# Managing Financial Resources Essay

## Managing Financial Resources

SUMMARY RESULTS AND RECOMMENDATIONS

The proposed refrigerator manufacturing and sales project for Tesca Works, Inc. is a financially complicated project which on the surface, given the increase in energy costs and customer demand may seem like a winning proposition. However, when we delve further into the details of the financial projections along with projections of the future of the refrigerator market we are able to make a confident recommendation to Mr. Burton and the executive staff at Tesca Works, Inc. Using the information provided by the Tesca team we were able to create a comprehensive capital budget and cash flow analysis for the proposed refrigerator project.

Through our analysis we found that the cost of capital of the project to be 13.487% and a Weighted Average Cost of Capital (WACC) to be at a value of 9.70%. Factoring in the WACC into our projections we found that if the demand maintains at an average rate the project will be at a positive Net Present Value of $5,997,505.31 with an IRR of 13.21%, a profitability index of 8.84, and an approximate payback period of 6.84 years. Please see Exhibits below for a snapshot of the capital budget and NPV values.

This information seemed to be very promising for the project in general. However, our continued analysis showed the project to be very sensitive to the sales price per unit of the refrigerator. We used the average demand scenario to produce a sensitivity analysis and found that with just a 5% decrease in the sales price of the refrigerator the NPV quickly dipped into a negative value thus showing the project to be extremely sensitive to the sales price of the refrigerator.

Our scenario analysis also exposed a strong probability of the project giving a negative Net Present Value and giving a probable low Internal Rate of Return of only 4.01%. This is mainly due to the projects sensitivity to the sales price of the refrigerator and the potentially lower sales in the event of weak demand for the product.

Because of the high probability for a very low IRR and negative NPV we are recommending that the project be rejected. The information we have uncovered through detailed financial analysis showed that the project is far too sensitive to lower demand and lower sales prices per unit. This is especially true for a lower sales price for the refrigerator. We found that even a small decrease in the sales price of just over 1% would cause the project’s NPV to become negative, even with an average unit sales demand. There may be potential for an average or strong demand in the marketplace, however there is too much risk to recommend project acceptance. A decision to move forward with the project would be mainly based on a ‘gut-feeling’ rather than on sound financial reasoning. Thus it is our official recommendation that Tesca Works, Inc. reject the project.

1) IMPORTANCE OF ENERGY COST SITUATION

The question of energy cost being a factor of the decision to move forward with this project is of critical importance. This is because whether or not consumers are inspired to purchase a new appliance may be spurred by increases in energy costs as well as possible tax benefits or rebates from power generating companies. Some consumers may be aware of the benefits of energy efficient appliances which may cause an increase in the normal demand for refrigerators. Tesca is in a unique position to be able to offer high efficiency refrigerators to the United States public at a time when the public is looking to reduce their use of electricity and other utility costs. When we look at the graph above it can be seen that the cost of electricity has steadily increased over the last 10 years. The price per kilowatt hour has increased almost 50% in 10 years (EIA, 2014).

Thus to the consumer the price of energy is a big concern and the costs will most likely continue into the future. There is potential for an increased demand to replace aging inefficient appliances that are causing increased electrical bills for consumers. The energy cost and potential benefits to the consumer are of importance when determining the future of this project. The project is forecast to be of a positive value if the demand for refrigerators is at an average or strong demand from consumers. However, the realization of a high or average demand is mainly based on ‘gut-feeling’ rather than on sound financial information. There are too many variables in the marketplace that could cause demand to be weaker than projected. Such variables as a weak economy or recession could cause sales to drop which in turn would cause the project to lose its value quickly.

2) What is the project’s cost of equity? What is the appropriate discount factor to use for evaluating the refrigerator project?

As seen in Exhibit I below, the project’s cost of equity (COE) is calculated to be 13.487%. We found this value by using the Capital Asset Pricing Model (CAPM) formula by adding the treasury note yield with the beta value, then taking the market return rate and subtracting the treasury note yield. We then multiply those values together to attain the cost of equity value of 13.487%. This means there is a rate of return on investment of 13.487%.

The Beta for Tesca Works, Inc. is fairly consistent with their competition. Tesca’s beta value is at 1.3 which means that Tesca’s value has been more volatile than the market. While this means there is more risk when investing in Tesca there is also a greater possibility for higher rates of return.

Exhibit I also shows the table used to calculate the Weighted Average Cost of Capital (WACC) or discount factor which we used to evaluate this particular project. We used the following formula to calculate the WACC for this project. We know that the higher the weighted average cost of capital the less likely it is that Tesca will be creating value for its investors. The WACC helps us to determine if a company is creating value and presents the minimum return to satisfy investors and creditors.

