Honda Project

 “The Power of Dreams”

Nathan J. Fragala

ECN 350-52

Honda Motor Corp. LTD

04/26/09

Project Phase I Narrative: Honda Motor Company

    1.)  Honda Motor Company: Should it Consider Serious Financial Investment in Fuel Cell Technology?

      In recent years scientists, congressmen, and business leaders have been growing increasingly concerned with the impact of global carbon emissions. Every year the average commuter dumps about a thousand tons of carbon into the atmosphere and while dismissed by some, many believe that this is a major contributor to Global Climate Change. The impact of these concerns is being felt across a wide variety of industries and the most deeply affected are beginning to see the potential benefits of making modifications to their business and firm-level strategies. Many auto manufacturers, for example, are introducing new hybrid vehicles that run on a combination of fossil fuels and alternative energy sources such as E83 Ethanol, electricity, and Bio-diesel. As the market continues to make these shifts towards renewable energy, Honda Motors finds itself strategically positioned to take center stage in the market for alternative energy because its foundation is based on a forward thinking philosophy that emphasizes new ideas, new technology, and new approaches to old problems. “Dreams inspire us to create innovative products that enhance mobility and benefit society. To meet the particular needs of customers in different regions around the world, we base our sales networks, research and development centers and manufacturing facilities in each region. Furthermore, as a socially responsible corporate citizen, we strive to address important environmental and safety issues (Honda. Com).” Since 1946 Honda Motor Company has been an industry leader in the production of small fuel-efficient vehicles and their corporate ethos of environmental protection and social responsibility makes them strategically positioned to capture the market as the industry for engine production begins to fully embrace alternative energy sources.

     The growing consumer concern about carbon emission represents an Externality in the industry for engine production. Externalities are the extra costs to society that might impede the success of a strategic decision despite whether or not that decision makes sound financial sense to internal stakeholders. Because externalities have effects that are not directly associated within the organization, many companies either choose ignore or completely overlook the additional costs it might incur if a decision doesn’t account for the external environment. Take the Big Three for example. The Big Three auto manufacturers focused their business models on the production of large and powerful vehicles because they occupied a strategic market niche, which made it more efficient for them to produce trucks and SUV’s rather than small fuel-efficient vehicles. Their infrastructure supported this type of business model and if all things had remained constant in the industry this strategic business model would have remained successful. As things began to change, however, and consumers started to favor fuel-efficiency over power production the Big Three found themselves unable to adapt as efficiently as the Japanese auto manufacturers who based their business models on flexibility, efficiency, and the ability to adapt to consumer demand. Because of a lack of concern for the obvious external precursors that suggested a shift towards fuel efficiency the Big Three have had to incur tremendous losses and plead congress for a $15 billion dollar bailout check (funded by John Q. Taxpayer). Meanwhile, despite also facing significant losses due to the global economic downturn and rising costs of oil and raw materials, Honda and other Japanese auto manufacturers weathered the storm by adapting to the external environment and adjusting their business models to incorporate shifts in consumer demand. 

     With only an 18% difference in market capitalization separating Honda Motor Co. from auto-industry leader Toyota Honda represents the number two spot in the auto industry. With six regional Board offices nationwide and a host of supporting business units facilitating the efficient production of engine components the decision at Honda to make significant financial investments in fuel-cell technology would have to be made at the top tiers of its firm-level strategy. Alignments would have to be made with major fuel cell production companies, capital budgeting would have to take place, research and development budgets would have to go up, long-tern capital investments might have to increase significantly if new production facilities have to be established, and the entirety of business operations would have to change in order to accommodate fuel-cell power as a major focus of the company. Having said that, many of the business-level strategies would need little, if any, modification because much of the lower operations would stay the same. Honda vehicles would still need chassis, wheels, suspension systems, exterior/interiors, and because many of these production processes are already highly refined they would need little modification to comply with fuel-cell technology. The major opportunity costs associated with this type of investment would be in adapting its engine production activities, product design/marketing techniques to influence beneficial consumer perception, and promoting infrastructural developments that would support electricity-based power production. In the long run I believe these types of strategic developments would be successful allocations of capital because they would allow Honda to maintain a competitive edge over the competition and get first mover advantages in what is an impending and dramatic market shift.

