UNIVERSITY OF OREGON Charles H. Lundquist College of Business Finance 316 Professor Larry Y.

Dann

Capital Budgeting Case

The case is due at the beginning of class on Tuesday, February 15, 2000. No late cases will be accepted. The case will be worth 10% of the total points available in the course. The work on this case must be done in groups (preferably the ones you formed for the stock case). If a majority of the group's members feel that a member of the group did not contribute any effort to the project, the majority can send me a sheet of paper that assigns zero credit to that group member. A brief explanation and the signature of each group member in the majority must be provided on that sheet of paper. Your group's write-up of the case should be in the form of a recommendation to a V.P. at General Motors. The write-up must be typed and cannot exceed 2 pages (not including supporting spreadsheets). Your recommendation should address all of the issues put forth on the next two pages. It should be obvious to me how you arrived at your recommendations. I should be able to determine exactly how you calculated the relevant answers from your analysis. All the analysis should be included in an appendix to your recommendation. The appendix is not subject to the 2 page limit. The quality of the writing and the clarity of your analysis will have a substantial impact on your grade. Be sure to include each group member's name on the single document that you turn in to me. This assignment will require a reasonable commitment of time from all group members. You will need to locate information using the Internet, design complex spreadsheets and compose a thoughtful analysis and recommendation -- all of which you will be expected to do in your first job. Do not wait until the last minute to start this case.

General Motors Sport-Utility Pickup Case General Motors Corporation (GM) is the largest maker of automobiles and has the second largest market share (behind Ford Motor Company) of pickup trucks in the world. However, GM's market share has been slowly but steadily eroding over the last several years, and GM executives are anxious to turn this recent trend around. Assume it is 1996 and General Motors, along with Ford and several other auto makers, are enjoying the strong market demand among car consumers of sport-utility vehicles, or SUV's. GM's entries in this segment of the ' market include the Chevrolet Blazer, Tahoe and Suburban models. SUV's typically are built on a truck 'bed', or frame. While SUV's have been capturing an increasing share of the car market, GM, Ford and other manufacturers have observed little crossover from the pickup truck market. Automotive executives believe this represents a missed opportunity, since SUVs typically provide much higher profit margins than either sedan model passenger cars or conventional pickup trucks. One concept GM engineers have been experimenting with is a hybrid vehicle that is a cross between an SUV and a pickup truck. This concept, which they have dubbed a 'sport-utility pickup', is intended to provide a combination of the comfortable ride and off-road capability of an SUV and the cargo handling capabilities of a pickup truck. One design that seems especially appealing has four sedan-like doors and an open, but enclosable, cargo bed. The ability to easily cover and lock the cargo bed, the engineers believe, will make this feature the counterpart of the trunk in a passenger car. GM top managers recognize that design engineers are inherently attracted to new products, but they also recognize that if GM decides to proceed with development and then production, the new vehicle, named the Avalanche, will not be introduced until 2001. However, managers are encouraged by results of a costly marketing trial in which

more than 2000 carefully screened consumers participated. In this marketing trial, a prototype Avalanche and numerous GM and rival model cars, pickups and SUVs were displayed in a simulated showroom. The Avalanche was among the top few vehicles participants said they would consider buying. [Source: The Wall Street Journal, January 3, 2000, p. 1.] In contrast to this encouraging news, however, GM also learned that Ford engineers were also working hard to develop a similar type of vehicle. The design and development costs, along with the marketing trial, have amounted to $80 million by 1996, and have been treated as expenses when incurred. Managers estimate that further development costs consisting of materials analysis, parts design and construction of production lines, will total $1.5 billion ($200 million in each of the years 1997-1999, and $900 million in 2000). All of this $1.5 billion will be capitalized (recorded as an asset on the company's balance sheet) and depreciated using the 7-year ACRS schedule (see Table 6.4 on p. 197 of the text) starting in 2001. GM would propose to introduce the Avalanche for sale in 2001. Sales of the Avalanche from GM to dealerships are expected to be $1.1 billion (in nominal terms) in 2001, $1.3 billion in 2002, and $2.1 billion in 2003-2005. Thereafter, sales are expected to decline at 5% per year. The cost of producing the Avalanche is 65% of its price. GM will spend $40 million advertising the introduction of the Avalanche in 2000, $100 million in 2001 and 2002. Beyond 2002, advertising expenditures will decline at a rate of 10% per year. GM expects that much of the demand for the Avalanche will come from consumers who would otherwise purchase an SUV or a pickup truck. Although GM's market research indicates that most sales of the Avalanche will be to consumers who might otherwise purchase a Ford, Chrysler, Toyota or Honda vehicle, some portion of the Avalanche's sales will come from potential customers of the Chevrolet Blazer, Suburban and Cavalier lines. GM's combined sales of these lines are expected to reach $8.0 billion by 2001, and to stabilize at that figure. However, introduction of the Avalanche (or possibly a similar vehicle by Ford) is expected to replace 2% of that $8 billion figure. The cost of producing those Chevrolet vehicles averages 85% of their sales prices. Production of the Avalanche would take place in facilities currently owned by GM near their truck assembly plant in Detroit, Michigan, but they would have to be converted for the Avalanche's use. Conversion costs are included in the estimated $1.5 billion of development costs mentioned above. These facilities have a current market value and book value of $220 million. Although the Avalanche would share many parts with the Suburban, parts and materials required for the Avalanche will require an investment by GM of $75 million in 2001; this inventory would have to increase to $125 million in 2003. GM will not have sufficient cash on hand to fully pay for the conversion of the production facilities for the Avalanche. GM estimates that it will have to borrow $700 million of the cost of converting the facilities, and managers believe that a five-year level payment loan can be arranged at an interest rate of 8% per year. GM faces a corporate income tax rate (combined state and federal) of 34%. The risk of this project is believed to be comparable to the risk of GM's current operations. Treat all cash flows as if they occur at year-end. Assume it is now December 1996. In order to determine the appropriate discount rate for the cash flows, you need to get a sense of GM's normal risk. Although we have not yet talked about measurement of risk in class, I am asking you to use the following intuitive idea for estimating the appropriate discount rate: Discount rate = Risk-free rate + Risk premium (additional return demanded by investors for bearing risk) = 0.05 + Beta * (0.08) We will discuss this formula in our lectures on Risk and Return and Capital Budgeting with Risk. For now, just use the formula as is, and I will explain where it comes from later. In order to calculate the discount rate using this formula, you will need a "Beta" for General Motors. My suggestion is that you go to the Finance Department Web Site (http://darkwing.uoregon.edu/~finance) and link to one of the financial information sites (Zack's Investment Research, Microsoft Investor or Market Guide Inc. are three good ones) and request information on General Motors (ticker symbol: GM). If you choose Zack's, ask for "The Whole Enchilada"; with Microsoft Investor, get the "Company Report"; for Market Guide, you want "Snapshot." Each of these sources will report a "Beta."

Should GM go forward with the development of the Avalanche sport-utility pickup? As a member of the operations finance group at General Motors, you have come up with all of the assumptions above and now it is time for your analysis and formal recommendation to the Senior V. P. You are saying "go" or "no-go" on a major investment, so be clear and concise and support your recommendation with thoughtful analysis. In addition to your quantitative analysis, your written analysis should include a discussion of non-quantitative factors that you believe should be considered in making the investment decision. If you can think of anything that you have not accounted for in your number-crunching, you should mention it, along with your assessment of how important it is and what effect it would have on the decision.