Capital Budgeting Case

FLIR was founded in 1978 and is headquartered in Wilsonville, OR. FLIR pioneered the development of
high-performance, low-cost infrared (thermal) imaging systems for airborne applications. FLIR is a
global company with annual revenues approaching $2 billion.
FLIR Systems is considering launching a new product line that would introduce thermal imaging
capability to the emerging autonomous (self-driving) car market. Historically thermal imaging has only
been utilized in industrial and governmental applications. FLIR recently introduced their technology into
the consumer market with the FLIR ONE product which brings thermal imaging technology to your
smartphone. The autonomous car market (ACM) is still in development but many analysts believe this
will be a significant market over the next 5-10 years. The ACM will use a variety of technologies to
navigate the car to include: GPS, radar and lasers. FLIR believes thermal imaging may complement
these technologies and provide another measure of safety by being able to detect heat signatures from
nearby automobiles, pedestrians or wildlife. If a heat signature was detected that was too close to the
vehicle, the car would take the appropriate evasive action. Given the safety concerns of ACM, FLIR
believes there may be significant demand and no other company can currently offer the technology.
The company has already invested $8 million in technology development, $3M in market research and
believes their product will have significant demand. You have been approached by the president of the
company to analyze the proposed project and make a recommendation to the company’s Executive
Committee on whether the company should launch the new product or not. Your analysis will only
consider the first (initial) generation of the product.
The first step is to create a set of financial statements and associated free cash flow (FCF) over the life of
the proposed project. The project financial statements (income statement and balance sheet) need to
include all of the operating items associated with the project (exclude all non-operating and financing
items). The project financial statements will be used to capture the companies forecast for how the
project is expected to perform over its life and as the basis to calculate FCF. Note: there is no need to
forecast results for the entire company, focus the forecast on the project.
You have decided to use a type of the Tops Down method to estimate revenue and have worked closely
with the marketing department to estimate the following information. To estimate potential demand,
the company has focused on the demand forecast for the ACM and how many automobile
manufacturers would likely adopt FLIR technology. The company estimates total autonomous car sales
of:

Once ready for production, the first product line is expected to be sold for 4 years. In the 5th year of
sales FLIR plans to transition to a second generation of the product (new hardware & software). In the
5th year of sales half of the volume will be from the first generation and half from the second generation.
In the 6th year, sales will be fully transitioned to the second generation product. The company forecasts
in any year approximately 15% of the autonomous vehicles sold would be equipped with a thermal
imaging solution provided by FLIR. The product that FLIR is planning for the market is expected to have
an average price of $180 / unit during the first year of sales and is expected to decrease in price by 3%
per year. The company is fairly confident in most of its projections, but market share and price are the
two items with the most variability.
Upon completion of the revenue forecast, you now move on to forecast the other operating items of the
project. Once product sales begin, it is believed that the project’s income statement and balance sheet
operating items will have a similar relationship (ratios) as the overall company.
To complete the operating forecast for the project during the period of sales, you plan to work through
the following steps:
 Obtain the 2015, 2016 and 2017 income statement and balance sheet for FLIR.
 Identify the operating items, for example: cost of goods sold, selling & administrative expenses,
inventory, accounts payable, accrued payroll, etc.
 Select appropriate ratios to calculate each of the operating items, for example: percent of sales,
inventory turnover, days of sales outstanding.
 Use the historical ratios you calculate for FLIR as a basis to apply to proposed new ACM product
in order to build the future financial statements for the proposed project. Note: it is good
practice to use a similar financial reporting structures for the project and total company if
possible.
 Assume that the project will not require any additional Cash & Equivalents and there are no long
term liabilities associated with the project (hint: don’t need to forecast these items). The
equipment mentioned below will be the only long term operating assets.
 Please forecast based on calendar year.
Prior to launching the new product line, FLIR will need to spend an additional $25 million on R&D over
the next two years to complete the design ($15M in 2018 and $10M in 2019), $6 million on test
marketing and $7M on capital equipment to support the manufacturing process. The equipment
purchase and test marketing will be done one year prior to the start of sales. The equipment will be
depreciated using the seven year MACRS schedule. The equipment will have a $1 million salvage value
after all sales of the initial product line have been completed and might be able to be used in a future
company project. Also, the company will need to invest $0.7 million in inventory prior to the first year
of sales.
After the initial investment of equipment, no other long term assets will be required for the project.
Once you have completed the operating income statement and balance sheet for the project you can
calculate Free Cash Flow for each year of the project. Based on the project financials you’ve created
and the free cash flow (FCF), make a recommendation on whether they should launch the new flight
service or not. Your recommendation should include the projects: NPV, IRR, MIRR, Payback and
Discounted Payback
In estimating the Weighted Average Cost of Capital (WACC) for FLIR, be sure to describe the sources of
capital the firm uses to finance operations. Include specific assumptions that support the calculations
for: cost of debt, cost of equity, market values of debt and equity. For cost of capital estimates it is best
to use the most recent financial and market information. To be consistent in the WACC estimate, please
refer to FLIR’s 2018, Second Quarter 10Q filing (filed July 2018) for its financial statements and current
capital structure. To estimate beta please use at least 2 published betas plus a calculation of industry
beta or conducting a regression analysis.
