Fred Smith and a few younger engineers started their own automobile company, which they named Electric Car Company [Electric Car]. Fred and his team were sure they could make an attractive car that would achieve high speeds while running solely on battery power. They were sure they could sell the car to an increasingly affluent and environmentally sensitive public.
Their strategy had three phases. In the first phase, the company would develop an expensive sports car. This car might not be profitable, but it would establish the company's brand name. In the second phase, they would introduce a more affordable family sedan that would have broader appeal. This car would firmly establish Electric Car as a successful automobile company that was in business for the long haul.
The first and second-phase cars would not burn petrol. However, their batteries would need to be charged occasionally, which means a power plant somewhere in the country would have to burn hydrocarbons into the open air to create electricity for recharging. This process would be cleaner than burning petrol inside a car engine, but Fred and his team wanted to be able to say their cars required no burning of hydrocarbons in the open air. So, in the third phase of its strategy, the company would modify the roofs of its cars to generate solar power that would continuously recharge the batteries.
Fred and his team developed an attractive sports car that accelerated as quickly as any competing car. Fred realised that he could sell the car on the Internet, so there was no need to develop an expensive dealership network.
In the early years, Electric Car obtained working capital by selling ordinary shares and by selling notes at a floating interest rate. The company spent a lot of money in its early years. Major expenditures were for these purposes:
• Establishing an automobile manufacturing site.
• Research and development (R&D) costs for building a new kind of car and long-lasting batteries.
• A network of charging stations using leased land at convenience stores or at highway rest stops.
• Sports car trade-in guarantees.
Electric Car's sports car sold well immediately because of its sleek lines, amazing acceleration, and resale option. In the plan, a buyer was guaranteed that the sports car would have a good trade-in value for eight years for any new car. For example, a sports car purchased in 2010 from Electric Car for $65,000 would be guaranteed to be worth $50,000 in 2017, $48,000 in 2018, and $46,000 in 2019. If an owner could not get the guaranteed amount for a trade-in, the company would give cheque for the difference.
The program helped overcome buyer reluctance in the company's early years. There were some early claims against Electric Car, but the program has not been a great financial drain on the company in recent years. However, the company's public accountants say that a liability must be recorded for potential claims, which are estimated to be $I billion at most. Management thinks the program is no longer needed and has discontinued it, but the potential liability for older sales still exists.
Electric Car has reached the end of the first phase of its strategy and is looking forward to the second phase. Two major developments in recent years will require capital expenditures in the foreseeable future:
• Electric Car engineers have designed and learned to build the reasonably priced family sedan, which they plan to start selling next year. As sales increase, the production line will be expanded accordingly.
• Through their R&D, company engineers have learned to make a better battery that will increase travel time between recharges. This gives them a marketing advantage for the future. They have entered into a joint venture with their battery supplier to capitalise on the R&D. They will build their own plant to make next-generation car batteries, which will ensure a stable supply of batteries at more controllable costs.
This is an important transition point for the company. Management hopes that family sedan sales will be adequate to establish profitability within the next three years. If Electric Car can achieve these profits, management thinks the company will be in the car business for the long run. At this point the company has $10 billion in cash, but management knows that much of this money will be exhausted in the next three years. Here is the key financial question for management:
What are the chances the company can make it through 2020 without having to raise new capital in the financial markets?
Management wants to get through the next three years without incurring significant bank debt and without having to go to the financial markets to sell common stock or issue notes. In three years, the current notes payable will be nearly paid off, and management hopes the company will be profitable enough to start Phase 3 of its master plan.
Management asks you to consider three scenarios for the three-year period from 2018 to 2020:
Scenario 1. The cost of petrol is increasing, the claim rate in each of the three years is one percent, the cost reduction factor in each of the three years is three percent, there are 30 new charger locations each year, and the momentum effect each year is seven percent.
Scenario 2: The cost of petrol is down, the claim rate in each of the three years is 10 percent, the cost reduction factor each year is one percent, there are no new charger locations each year, and the momentum effect each year is two percent.
Scenario 3: The cost of petrol is stable, the claim rate in each of the three years is five percent, the cost reduction factor each year is two percent, there are 20 new charger locations each year, and the momentum effect each year is four percent.
The key year is 2020. By 2020,
(1) management would like to see a positive net income for the year.
(2) management wants to owe nothing to the bank; only $l.2 billion of notes payable would remain.
(3) management wants the company's cash on hand to exceed $l billion. This outcome would tell management that the grand strategy is still viable.
Failing the above outcome, however management could accept some amount owed to the bank, as long as the company had turned the corner and was making money in 2020. Management would conclude that the company still has a good chance of succeeding.
(1) draw out and highlight the key points that need to be considered in evaluating the three scenarios you are being asked to consider;
(2) present a brief analysis of each of the scenarios;
(3) outline any factors that you feel Fred Smith and the management team at the Electric Car Company have not considered;
(4) and conclude with your preliminary choice of the preferred scenario and why you have chosen this scenario.