Scenario And Assignment Details On Elon Motors Producing Ele
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 that manufacturing their own batteries instead of purchasing them from their current vendor, Avari Battery Company, could lead to significant cost savings. Currently, the company pays $300 per battery, purchasing 2,500 batteries annually, with expectations to maintain this volume over the next ten years. To produce batteries internally, Elon Motors would need to invest in specialized equipment costing $1,670,000, which has a useful life of ten years and an estimated salvage value of $99,700. The company aims to evaluate the financial viability of this investment by calculating key financial metrics, including annual cash flows, payback period, accounting rate of return, net present value, internal rate of return, and modified internal rate of return.
Paper For Above instruction
Introduction
Elon Motors, a prominent manufacturer of electric vehicles, is contemplating a strategic shift in its production process to enhance profitability by manufacturing its own batteries. Currently, the company purchases batteries from a third-party vendor, incurring a cost of $300 per unit, and purchases 2,500 batteries annually. The proposal involves significant capital investment in specialized equipment, which necessitates a comprehensive financial analysis to determine whether the investment would yield adequate returns over its expected lifespan. This paper assesses the expected cash flows and evaluates the feasibility of this proposal using various investment appraisal techniques.
Analysis of Investment and Cost Structures
The core of the proposal involves the purchase and installation of a specialized manufacturing machine costing $1,670,000. This equipment has a useful life of ten years, with an expected salvage value of $99,700 at the end of this period. Since the company expects to produce batteries consistently for ten years, the equipment’s depreciation will be calculated using the straight-line method, which spreads the cost evenly over its useful life, thereby affecting the annual accounting figures.
Cost Savings from In-house Production
The primary motivation behind this investment stems from the anticipated reduction in costs associated with battery production. The current expense paid to the supplier is $300 per battery, amounting to annual expenditures of $750,000 (2,500 batteries x $300). By manufacturing the batteries internally, the direct material cost is estimated at $100 per unit, which substantially lowers production costs.
Additional costs include labor, benefits, and manufacturing overheads. Operations would require hiring two production workers, each earning $25 per hour, working 2,080 hours annually. Total annual wages for these workers would be $104,000 (2 workers x $25/hour x 2,080 hours). Inclusion of health benefits at 20% of wages adds an annual benefit expense of $20,800, bringing total labor costs to $124,800 annually.
Variable manufacturing overhead costs are projected at $20 per unit, amounting to $50,000 annually (2,500 units x $20). Therefore, the total variable manufacturing costs per battery would be $120 ($100 materials + $20 overhead). This cost structure results in total annual variable costs of $300,000 (2,500 units x $120).
Financial Analysis
The economic evaluation involves calculating the expected annual cash flows, considering the savings in purchase costs against the costs of production. The key steps include computing the depreciation expense, operational cash flows, and investment recovery metrics such as payback period, accounting rate of return, net present value, internal rate of return, and modified internal rate of return.
Annual Cash Flows
The annual savings from producing batteries internally can be calculated by comparing the current expenditure with the expected costs of manufacturing in-house. The savings per unit are the difference between current purchase cost and production cost: $300 - $120 = $180.
Total annual savings, therefore, would be $180 per battery times 2,500 batteries, equating to $450,000. Since manufacturing in-house involves fixed costs and depreciation, these should be deducted to determine net cash flows.
Depreciation Expense
Using straight-line depreciation, the annual depreciation expense is calculated as:
\[
\text{Depreciation} = \frac{\text{Cost of Equipment} - \text{Salvage Value}}{\text{Useful Life}} = \frac{1,670,000 - 99,700}{10} = 157,030
\]
The depreciation monthly reduces taxable income and affects after-tax cash flows, but since we are calculating cash flows, depreciation adds back to net income for cash flow purposes.
Operational Cash Flows
The total annual incremental cash flow from the project, before taxes, is derived from the savings less depreciation (tax shield), continuous operational costs, and taxes.
Calculations of taxes and after-tax savings involve considering the 21% tax rate:
\[
\text{Tax shield} = \text{Depreciation} \times \text{Tax rate} = 157,030 \times 0.21 = 32,996
\]
Operational cash flow before tax:
\[
\text{Savings} - \text{Variable costs} = 450,000
\]
Considering taxes on savings:
\[
\text{Tax on operational savings} = (450,000 - \text{Tax shield}) \times 0.21
\]
But since depreciation is tax-deductible, the net operating cash flow after taxes, including the tax shield, is:
\[
\text{Net cash flow} = (\text{Savings} - \text{Depreciation}) \times (1 - \text{Tax rate}) + \text{Depreciation}
\]
Plugging in the figures:
\[
= (450,000 - 157,030) \times 0.79 + 157,030 = 293,208.70 + 157,030 = 450,238.70
\]
Thus, the annual net cash inflow is approximately $450,239.
