Estimating Net Present Value
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General Auto (GA) Corporation is developing a new model of a compact hybrid car. This car is assumed to generate sales for the next five years. GA has gathered information about the following quantities through focus groups with the marketing and engineering departments.
Fixed cost of developing the car. This cost is assumed to be $1.4 billion. The fixed cost is incurred at the beginning of year 1, before any sales are recorded.
Margin per car
This is the unit selling price minus the variable cost of producing a car. GA assumes that in year 1, the margin will be $5,000. Every year afterwards, GA assumes the margin will decrease by 4%. This expected margin decrease is due to the fact that variable costs will tend to increase over the next 5 years, whereas the selling price is expected to remain fairly constant.
Sales
The demand for the car is the uncertain quantity. In its first year, GA assumes that the number of cars sold will be most likely around 150,000, in the worst case around 100,000 and in the best case around 170,000. Because of increasing competition in this auto market sector, the company assumes that the sales will decrease by some percentage each year as compared to the previous year, where this percentage is triangularly distributed with parameters 5%, 8% and 10%. GA assumes that the percentage decreases in successive years are independent of each other
Depreciation and taxes. The company will depreciate its development cost on a straight-line basis over the five years. The corporate tax rate is 40%. Assume that all the depreciation is tax-deductible in this case.
Discount rate
GA figures its cost of capital at 15%.
Estimate the NPV of the after-tax cash flows for this new car over the 5-year time horizon
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Solution Summary
This solution provides calculations for net present value of the after-tax cash flows.
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Given that,
Fixed cost $1,400,000,000
Margin in the first year $5,000
%decline in margin every year 4%
Sales
Most likely 150,000
Worst case 100,000
Best case 170,000
Average 140,000
Decline in sales
1st year 5%
2nd year 8%
3rd ...
Education
- MBA, Indian Institute of Finance
- Bsc, Madras University
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