”

Tesca Works

Introduction

Michael Burton has recently been hired as the CEO of Tesca Works, Inc. Previously he had been the marketing manager
for a large manufacturing company and had established a reputation for
identifying new consumer trends. Tesca Works Inc. is a California-based
generator manufacturing company. The company is well known for manufacturing
large, heavy-duty generators at a reasonable cost. One of its greatest
achievements is that its generators can be easily modified or customized for
different applications. Also, Tesca Works currently builds commercial
appliances.

The
company is considering an expansion of its current product line to include
refrigerator and maybe, sometime in the future, consumer appliances. Mr. Burton
feels that due to high energy prices, consumers will be more willing to
consider purchasing new efficient appliances.

Tesca Works Inc. is a California-based
generator manufacturing company. The company is well known for its innovation
and ability to produce high quality products at a reasonable cost. One of its
greatest achievements is that its manufacturing processes are adaptable to
other durable goods. Also, Tesca Works currently builds commercial appliances.

Profile
of Tesca Works

Tesca Works, Inc. was established by the
Smith brothers in 1880 as the Logging Saw Company. The firm started
manufacturing large steam saws to serve the logging industry which processed
lumber. Their customers were construction companies that provided housing for the
population increase in California. The Smith brothers quickly realized that the
times were changing. They started looking for the technologies that would keep
them at the forefront of their field of business. In 1915, the Smith brothers
decided that they needed to make generators as replacements for the saws. They
realized that the logging industry was not viable anymore and that generators
were starting to serve the same purpose.

The
company started making generators in the early 1940s. Tesca Works then opted
to produce commercial appliances. It was an easy decision to make since the
commercial appliances would use common parts with the companys generators and
the customers were local hospitals, schools, and governments. Starting in the
1950s the commercial appliances business accounted for about 50% of Tesca
Works revenues.

The
refrigerator

Mr.
Burton arranged a meeting with the firms top management and the chief design
and the chief manufacturing engineers to propose a new product. Mr. Burton presented
an argument that more individuals in the United State and Canada would be
willing to purchase newer appliances because people are becoming more
environmentally conscious. The new appliances are more efficient and
environmentally friendly. Also,

2

the recent increase in electricity costs
seems to be long lasting. This is an opportunity to get people hooked on
environmentally friendly appliances as he put it.

The
proposal under consideration is for the introduction of a new, energy star
refrigerator. To distinguish Tesca Works from other manufacturers, the proposal
included details about the convenience, large shelves in the doors, high volume
water and ice dispensers, efficiency, and quietness of operation that need to
be developed.

Mr. Phillips and Mr. Lopez, the two
engineers, enthusiastically and quickly pointed out that the needed technology
could be based on the companys generators. The framework currently used for
building the generators can be modified to work for appliances at a low cost.
The marketing vice president, Mr. Chen, pointed out that the marketing analysis
could be done quickly and at a reasonable cost. At this point, Mr. Burton
charged the participants in the meeting to produce a financial plan for the
development and production of the refrigerator.

Consumer
Appliances

Most
people purchase appliances and keep them for a very long time or until they
stop working. Some get them when they purchase a home and do not think about
them.

Recently,
most power companies started educating people about the efficiency of new
appliances and began offering rebates on the most efficient consumer models.
These

3

approaches increased public interest.
This renewed the publics interest in low power-consuming appliances.

The
decision

Three
weeks later, the vice presidents presented the sales and cost forecasts shown
in the exhibits. The information presented contains the cost of production,
financing information, and warranty cost estimates. In addition, there were two
options for the compressor in the refrigerators. The MC 004 is more expensive
to install, but has a lower warranty cost. The TS L12 is cheaper to install,
but has a higher warranty cost. Which compressor should be used?

The
analysis

Mr. Burton noticed that there is an
abundance of enthusiasm about entering the refrigerator building business, but
his cautious nature made him seek a more neutral analyst. This is your
responsibility. You have been hired by Tesca Works to analyze the proposal to
build the refrigerator and provide recommendations to Mr. Burton. The issues
that need to be addressed in your report are the following:

1)
How much importance should be given to
the energy cost situation?

2)
What is the projects
cost of equity? What is the projects cost of debt? What is the appropriate
discount factor to use for evaluating the refrigerator project?
3)
Which of the two
compressors should be used in the refrigerator if you decide to go ahead with
the project and why?