Payback Period
The payback period is the time it takes for the initial investment to be recovered from cash inflows and is calculated as:
\[
\text{Payback period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflows}} = \frac{1,670,000}{450,239} \approx 3.71 \text{ years}
\]
Accounting Rate of Return (ARR)
The ARR evaluates profitability based on average annual accounting profit relative to initial investment. Assuming the depreciation expense approximates annual accounting profit:
\[
\text{ARR} = \frac{\text{Average Annual Profit}}{\text{Initial Investment}} \times 100\%
\]
Calculating average annual profit as operating savings less depreciation:
\[
= \frac{(450,000 - 157,030) \times (1 - 0.21)}{1} \approx 293,208.70 \times 0.79 \approx 231,902
\]
Therefore:
\[
\text{ARR} = \frac{231,902}{1,670,000} \times 100\% \approx 13.9\%
\]
Net Present Value (NPV)
NPV assesses the difference between the present value of cash inflows and outflows, discounting future cash flows at the company's hurdle rate of 12%. The present value of inflows over ten years, considering a constant annual cash flow of approximately $450,239, is:
\[
NPV = \left( \sum_{t=1}^{10} \frac{CF}{(1 + r)^t} \right) + \frac{\text{Salvage Value}}{(1 + r)^{10}} - \text{Initial Investment}
\]
Using standard annuity formulas or financial calculator, with an annual cash flow of $450,239 and discount rate of 12%, the present value (PV) of these cash flows is:
\[
PV = 450,239 \times \left( \frac{1 - (1 + 0.12)^{-10}}{0.12} \right) \approx 450,239 \times 6.7101 \approx 3,020,543
\]
Present value of salvage value:
\[
SV_{PV} = \frac{99,700}{(1 + 0.12)^{10}} \approx \frac{99,700}{3.105} \approx 32,125
\]
Finally, NPV:
\[
NPV = 3,020,543 + 32,125 - 1,670,000 = 1,382,668
\]
Since NPV is positive, the project is financially attractive.
Internal Rate of Return (IRR)
IRR is the discount rate that makes the NPV zero. Based on the above cash flows, the IRR can be approximated through financial software or iterative testing, but given the high positive NPV at 12%, IRR is significantly higher, estimated around 35%-40%.
Modified Internal Rate of Return (MIRR)
MIRR considers both the cost of capital and the reinvestment rate. Assuming the reinvestment rate equals the hurdle rate of 12%, and financing costs are incorporated, MIRR is computed as:
\[
MIRR = \left( \frac{\text{Terminal value of inflows}}{\text{Present value of outflows}} \right)^{1/n} - 1
\]
Given the cash flows are stable and positive, MIRR would also be above the hurdle rate, approximating 30%-35%.
Conclusion
The comprehensive financial analysis indicates that the investment to produce batteries internally offers significant benefits. The payback period of approximately 3.7 years demonstrates a relatively quick recovery of initial investment. The ARR of nearly 14% exceeds typical managerial thresholds, and the high positive NPV confirms the project's profitability. The IRR, estimated well above the company's Hurdle rate of 12%, further supports proceeding with the investment. Therefore, Elon Motors should consider moving forward with the plan to produce batteries in-house, as it promises substantial long-term financial gains, aligns with cost-reduction goals, and optimizes resource utilization over the equipment's lifecycle.
References
- Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory & Practice (15th ed.). Cengage Learning.
- Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2021). Fundamentals of Corporate Finance (12th ed.). McGraw-Hill Education.
- Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2020). Managerial Accounting (8th ed.). McGraw Hill.
- Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). Wiley Finance.
- Higgins, R. C. (2018). Analysis for Financial Management (11th ed.). McGraw-Hill Education.
- Gitman, L. J., & Zutter, C. J. (2019). Principles of Managerial Finance (8th ed.). Pearson.
- Padachi, K., & Ramdhani, A. (2006). Financial Performance of Small and Medium Enterprises: Evidence from Mauritius. Journal of Business & Economics Research, 4(1), 47-56.
- Park, C. W. (2020). Strategic Financial Management. Routledge.
- Ross, S., & Westerfield, R. (2020). Corporate Finance. McGraw-Hill Education.
- Palepu, K., & Healy, P. (2018). Business Analysis & Valuation: Using Financial Statements (6th ed.). Cengage Learning.