Tesca Works case study

Tesca Works

Introduction

Michael Burton has recently been hired as theCEO of Tesca Works, Inc. Previously he had been the marketing manager for a largemanufacturing 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 ofits 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 considerpurchasing new efficient appliances.

Tesca Works Inc. is a California-based generator manufacturing company. The company is well known for its innovation and abilityto 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 firmstarted manufacturing large steamsaws 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 startedlooking for the technologies that would keep themat 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 viableanymore and that generators were starting to serve the same purpose.

The company started making generators in the early 1940’s. 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 company’s generators and the customers were local hospitals, schools, and governments. Starting in the 1950’s the commercial appliances business accounted for about 50% of Tesca Works’ revenues.

The refrigerator

Mr. Burton arranged a meeting with the firm’s 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 appliancesare more efficient and environmentally friendly. Also,

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 fromother manufacturers, the proposal

included details about the convenience, large shelves in the doors, high volume water and ice dispensers, efficiency, and quietness ofoperation that need to be developed.

Mr. Phillips and Mr. Lopez, thetwoengineers,enthusiastically and quickly pointed out that the needed technology could be based on the company’sgenerators.The framework currently used for building the generators can bemodified 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 peoplepurchase appliances andkeep themfor 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

approaches increased public interest.Thisrenewed the public’s interest in low power- consuming appliances.

The decision

Three weekslater, 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. Inaddition, there were two options for the compressor in the refrigerators. The CM – 004 is more expensive to install, but has a lower warranty cost. The TS – L12 is cheaperto install, but has a higherwarrantycost. Which compressor should be used?

The analysis

Mr.Burtonnoticedthatthereisanabundance of enthusiasmabout entering the refrigerator building business,but his cautious nature made himseek a more neutral analyst. This is your responsibility. You have been hiredby Tesca Works to analyze the proposal and the capital budget analysis completed by the Tesca Finance staff. Prepare a memorandum to Mr. Burton on your analysis (based on the questions below) to build the refrigerator and provide recommendations to Mr. Burton. The issues that need to be addressed in memorandum report are the following:

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

2) What is the project’s hurdle rate? 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) Based on the scenario and sensitivity analysis, comment on the overall riskiness ofthe project.

5) Perform a SWOT analysis of the project.

6) Would you recommend that Tesca Works accept or reject the project? What is the basis for your recommendation?

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Note: The Project Variables begin on Page 7

Exhibit 1 Sales forecasts:

The forecasts are based on projectedlevels of demand. The firmcould face weak, average, and strong demand. All the numbers are expressed in today’s dollars. The forecasted average inflation per year is 1.5%.

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 cost per refrigerator	$300	$300	$300
Selling General & Administrative	$10,000,000	$10,000,000	$10,000,000
Average warranty cost per year per refrigerator for the three years is $75. The present value of thiscost 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 compressorand installation	$280	$250
Average annual warrantycost per year for three years. Afterwards, the refrigerator owner will become responsible the repairs*.	$40	$50
The chosen compressor will be installed in everyrefrigerator and will become a cost figure for each unit produced.

Exhibit 3 Investment needs:

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

Year 0	Year 1	Year 2	Year 3
$3million	$5million	$3million	Productionandsellingof commercialappliances starts

Straight linedepreciation will be used. There is no salvage value.

To facilitate the operation ofmanufacturing the refrigerators, the company will have to allocate funds to net working capital (NWC)equivalent to 12% of annual sales. The investment in NWC will be recovered at the end ofthe project.

Exhibit 4 Financing

The following assumptions are used to determine the cost of capital. Historically, the company tried to maintain a debt to equityratio equal to 0.50. This ratiowas used because lowering the debt implies giving up the debt tax shield and increasing it makes debt service a burden on the firm’s cash flow. In addition, increasing the debt level may cause a reduced rating of the company’s bonds.The marginal tax rate is 25%.All the numbers are expressed in today’s dollars. The forecasted average inflation per year is

1.5%.

Cost of debt:

The company’s bond rating is roughly at the highend 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
Interestcostrange	3.5%~ 4.5%	4.5% ~ 5.5%	5.5% ~ 7.0%

The company’s current bondshave a rating of A.

Cost of equity:

The current 10-year Treasury notes have a yield to maturity of 1.50% and the forecast for the S&P 500 market premium is 10.0%. The company’s overallbis 1.25.

banalysis:

Company	Tesca Works	Electrics Plus	General Generators	Universal Power	Generators Inc.	International Generators
Over allb	1.25	1.4	1.3	1.6	1.2	1.35
Debt to equity	0.5	0.3	0.5	0.45	0.35	0.25
Percentageof income from generators	50	45	90	95	85	85