3) Which of the two compressors should be used in the refrigerator if you decide to go ahead with the project and why?

As seen in Exhibit II we determined that the CM-004 compressor should be used for this particular project. We came to this conclusion by finding the present value of the five year compressor warranty and adding that to the cost of the compressor. We used the weighted average cost of capital as the rate in our present value calculations.

While the TS-L12 has a less expensive purchase price it has a more expensive warranty cost for the five year warranty period thus making it a more expensive overall compressor. When we use the present value calculations on both compressors, factoring in the warranty, we found that the present value of the CM-004 is $18.21 less expensive than the TS-L12 compressor. This makes the CM-004 compressor 4% less expensive to purchase for the warranty life of the compressor.

It was important to take calculate the present values of both compressors to get an accurate comparison of the costs of the two compressors for the five year warranty costs of each compressor. While on the surface the TS-L12 may have seemed less expensive the overall cost in present dollars was higher when we factored in the value of the five year warranty on both compressors.

4) Forecast the project’s cash flows for the next twenty years. What assumptions did you use?

Once we selected the appropriate compressor to use we were able to plug in certain input values into our equations to create a cash flow projection for the entire project lifetime. We used the weighted average cost of capital value found in our earlier calculations as one of our input values. We also found the present value of the refrigerator, see Exhibit IV, by using the input values given in the financial information from Tesca such as the labor, parts, and compressor costs. We found the cost of the refrigerator to be $1,269.36, see

Exhibit III. ASSUMPTIONS MADE:

Certain assumptions were made when calculating the projected cash flows for the refrigerator project. We assumed inflation would remain at 2.5% and used that value to increase the sales price, variable cost, and administrative fixed costs each year. Please see Exhibit IV for a breakdown of the inputs used for the cash flow projections. This allowed us to gain a more a more realistic forecast of the project’s potential cash flows for the entire project. We also used the average demand as our base projections for the project. This is because the average demand scenario has the highest probability of 45%.

We used straight-line depreciation with regard to depreciating the investment in the project over time. We detailed the first three years of the project, years zero through two with the appropriate investment amounts during each of those years. Since production and sales did not begin until year three we were able to make an assumption of potential tax returns on the invested dollars for years one and two. We used the tax rate of 25% to calculate the tax returns along with the taxable amounts for all years. See the attached spreadsheet for the detailed cash flow projections. We also assumed that since the refrigerators could be produced for a total of 20 years the entire life of the project would span from year zero through year 22. This is because the production of the refrigerators could not begin until year three, thus making the projects timeline from year zero through year 22.

With this information and assumptions we found that when the units are in production and being sold the project will yield a positive annual cash flow. The working capital was found by taking the 11% and carrying it over for each year. We used the initial Net Operating Working Capital (NOWC) found in year two then calculated the difference using 11% of the difference of the sales each year and calculated that for the entire life of the production.

5) Use the appropriate capital budgeting techniques to evaluate the project.

As seen in Exhibit V we used the appropriate capital budgeting and performance measures to evaluate the life of the project. Exhibit VI displays the results of the capital budgeting analysis. We found the NPV for the average demand scenario to be $5,997,505.31 which is a positive value for the project given the average demand inputs. The Internal Rate of Return was calculated as 13.21% which, again, is a positive value and could provide for a nice rate of return on the project since it is higher than the weighted average cost of capital and the market return rate.

The profitability index was found to be at a value of 8.84. Because the profitability index is higher than 1.0 that shows that the project present value is greater than the initial investments in the project. We then calculated the number of years for a payback on the initial investments in the project. We found that the simple payback of the initial investments would take 6.48 years for the average demand scenario.

In simple terms, and if we only used the average demand assumptions, this project would seem to provide positive net results for Tesca. Using the average demand inputs the NPV, IRR, Profitability Index, and Payback Years are at an acceptable level. However, as we will cover in later sections, when we include probability analysis of the other demand scenarios we find that the project is less than desirable.

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. We used the average demand scenario to produce a comprehensive sensitivity analysis of the project. We utilized three variables when conducting our sensitivity analysis, the sale price of the refrigerator, the cost of the

compressor, and the project’s weighted average cost of capital. We included the weighted average cost of capital as an extra variable to get further details on the sensitivity of the project.

We used a scale of 5% increments from -25% to 25% which allowed us to produce a sensitivity analysis with adequate details. Please see Exhibits VIII and IX for the numerical details and sensitivity graph for the project.

The sensitivity analysis uncovered the following critical information with respect to how sensitive the NPV of the project was to the given variables.

