You have taken a job with Afford Motor Company. The CEO, Kit Carson, has propose

Question

You have taken a job with Afford Motor Company. The CEO, Kit Carson, has proposed that Afford Motors develop, manufacture, and sell an electric car that she claims will present a great business opportunity for Afford Motors and save the environment from global warming.

After investigating numerous prototypes, you and your project team have determined that there are two cars that should be seriously considered: Model A and Model B. Characteristics of these two prototypes are indicated in the table below:

The market research department has estimated that number of electric cars demanded will be a function of the future price of gasoline as well as the car's characteristics. To forecast the future price of gas, you hired Sandy Shores, a well-known professor and consultant in the Puget Sound region.   Sandy estimates that the future price of gas (relative to today's prices) could be falling with a probability of 0.3, stable with a probability of 0.45, or rising with a probability of 0.25.   Her estimates of annual sales (in number of cars) as a function of changing gas price levels is indicated in the table below:

Model A is based on a currently available technology; as a result, senior managers feel confident that it could be ready for sales in one year if you commit the R&D/tooling immediately. On the other hand, Model B is based on newer technologies that have been developed but not thoroughly tested; as a result, Model B would require two years of development and tooling before it would be ready for the market. If you decide to proceed with Model B, however, you would only need to commit 50 percent of the development and tooling costs at this time (the remainder would be required after one year). Experts in the automotive industry feel that Model A would have an expected life span of nine years but Model B (since its introduction would be later than the introduction of Model A) would only have an eight year life span.

The CEO has said that Afford Motors can undertake the development of at most one electric car as the company lacks sufficient resources to develop both models and he is reluctant to accept bailout money from the US government (with accompanying restrictions on his bonuses).   Kit also indicated that Afford will market these cars directly to individual consumers (assume that cars sell at their MSRP). Carson feels that a discount rate of twelve percent is appropriate for these potential projects based on his estimate of the Afford Motor weighted average cost of capital (WACC).

You must make a decision shortly on whether or not to proceed with either (or neither) of the two electric car models.

a) Based on Afford's expected (discounted) profit over the forecasted life of the electric cars, what would you recommend? Should Afford proceed with the development of Model A, Model B, or neither? Support your answer….

b) The economist, Sandy Shores, has told you that she will be able to determine (with certainty) after one year the price trend of gas for the next nine years (before you would have to commit to the second half of Model B's development and tooling cost if you had started the development of Model B this year). Does this affect your decision? If so, how and why?

Explanation / Answer

A) Statement Showing Profitability for each Model Particulars Model A Model B 1 MSRP 17 500 26 000 2 Average Variable Cost 5 000 7 600 3 Earning before charging Fixed Cost(R&D)(1-2) 12 500 18 400 4 Estimated Sales (Working Note-1) 1 525    531 5 Discounting Factor (Working Note-2)    5.32825    4.43539 6 Gross Earning(4*5) 101 569 762 43 355 963 7 R&D & Tooling Cost For Model A, this cost committed very first year 100 000 000 For Model B, 50% this year & next 50% next year, so total present value for the first year (70000000+55803571) 125 803 571 8 Net Profit (6-7) 101 569 762 43 355 963 Working Note-1 Estimated Sales under each probability Price of Gas (a)Probability (b) Sales of Model A (c) Sales of Model B Estimated sales of Model A (a*b) Estimated sales of Model B (a*c) Falling 0.3 1000 700 300 90 Stable 0.45 1500 1600 675 303.75 Rising 0.25 2200 1750 550 137.5 Estimated Sales(per year) 1525 531.25 Working Note-2 Discounting Factor Year Model A Model B 1 1.12 0.892857 2 1.12 0.797194 0.797194 3 1.12 0.71178 0.71178 4 1.12 0.635518 0.635518 5 1.12 0.567427 0.567427 6 1.12 0.506631 0.506631 7 1.12 0.452349 0.452349 8 1.12 0.403883 0.403883 9 1.12 0.36061 0.36061 Total 5.32825 4.435393 As per Profitability Statement, Model A should be produced as it gives net profit after all fixed cost. So, Model A should be produced eventhough earning per unit of Model B is higher than Model B. (B) If The economist, Sandy Shores, has told that she will be able to determine (with certainty) after one year the price trend of gas for the next nine years (before you would have to commit to the second half of Model B's development and tooling cost if you had started the development of Model B this year), then the estimation sales figure would change and will require to recalculate the exact sales figures & profitability for decision making.

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