4

4)
Forecast the projects
cash flows for the next twenty years. What assumptions did you use?
5)
Use the appropriate capital budgeting
techniques to evaluate the project.

6)
Use the average demand
scenario to evaluate the sensitivity of the projects NPV with respect to sale
price of the refrigerator and the cost of the compressor.
7)
Based on the scenario
and sensitivity analysis you performed above, comment on the overall riskiness
of the project.
8)
Would you recommend
that Tesca Works accept or reject the project? What is the basis for your
recommendation?

5

Exhibit
1 Sales forecasts:

The
forecasts are based on projected levels of demand. The firm could face weak,
average, and strong demand. All the numbers are expressed in todays dollars.
The forecasted average inflation per year is 2.5%.

Demand level

Weak

Average

Strong

Probability

25%

45%

30%

Price
per refrigerator

$1,375

$1,575

$1,600

Units
sold per year

40,000

42,500

43,000

Labor
cost per refrigerator

$250

$250

$250

Parts

$300

$300

$300

Selling
General & Administrative

$10,000,000

$ 10,000,000

$10,000,000

Average
warranty cost per year per refrigerator for the first five years is $75. The
present

value of this
cost will be used as a cost figure for each refrigerator. Afterwards, the

refrigerator
owners will become responsible the repairs.

The
refrigerators can be produced for twenty years. Afterwards, the designs
become

obsolete.

Exhibit 2
Compressor costs:

Compressor
choices:

Compressor
model number

CM
– 004

TS
– L12

Price
per compressor and installation

$280

$260

Average
annual warranty cost per year for five

$40

$50

years. Afterwards, the refrigerator owner will

become
responsible the repairs*.

.0/msohtmlclip1/01/clip_image001.gif””>.0/msohtmlclip1/01/clip_image002.gif””>.0/msohtmlclip1/01/clip_image002.gif””>.0/msohtmlclip1/01/clip_image003.gif””>The
chosen compressor will be installed in every refrigerator and will become a
cost figure for each unit produced.
.0/msohtmlclip1/01/clip_image004.gif””>
*
The compressor manufacturers are not providing Tesca Works with any warranty.
However, Tesca Works will provide warranty to its customers. After the initial
five years, the refrigerator owners may purchase extended warranty from any
insurance company that offers such packages.
.0/msohtmlclip1/01/clip_image005.gif””>

6

Exhibit
3 Investment needs:

To implement the
project, the firm has to invest funds as shown in the following table:

Year 0

Year 1

Year 2

Year 3

$3
million

$5
million

$3
million

Production
and selling of

commercial
appliances

starts

Straight line
depreciation will be used.

To
facilitate the operation of manufacturing the refrigerators, the company will
have to allocate funds to net working capital (NWC) equivalent to 11% of annual
sales. The investment in NWC will be recovered at the end of the project.

Exhibit 4
Financing

The
following assumptions are used to determine the cost of capital. Historically,
the company tried to maintain a debt to equity ratio equal to 0.60. This ratio
was used because lowering the debt implies giving up the debt tax shield and
increasing it makes debt service a burden on the firms cash flow. In addition,
increasing the debt level may cause a reduced rating of the companys bonds.
The marginal tax rate is 25%. All the numbers are expressed in todays dollars.
The forecasted average inflation per year is 2.5%.

Cost of debt:
The
companys bond rating is roughly at the high end of the A range. Surveying the
debt market yielded the following information about the cost of debt for
different rating levels:

Bond
rating

AA

A

BBB

Interest
cost range

3.5% ~ 3.75%

3.75% ~ 4.50%

4.50% ~ 5.00%

The
companys current bonds have a rating of A.

.0/msohtmlclip1/01/clip_image006.gif””>.0/msohtmlclip1/01/clip_image007.gif””>.0/msohtmlclip1/01/clip_image008.gif””>.0/msohtmlclip1/01/clip_image007.gif””>.0/msohtmlclip1/01/clip_image009.gif””>.0/msohtmlclip1/01/clip_image010.gif””>.0/msohtmlclip1/01/clip_image006.gif””>.0/msohtmlclip1/01/clip_image006.gif””>
Cost of equity:
The
current 10-year Treasury notes have a yield to maturity of 2.71% and the five
year rolling average for the S&P 500 market return is 11.0%. The companys
overall is 1.3.

analysis:

Company

Tesca

Electrics

General

Universal

Generators

International

Works

Plus

Generators

Power

Inc.