In addition to their current WACC, please estimate a second weighted average cost of capital based on a
target capital structure. Please assume the company’s long term target capital structure is 80% equity
(common stock) and 20% debt. For Target structure, please assume that FLIR prefers to have bonds with
a 10-year duration.
Given your analysis requires a lot of assumptions about the future, be sure to perform a risk analysis
The assignment will be split into two parts:
 Part 1 – Due October 23, 2018
o This is a preliminary analysis focused on financial statement analysis and project
forecast.
o FLIR’s financial statement analysis (2015, 2016, 2017) used for forecast assumptions
o Forecast of the project income statement and balance sheet by year over its life
o Forecast the project Free Cash Flow by year over its life
o Initial observations about the project
o Exhibits should include financial statement ratio analysis, revenue estimate, income
statement, balance sheet, FCF, chart of annual & cumulative FCF.
o Note: forecast and FCF is for the pilot project NOT the entire company
 Part 2 – Due November 29, 2018
o This is the full report & analysis of the project
o Revised project financials (income statement, balance sheet, FCF)
o FLIR’s Weighted Average Cost of Capital (Current and Target)
o Project NPV, IRR, MIRR, Payback and Profitability Index
o Risk analysis
o Project Recommendation
Papers for each part should be between 4-5 pages in length (line spacing between 1 – 1.5,
approximately 2,000 words) plus any exhibits in an appendix. Grading will consider your overall
approach, assumptions made, analysis and communication (grading rubrics are below).
At the end of the term I will ask for feedback on your teammates based on their contributions. The
feedback can impact individual grades.
Part 1 Rubric – Interim Report
Part 2 Rubric – Full Report
Note: An Executive Summary is typically used to distill the entire report into one paragraph at the very
beginning of the report. This would include the purpose of the report, method/s used to reach a
recommendation and the actual recommendation.
Absent Satisfactory Excellent
Historical Analysis & Revenue 0 1 2 3 4
Historical Ratio Analysis
Revenue forecast
Non revenue forecast assumptions
Forecast of Project Financials
Income Statement
Balance Sheet
FCF Calculation
FCF Charts
Communication
Executive Summary
Organization
Supporting evidence
Initial observations / findings
Grammar, spelling
Use of Exhibits, Charts
Absent Satisfactory Excellent
0 1 2 3 4
Historical Analysis & Revenue
Project Financials
Forecasted Income Statement
Forecasted Balance Sheet
FCF Calculation
WACC
Market value of Debt
Market value of Equity
Cost of Debt
Cost of Equity
WACC based on current structure
WACC based on target structure
Decision Criteria
Decision Framework
NPV, IRR, MIRR, PI, Payback
Risk Analysis
Communication
Executive Summary
Organization
Supporting evidence
Recommendation
Grammar, spelling
Use of Exhibits, Charts
General guidelines on resource and to estimating the weighted average cost of capital:
 Historical Financials: It is recommended to use financials the company has filed with the
Securities and Exchange Commission (SEC). These are the official financials and information on
websites such as Google Finance, Yahoo Finance or Morningstar may not be reported the same
as the company’s submission to the SEC. The company financials can often be found on their
website (About Us or Investor Relations are common sections). You can also find them at the
SEC’s EDGAR database.
 Utilize the Capital Asset Pricing Model to estimate the cost of equity:
o Risk Free Rate: The proxy for the Risk Free Rate should be a US Treasury bond
o Beta: To estimate beta you can utilize published betas which can be found at a variety
of finance sites to include: Morningstar, Yahoo! Finance, Google Finance and databases
available at the PSU Library and calculate your own estimate of beta (regression or
industry approach)
o Market Risk Premium: Decide on an appropriate approach to estimate the Market Risk
Premium and incorporate the necessary assumptions.
 Utilize the after tax yield to maturity of debt for the company to estimate the cost of debt:
o A company will often have multiple bonds outstanding at any one time. If so, calculate a
weighted average YTM for the bonds outstanding.
o A list of bonds outstanding can be found in the Notes section of the company’s 10Q or
10K
o The current pricing and YTM on publically traded bonds can be found at:
http://finra-markets.morningstar.com/BondCenter/Default.jsp
Note: if the debt is not publicly traded, the cost of debt may be estimated by:
 Company disclosures in their financial statements and notes, or
 Using the default spread methodology, or
 Observing the YTM from companies of similar risk
 Financing weights. Calculate the market value of debt and equity. The value of debt plus equity
is equal to the overall value of the firm. Based on the values of debt and equity you can
calculate the weights of each type financing. For this case, please use the market value weights
to estimate the weighted average cost of capital.
o The market value of equity is also known as market capitalization and can be
determined by finding the current stock price per share and multiplying it by the
number of shares outstanding.
o The market value of debt can be calculated from the bond site listed above.
o Market prices of bonds are often quoted as a percentage of par value. For example, if a
bonds current price is 110, it is currently trading at 110% of par.
o The book values of debt and equity can be obtained from the company’s balance sheet.
 Target capital structure. The company plans to use a different capital structure in the future. As
compared to your estimate of current WACC, the weights of debt & equity will change as well as
the estimates for cost of equity and cost of debt (investor expectations).