AA Metals Corp.

Capital Budgeting with Real Options

AA Metals Corp. has just completed a $400,000, two-year marketing study of a new
Classic series of aluminum wheels. The wheels will be sold for the next 7 years, and the
company estimates the following sales volumes:
Year
1
2
3
4
5
6
7

Unit Sales
10,000
9,000
9,000
8,000
7,000
7,000
6,000

In the first year, cost of goods sold (COGS) per unit will be $7,300 and the selling price
will be $9,500. COGS per unit is expected to grow by 4% per year due to inflation.
Selling price will be increased by 4% one year after introduction, but no further price
increases will be made because AA Metals Corp. expects growing competition from newer
products. (The above volume estimates are consistent with this pricing plan.)
The year-end inventory on hand will be equal to 0.5 times the coming years
variable cost. Accounts payable will be 25% of inventory, and year-end accounts
receivable will be 10% of sales for the year just completed. Fixed costs are $700,000 in
the first year, and will grow at 2% per year. The equipment required for production will
cost $27 million and will have the following depreciation factors: 0.1429, 0.2449, 0.1749,
0.1249, 0.0893, 0.0893, 0.0893 and 0.0445. It is estimated that the salvage value of this
equipment will be $7.9 million at the end of year 7 (in year-7 dollars).
An existing plant needs to be upgraded to produce the wheels. At the moment, the
plant is vacant, and AA Metals Corp. has been offered $9 million for the existing building
and land. Alternatively, after 7 years AA Metals believes it will be able to sell the same
land and building for $11 million (in year 7 dollars). The land has a book value of $2.1
million (equal to its original purchase price), and the building has zero book value for tax
purposes (it has been fully depreciated).
However, the building must be modified if the company is to manufacture the
new product, and the total investment for the building is $5.1 million. Of this, $300,000
represents architecture and engineering fees that have already been paid and expensed, and
$1.0 million will be counted as repairs to the old facility and will be expensed in the year
before product introduction (call it year 0). The balance of the building investment ($3.8

million) will be in the 39-year depreciation class (first year write-off of 2.461%, next 38
years are all 2.564% and 40th year is 1.07%).
The historical society has asked if it would be possible to retain the stately look
of the old brick factory. The architects developed a plan that would retain the old facade,
but would increase the total cost of the building to $5.3 million, including $100,000 of
additional architectural/engineering expenses that would be paid in year zero. If this
change is made, then a larger fraction of the investment would be counted as repairs. It is
estimated that of the $4.9 million excluding architectural/engineering, $4.1 million would
be expensed in year zero and $0.8 million would be written off over 39 years. Any building
modification will not affect the estimated value of $11 million in 7 years. That is, in 7
years, AA Metals Corp. will still be able to sell the land and building for $11 million (in
year 7 dollars).
The marginal tax rate is 38%. The discount rate is a function of the risk
(uncertainty) of cash flows. AA Metals Corp. has two divisions Engineered Products
(that manufactures wheels etc.) and Basic Metal. Engineered Products is about half as
risky as Basic Metal. AA Metals raises funds for both divisions, each of which need the
same amount of funds. AA Metals can raise equity at 17% and debt at an yield of 14%.
The target debt-equity ratio for AA Metals is 0.32. The risk free rate is 5%
Questions
What options does AA Metals Corp. have?
Compute the discount rate.
Show all the cash flows, neatly labeled.
Compute all the relevant NPVs.
What should AA Metals Corp. do?