Generators

Over
all

1.3

1.4

1.3

1.6

1.2

1.35

Debt
to

0.4

0.3

0.5

0.45

0.35

0.25

equity

Percentage
of

50

45

90

95

85

85

income from

generators

7
Tesca WorksIntroductionMichael Burton has recently been hired
as the CEO of Tesca Works, Inc. Previously he had been the marketing manager
for a large manufacturing company and had established a reputation for
identifying new consumer trends. Tesca Works Inc. is a California-based
generator manufacturing company. The company is well known for manufacturing
large, heavy-duty generators at a reasonable cost. One of its greatest
achievements is that its generators can be easily modified or customized for
different applications. Also, Tesca Works currently builds commercial
appliances.The
company is considering an expansion of its current product line to include
refrigerator and maybe, sometime in the future, consumer appliances. Mr. Burton
feels that due to high energy prices, consumers will be more willing to
consider purchasing new efficient appliances.Tesca Works Inc. is a California-based
generator manufacturing company. The company is well known for its innovation
and ability to produce high quality products at a reasonable cost. One of its
greatest achievements is that its manufacturing processes are adaptable to
other durable goods. Also, Tesca Works currently builds commercial appliances.Profile
of Tesca WorksTesca Works, Inc. was established by the
Smith brothers in 1880 as the Logging Saw Company. The firm started
manufacturing large steam saws to serve the logging industry which processed
lumber. Their customers were construction companies that provided housing for the
population increase in California. The Smith brothers quickly realized that the
times were changing. They started looking for the technologies that would keep
them at the forefront of their field of business. In 1915, the Smith brothers
decided that they needed to make generators as replacements for the saws. They
realized that the logging industry was not viable anymore and that generators
were starting to serve the same purpose.The
company started making generators in the early 1940s. Tesca Works then opted
to produce commercial appliances. It was an easy decision to make since the
commercial appliances would use common parts with the companys generators and
the customers were local hospitals, schools, and governments. Starting in the
1950s the commercial appliances business accounted for about 50% of Tesca
Works revenues.The
refrigeratorMr.
Burton arranged a meeting with the firms top management and the chief design
and the chief manufacturing engineers to propose a new product. Mr. Burton presented
an argument that more individuals in the United State and Canada would be
willing to purchase newer appliances because people are becoming more
environmentally conscious. The new appliances are more efficient and
environmentally friendly. Also,2the recent increase in electricity costs
seems to be long lasting. This is an opportunity to get people hooked on
environmentally friendly appliances as he put it.The
proposal under consideration is for the introduction of a new, energy star
refrigerator. To distinguish Tesca Works from other manufacturers, the proposal
included details about the convenience, large shelves in the doors, high volume
water and ice dispensers, efficiency, and quietness of operation that need to
be developed.Mr. Phillips and Mr. Lopez, the two
engineers, enthusiastically and quickly pointed out that the needed technology
could be based on the companys generators. The framework currently used for
building the generators can be modified to work for appliances at a low cost.
The marketing vice president, Mr. Chen, pointed out that the marketing analysis
could be done quickly and at a reasonable cost. At this point, Mr. Burton
charged the participants in the meeting to produce a financial plan for the
development and production of the refrigerator.Consumer
AppliancesMost
people purchase appliances and keep them for a very long time or until they
stop working. Some get them when they purchase a home and do not think about
them.Recently,
most power companies started educating people about the efficiency of new
appliances and began offering rebates on the most efficient consumer models.
These3approaches increased public interest.
This renewed the publics interest in low power-consuming appliances.The
decisionThree
weeks later, the vice presidents presented the sales and cost forecasts shown
in the exhibits. The information presented contains the cost of production,
financing information, and warranty cost estimates. In addition, there were two
options for the compressor in the refrigerators. The MC 004 is more expensive
to install, but has a lower warranty cost. The TS L12 is cheaper to install,
but has a higher warranty cost. Which compressor should be used?The
analysisMr. Burton noticed that there is an
abundance of enthusiasm about entering the refrigerator building business, but
