Mike Burry, Felix Resources (FR)’s CFO, along with George Chen, Burry’s assistant, and Tony Martinez, a consultant and college finance professor, comprise a team set up to teach FR’s directors and senior managers the basics of international financial management. The program includes 16 sessions, each lasting about two hours, which are held immediately before the monthly board meetings. Ten sessions have been held, and they have included studies of exchange rates, risk analysis, financial statements, bond valuation, stock valuation, and the cost of capital. The team is now preparing Session 11, which will deal with the basics of capital budgeting. The next session will extend the discussion of capital budgeting to formal procedures dealing with risk.
The introductory capital budgeting session will focus on two main points: (1) The different criteria that are used to evaluate proposed capital expenditures and (2) identifying the cash flows that are relevant in capital budgeting decisions. The team decided that the session would be most productive if they analyze an actual decision that FR now faces: whether or not to produce a new heatsensing device that would be used by airlines to determine if passengers are too sick to be allowed on flights. After the SARS epidemic in 2003, airlines are very much interested in such capabilities in order to protect other passengers and thus to convince the flying public that airline travel is safe. The project has been dubbed HSD, for heat-sensing device, in internal discussions, and Burry is quite sure the directors will be interested in analyzing it in detail.
The devices will be sold to airlines all over the world, and they are small enough to be transported economically by airfreight. Therefore, they can be manufactured anywhere, in the United States or overseas. Other things held constant, FR favors basing its operations in the United States, but if a project would be more profitable based elsewhere, then management will not hesitate to locate a facility overseas. For the HSD project, the most promising overseas location is northern Italy. FR has several facilities in the Milan area, and the labor force in northern Italy is highly skilled, which is important for a high-tech product such as HSD. Italy also has the advantages of a relatively stable government, operating in the euro zone, and no significant repatriation problems. Therefore, Burry wants to evaluate the project in Italy. He has stressed to his global management team to look at issues from all angles and, therefore, wants the project analyzed from the project perspective, parent perspective, and the country perspective. Burry has instructed FR’s staff to use a risk adjustment of 1.5 percent above its WACC, since the project is being carried out in Italy. That assessment may change later.
FR has a capital budgeting model that is used to analyze all proposed projects, with modifications made to accommodate specific situations. The model is used to obtain the most-likely estimates of NPV, IRR, and payback for each location, and then it is run under alternative sets of assumptions to get an idea of the project’s riskiness. Burry, Chen, and Martinez plan to restrict their analysis in the upcoming session to the most-likely results and then, in the next session, go on to include risk analysis.
Table IC 11-1 shows the basic assumptions regarding the HSD project in Italy. There are several important things to note about the input data. Some of the directors have criticized the choice of Italy for this project. They cite labor costs that are similar to U.S. labor costs and far exceed labor costs if taken to the Far East or Latin America. Mike Burry has maintained that alternate locations, while cheaper, will not provide FR the skilled labor it requires for this project. In addition, he has noted that he has negotiated higher license and management fees with the Italian government than has been possible with any other nation. Also, required NOWC will be funded by a loan borrowed by the subsidiary from a local lender. Fixed assets will be depreciated using the straight-line method and are expected to be worth 15 percent above book value at the end of the project. And the project is expected to take away from a less-sophisticated security device FR is currently selling. That product is produced at a plant in the southeastern United States and the unit responsible has a profit margin of 6 percent.
In addition, Table IC11-2 was created to list the advantages as well as disadvantages this project brings to Italy. FR’s Business Development Team used these points listed in Table IC11-2 to negotiate with Italian government authorities. Note that this project would bring no disadvantages to Italy.
Chen stated that she thought it would be best to lead off with an explanation of the three capital budgeting criteria, using a simplified set of data. Burry and Martinez agreed, so they decided to use the following data for illustrative purposes:
Year (t) 0 1 2 3 4
Project S -$10,000 $8,000 $3,000 $1,000 $1,000
Project L -10,000 1,000 2,000 5,000 7,500
Also for illustrative purposes, they plan to assume a 10 percent cost of capital.
Chen, Burry, and Martinez then compiled the following set of questions, which they plan to discuss during the session. As with the other sessions, they plan to use an Excel model to answer the quantitative questions. Assume that you are George Chen, and that you must prepare answers for use during the session.
1. Now suppose Projects S and L are mutually exclusive. Which one, if either, should be accepted? Some of the directors are likely to ask for an explanation, so be prepared to explain why any conflicts arise, and why you might choose one project over the other. Graph the projects’ NPV profiles and use this graph in your explanation.
2. Given the data in Table IC11-1, find HSD’s annual euro free cash flows, and then calculate its NPV, IRR, and payback. On the basis of your project analysis, should the project be accepted if it is to be produced in Italy?
3. Suppose that a year ago FR performed a feasibility study for the HSD project. The cost of this study was $100,000, and it was expensed for tax purposes last year. Describe in words how this would be incorporated in your capital budgeting analysis.
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