If
you feel that there are important elements of this story that are missing,
you should first fill them in with your own (creative) assumptions. Be very
clear about these details. Then develop your proposal. Be specific with
respect to your recommended methodology, data requirements, and
approach.
The classic capital budgeting process has three steps: (1) identify the
relevant incremental cash flows for the project; (2) calculate a discount
rate, also called weighted average cost of capital, kwacc; and (3) calculate
the decision criteria: net present value (NPV), profitability index (PI),
internal rate of return (IRR), and payback period (PP).
For the hybrid cars, the first investment will likely be in property,
plant, and equipment (PPE) in order to produce the vehicles. This will be an expenditure that the
capital budgeting process needs to consider in how long it will take to
recoup the cash flow expended for the PPE.
However, the company may need to produce one or more prototypes before
diving into developing say a factory.
Prototypes are important because it will give the sales team a product
to pre-sale. This way the company can
start marketing the hybrids and hopefully take orders. This may increase accounts receivable as
another cash flow. Presales may also
be helpful in predicting yearly sales revenue.
We’re going to need to determine the operating costs next. Here, the size of the factory, staff,
location, and other relevant factors will be important. If the company wants to sell hybrids in the
North American Market, perhaps Mexico would be an ideal place to build the
plant/factory. This is a strategic
location where many other automotive companies have plants to service the
North American market. The operating
costs are lower in Mexico and the transportation expense to deliver the
vehicles to the sales and marketing locations is also lower than if the
hybrids were built in say the United States.
A discount rate is needed before you can perform the present value
calculations. Here we need to know if
the entrepreneur intends to borrow money or self fund the project. In the case where he or she wants to
borrow, the interest rate and income tax rate are involved in this
calculation. If this project is
self-funded, then we don’t need a coupon rate and can assume the normal
income tax rate. For the Cost of
Equity analysis, we’d calculate that as RISK-FREE-RATE + (BETA x RISK
PREMIUM). COE will be higher if the
project is self funded.
Finally, we’ll use the following four decision criteria: (1) Net Present
Value (NPV); (2) Profitability Index (PI), also called Benefit-Cost Ratio
(BCR); (3) Internal Rate of Return (IRR); and (4) Payback Period (PP).
For these projects, we’ll want a payback period of less than six years and
an IRR at 10%. It is hard to gage a
good NPV without making up the numbers, but we can accept zero because a zero
NPV means that the project rate of return equals the discount rate, the
discount rate. We’ll accept a PI of
1.0, the ratio of free cash flow to investment overlay. With these criteria we can analyze each
project for the revolutionary hybrid cars. |