his cautious nature made him seek a more neutral analyst. This is your
responsibility. You have been hired by Tesca Works to analyze the proposal to
build the refrigerator and provide recommendations to Mr. Burton. The issues
that need to be addressed in your report are the following:1)
How much importance should be given to
the energy cost situation? 2)
What is the projects
cost of equity? What is the projects cost of debt? What is the appropriate
discount factor to use for evaluating the refrigerator project? 3)
Which of the two
compressors should be used in the refrigerator if you decide to go ahead with
the project and why? 44)
Forecast the projects
cash flows for the next twenty years. What assumptions did you use? 5)
Use the appropriate capital budgeting
techniques to evaluate the project. 6)
Use the average demand
scenario to evaluate the sensitivity of the projects NPV with respect to sale
price of the refrigerator and the cost of the compressor. 7)
Based on the scenario
and sensitivity analysis you performed above, comment on the overall riskiness
of the project. 8)
Would you recommend
that Tesca Works accept or reject the project? What is the basis for your
recommendation? 5Exhibit
1 Sales forecasts:The
forecasts are based on projected levels of demand. The firm could face weak,
average, and strong demand. All the numbers are expressed in todays dollars.
The forecasted average inflation per year is 2.5%.Demand levelWeakAverageStrongProbability25%45%30%Price
per refrigerator$1,375$1,575$1,600Units
sold per year40,00042,50043,000Labor
cost per refrigerator$250$250$250Parts$300$300$300Selling
General & Administrative$10,000,000$ 10,000,000$10,000,000Average
warranty cost per year per refrigerator for the first five years is $75. The
presentvalue of this
cost will be used as a cost figure for each refrigerator. Afterwards, therefrigerator
owners will become responsible the repairs.The
refrigerators can be produced for twenty years. Afterwards, the designs
becomeobsolete.Exhibit 2
Compressor costs:Compressor
choices:Compressor
model numberCM
– 004TS
– L12Price
per compressor and installation$280$260Average
annual warranty cost per year for five$40$50years. Afterwards, the refrigerator owner willbecome
responsible the repairs*..0/msohtmlclip1/01/clip_image001.gif””>.0/msohtmlclip1/01/clip_image002.gif””>.0/msohtmlclip1/01/clip_image002.gif””>.0/msohtmlclip1/01/clip_image003.gif””>The
chosen compressor will be installed in every refrigerator and will become a
cost figure for each unit produced..0/msohtmlclip1/01/clip_image004.gif””>*
The compressor manufacturers are not providing Tesca Works with any warranty.
However, Tesca Works will provide warranty to its customers. After the initial
five years, the refrigerator owners may purchase extended warranty from any
insurance company that offers such packages..0/msohtmlclip1/01/clip_image005.gif””>6Exhibit
3 Investment needs:To implement the
project, the firm has to invest funds as shown in the following table:Year 0Year 1Year 2Year 3$3
million$5
million$3
millionProduction
and selling ofcommercial
appliancesstartsStraight line
depreciation will be used.To
facilitate the operation of manufacturing the refrigerators, the company will
have to allocate funds to net working capital (NWC) equivalent to 11% of annual
sales. The investment in NWC will be recovered at the end of the project.Exhibit 4
FinancingThe
following assumptions are used to determine the cost of capital. Historically,
the company tried to maintain a debt to equity ratio equal to 0.60. This ratio
was used because lowering the debt implies giving up the debt tax shield and
increasing it makes debt service a burden on the firms cash flow. In addition,
increasing the debt level may cause a reduced rating of the companys bonds.
The marginal tax rate is 25%. All the numbers are expressed in todays dollars.
The forecasted average inflation per year is 2.5%.Cost of debt:The
companys bond rating is roughly at the high end of the A range. Surveying the
debt market yielded the following information about the cost of debt for
different rating levels:Bond
ratingAAABBBInterest
cost range3.5% ~ 3.75%3.75% ~ 4.50%4.50% ~ 5.00%The
companys current bonds have a rating of A..0/msohtmlclip1/01/clip_image006.gif””>.0/msohtmlclip1/01/clip_image007.gif””>.0/msohtmlclip1/01/clip_image008.gif””>.0/msohtmlclip1/01/clip_image007.gif””>.0/msohtmlclip1/01/clip_image009.gif””>.0/msohtmlclip1/01/clip_image010.gif””>.0/msohtmlclip1/01/clip_image006.gif””>.0/msohtmlclip1/01/clip_image006.gif””>Cost of equity:The
current 10-year Treasury notes have a yield to maturity of 2.71% and the five
year rolling average for the S&P 500 market return is 11.0%. The companys
overall is 1.3.analysis:CompanyTescaElectricsGeneralUniversalGeneratorsInternationalWorksPlusGeneratorsPowerInc.GeneratorsOver
all1.31.41.31.61.21.35Debt
to0.40.30.50.450.350.25equityPercentage
of504590958585income fromgenerators7″