Sales Price Sensitivity

We found that even a small decrease in the sales price of the refrigerator of just over 1% caused the project’s NPV to become negative. The graph in Exhibit IX shows the steep sensitivity line with respect to the change in the sales price per unit. Even with an average sales demand, if the price dropped to 15% which is approximately the same sale price of our weak demand scenario the NPV was substantially below zero at a negative value of $-57,667,920. With each 5% increment the NPV values sometimes increased or decreased at a rate that doubled or more because of the projects extreme sensitivity to the sales price of the refrigerator. The profit margin on the refrigerator of 19.41% and markup of only 24% does not leave much room for a price reduction in the sales price of the refrigerator. The data also points to a wide range in NPV with respect to the sales price of the units. There was a total range of over $212 million for the sensitivity of the sales price per unit. This data leads to the discovery that the project is extremely sensitive to the sales price of the refrigerator.

Compressor Cost Sensitivity

The project was not as sensitive to the cost of the compressor, however, it did not take a large percentage increase in the cost of the compressor to throw the NPV of the project into a negative value, just over 5%. Exhibit IX’s graph shows the sensitivity lines for the project. The compressor sensitivity is not nearly as steep as the price sensitivity per unit. Because the cost of the compressor affects the profit margin on each refrigerator the lower the cost of the compressor the better the NPV because of the increased profit margin per unit.

7) Based on the scenario and sensitivity analysis you performed above, comment on the overall riskiness of the project.

Based on the scenario and sensitivity analysis we were able to determine that the project is of a high risk nature. There are several factors that make this project such a high risk which include the narrow profit margin per unit, the uncertainty of the future market, the high cost per unit, and the high administrative costs.

Through a scenario analysis we analyzed the three potential demand scenarios for this project. We used the weak, strong, and average demand scenario variables to formulate the probabilities for the project. We found that the probability of the NPV is a significant negative value of $-6,300,213, see Exhibit VII for details of the scenario analysis. We also found that the probable IRR of the project was very low at 4.01%. Given the low IRR probability of 4.01% that means it is significantly lower than the S&P 500 market return of 11% and barely a point higher than the 10-year treasury note yield of 2.71%. The low probable internal rate of return is another red flag for the riskiness and viability of the refrigerator project for Tesca Works, Inc.

The weak demand scenario produced significant negative values for the NPV and the internal rate of return (IRR). The weak scenario also produced a non-existent payback period within the 20 year production lifecycle of the project. With each scenario the selling price and unit sales were changed, however, the high cost of each unit and administrative costs remained the same, thus adding to the risk of the project since it is highly reliant on an average or strong demand and higher sales prices per unit.

While the project has the potential of a very high NPV, IRR, and payback period with a strong demand, the projects sensitivity to price and market demand make this a very risky project to undertake at this time. If there were ways to increase the profit margin or decrease the fixed costs of the project that may help decrease the risky nature of this particular project.

8) Would you recommend that Tesca Works accept or reject the project? What is the basis for your recommendation?

We would not recommend this project for Tesca Works, Inc. Our recommendation is for Tesca management to reject the project. Our analysis has shown this project to be too sensitive to market shift and too risky to undertake at this time. While there is excitement across the country for more energy efficient appliances, we feel that the project poses some significant risks for Tesca. The successful outcome of the project truly relies on the demand from consumers. Their demand will determine the selling price and sales volume of the refrigerator units. If this demand is barely below the average demand we will see a negative NPV for the project and thus a negative result for Tesca Works, Inc. Recent economic history in the United States has shown the economy to be unstable and may not provide an average or strong demand for the product. While we feel the energy costs across the country could be of significant importance for a project of this nature we do not feel that there is enough leeway in the profit margin of the project to be economically feasible should demand be lower than anticipated.

Our analysis showed the project to be very sensitive to the sales price per unit value of the refrigerator. We used the average demand scenario to produce a sensitivity analysis and found that with just a 5% decrease in the sales price of the refrigerator the NPV quickly dipped into a negative value thus showing the project to be extremely sensitive to the sales price of the refrigerator.

Our scenario analysis also exposed a strong probability of the project giving a negative Net Present Value and giving a probable low Internal Rate of Return of only 4.01%. This is mainly due to the projects sensitivity to the sales price of the refrigerator and the potentially lower sales in the event of weak demand for the product.

The project’s profit margin is too close to allow for market demand fluctuations which would cause the project to have a negative net present value. If Tesca were to offer the refrigerator at a higher sales price this would yield a stronger profit margin and may alter the recommended rejection of this project. As we discussed the project is far too sensitive to changes in the sales price of the refrigerators. Even with an average demand of sales volume, if we reduce the sales price we begin to see a negative NPV for the project. Thus, the project is too sensitive to minor changes in the profit margin of the refrigerators. Which is why we are recommending a rejection of this project for Tesca Works, Inc.