NEWSWIRE - FEBRUARY 11, 1998

Topic: Capital Budgeting and Risk Analysis

Source: "In China, GM Bets Billions on a Market Strewn with Casualties," by Craig S. Smith and Rebecca Blumenstein, Wall Street Journal, Wednesday, February 11, 1998, page A1.

Synopsis of Article: While a number of automobile manufacturers have made significant investments in the fledgling Chinese automobile market, most have experienced substantial losses. It is very alluring to tap into a growing economy where there is currently one car for every 110 people (vs. one for every 2 in the U.S.) and where demand for more cars in rampant. However, these automobile manufacturers are hostages to political risk as the government decides on the relative benefits from planned versus market driven economic development.

For example, some regional authorities have curtailed automobile financing programs limited the engine size for privately owned cars, and stopped issuing license plates. These government officials are concerned with the mismatch between China's poorly developed support structure for automobiles (roads, parking facilities, and service stations) and the strong demand.

GM has jumped into this market with both feet. Their proposal to build in the Shanghai province was accepted, not because it offered the highest economic benefits, but becuase the Buicks they intend to manufacture are considered high prestige cars. GM's investment is expected to grow more than $2 billion over the next two years, far more than any other foreign manufacturer. They plan to build 150,000 Buick sedans per year, but current restrictions allow only high level government officials to own a car with the Buick's engine size. GM is also expected to share production technology with Chinese firms that will eventually become competitors. While GM views this as a long term investment, other firms such as Chrysler, Daimler-Benz, and Citroen-Peugeot, are closing plants and leaving China until the political environment changes. Only VW is running a profitable operation in China. They sell most of their vehicles to government agencies and as taxis, a market that is expected to reach saturation very soon.

Questions:

1. Describe the concept of weighted average cost of capital. Should GM's WACC be used as the cost of capital for this investment?

2. How might a budget analyst at GM evaluate the stand-alone risk of this project?

3. Would corporate (within-firm) or market risk measures be more appropriate for this project?

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