chan, K. & Scott, E. M. (2000). Sensitivity analysis (Vol. 134). New York: Wiley. Tirole, J. (2010). The theory of corporate finance. Princeton: Princeton University Press. Yeh, R. H. & Lo, H. C. (2001). Optimal preventive-maintenance warranty policy for repairable products. European Journal of Operational Research, 134(1), 59-69. Read More