Scenario And Assignment Details Elon Motors Produces Electri

Scenario And Assignment Detailselon Motors Produces Electric Automobil

Scenario and Assignment Details Elon Motors produces electric automobiles. In recent years, they have been making all components of the cars, excluding the batteries for each vehicle. The company's leadership team has been considering ways to reduce the cost of producing its cars. They believe Elon Motors could cut costs if it produces the car batteries internally instead of purchasing from its current supplier, Avari Battery Company. Currently, the cost per battery from the vendor is $325. Elon Motors thinks that manufacturing batteries might significantly reduce costs, but it would require purchasing specialized equipment. The equipment costs $1,570,000 with a salvage value of $70,000 and a useful life of 10 years. The company currently purchases 3,000 batteries annually and expects this volume to remain consistent over the next decade. Relevant data for the project includes the purchase of direct materials at $125 per battery, employment of three workers each earning $25 per hour with health benefits equating to 20% of wages, variable manufacturing overhead costs of $25 per unit, and no additional fixed costs due to unused space. The company’s cost of capital is 10%, and the tax rate is 30%. The equipment will be depreciated straight-line over 10 years.

Paper For Above instruction

Introduction

Elon Motors is contemplating a strategic shift in its manufacturing process by producing its own car batteries in-house, instead of outsourcing. This decision is driven by the potential to reduce production costs significantly and improve profitability. The analysis of this investment involves evaluating the financial viability and impact over the equipment's lifespan, using various capital budgeting techniques such as payback period, accounting rate of return (ARR), net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR). This paper comprehensively explores these financial metrics based on the provided data, illustrating how Elon Motors can assess the project's feasibility.

Cost Analysis and Investment Details

The initial capital expenditure involves purchasing specialized battery manufacturing equipment costing $1,570,000, with an estimated salvage value of $70,000 after 10 years, implying a straight-line depreciation expense of $150,000 annually. The production volume is fixed at 3,000 batteries annually, with direct material costs at $125 per battery and variable manufacturing overhead costs of $25 per unit. Employment costs are based on three workers earning $25 per hour for 2,080 hours annually, resulting in a gross wage expense of $156,000 per year, with additional health benefits amounting to 20% of wages ($31,200), totaling $187,200 annually.

Financial Analysis

1. Annual Cash Flows

The annual cash flows comprise the savings from not purchasing batteries externally, minus the operating costs and the depreciation expense, adjusted for tax impacts. Since the current purchase cost is $325 per battery, purchasing 3,000 batteries annually amounts to a total expenditure of $975,000. Producing in-house would incur direct material costs of $375,000, labor costs of approximately $187,200, manufacturing overhead of $75,000 (at $25 per unit), and annual depreciation of $150,000. The incremental annual operating cash flow considers tax savings from depreciation, direct cost savings, and the tax effect on operating expenses.

2. Payback Period

The payback period measures how long it takes for the initial investment to be recovered from the project's cash inflows. It is calculated by dividing the initial investment by the annual net cash inflow. Given the upfront cost and the annual cash savings, the payback period can be determined to assess liquidity and investment risk.

3. Accounting Rate of Return (ARR)

ARR evaluates the average annual accounting profit generated by the investment as a percentage of the initial investment. It considers depreciation and operational costs, providing insight into the project's profitability relative to the investment amount. The ARR threshold for decision-making can be benchmarked against the company's required rate of return.

4. Net Present Value (NPV)

NPV measures the total value created by the project by discounting all future cash flows to their present value using the company's hurdle rate of 10%. A positive NPV indicates the project’s potential to generate value beyond the required return, justifying the investment.

5. Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value of cash inflows with the initial investment, reflecting the project's expected rate of return. Comparing IRR with the company's hurdle rate indicates whether the project meets the desired profitability.

6. Modified Internal Rate of Return (MIRR)

MIRR adjusts for the reinvestment rate assumption and provides a more accurate measure of profitability. It considers the reinvestment of interim cash flows at the company's cost of capital, offering a realistic evaluation of the project's viability.

Conclusion

The decision to produce batteries internally involves a thorough financial analysis considering various metrics. If the NPV is positive, IRR exceeds the hurdle rate, and payback period aligns with management’s risk appetite, Elon Motors should proceed with the investment. The comprehensive evaluation ensures that strategic moves are financially sound, contributing to cost savings and competitive advantage.

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