     The financial modeling that I intend to pursue with this project involves various industry and company wide factors that I believe will be most influential in Honda’s decision to make significant financial investments in fuel-cell/electric power sources. Short-term liabilities are going to have to be levied in order to increase the availability of cash that can be used to finance certain expenditures, the time dimension of such an investment is to be considered carefully so that Honda can prevent diminishing marginal returns, any long-term debt is going to have to be managed effectively in order to accommodate for new facilities, and any risk and uncertainty that might be associated with such a significant business venture has to be dealt with accordingly by using basic financial models that incorporate changes in revenue, liabilities, COGS, and shareholders equity.

     It is my belief that if Honda made slight divestments in certain less-than-profitable business units such as its Formula 1 and Motorcycle Racing activities, its non-engine related technology developments (ASIMO, walk-assist etc.), and its Power Equipment business unit the company could generate the necessary funding to support such a capital intensive strategic decision. As mentioned earlier the firm has to watch out for things such as diminishing marginal returns, risk and uncertainty, and resource allocation but I feel that with proper management and continuing support of the company’s existing corporate philosophy of social responsibility and environmental protection Honda could really transform the world with its electricity based power production activities. If their business and firm-level strategies (based on sound financial modeling) can successfully incorporate large-scale investments in fuel-cell technologies then eventually other companies will catch on and the whole industry will shift its focus from fossil fuels to green energy. A shift this large would constitute a change in the perception big business has in the profitability of green technologies. This might trigger other industries to make similar significant investments in things like carbon scrubbers, public transit, household heating, agriculture, ecological preservation, and global awareness. Only when capitalist entities see the profitability associated with this type of Green thinking will they make significant investments in the promotion of this type of technology, but in order to do that the process has to be backed up with proven examples of sound financial models and I think Honda is strategically positioned to take the first steps.

Project Phase II Narrative: Honda Motor Company

     1.)         Multi-Year Cash flow (5 year):  Descriptions and assumptions for doing business over the course of 5 years.

     As the world’s foremost producer of engines and the second largest auto manufacturer next to Toyota, Honda is in a class all its own. Its multi-year cash flows rival that of entire nations and the expansiveness of its daily operations suggests it could likely populate one as well. This makes expansion one of the major factors influencing the company’s generic business strategy because without it Honda couldn’t keep up with the world’s growing demand. By reaching into supporting industries HMC is able to operate more efficiently than its competition and provide affordable products without sacrificing quality. Because expansion is such a major theme of the Honda business strategy I have modeled the fundamentals of the Honda organization and projected two (5 year) Cash Flows that explain how certain critical areas of the company’s financial reports would be adjusted should it pursue $15,000,000 plant expansion through A, divestment in existing operations, or B, via the incursion of Long-Term Debt. My models, while extremely comprehensive, are not meant to be exactly accurate depictions of these two assumptions. Rather, they provide a hypothetical framework for making decisions and offer corporation-wide visual representations of the affects these decisions might have.

     First and foremost, it is important to note the structure and flow of the accompanying model so that changes can be made under the correct conditions and one understands how each table relates to the next. Under the “Assumptions-Summary Data” tab there are two tables that depict a myriad of financial datum from R&D and Managerial Costs associated with doing business to other affected items such as Common Vs Treasury Stock, P.P.E., Cash, and Long-Term Debt. These represent only a few of the important areas of the business affected by significant operational decisions but the ones that I have assembled provide a useful glimpse into some of the system wide changes that might occur should either of the assumptions be accepted. The model works by aggregating specific data points and then translating the assumed numerical changes to other affected areas- ultimately showcasing these changes on the Income Statement, Balance Sheet, Financial Ratios, and Graphical Representations sections of the model. The numerical data was forecasted under a logical thought process but are not meant to be 100% accurate. General explanations of each numerical projection can be found in a comment nested within the affected area’s title cell.

     Under each assumption there is a table showing the Unit Sales breakdown for each of Honda’s primary Strategic Business Units (SBU). For simplification purposes I assumed that each product’s average price (found by dividing each SBU’s Net Income by its 08 Sales Units) would remain constant so that consumer demand could be assessed in relation to the “Factor Changes” rather than the price changes the assumption might or might not illicit. Price is later assessed in terms of its risk to Unit Sales in a handy model placed beneath the two assumptions tables. Lastly, “Assumption Documentation” and “Customer Assumptions” for each table can be viewed in each assumption by rolling over specific cells contained within the Demand Analyses. The former is located under the “Factor Change” section and the latter can be viewed by rolling over the numerical data contained within each table.     

     Assumption A, “Divestment as a Means of Funding” is probably the less likely of the two situations because reductions in other operations would provide the necessary funding for Honda’s plant expansion rather than the more logical L-T debt incursion. This would reduce funds for each SBU and likely result in sales reductions across Honda’s product line. Some important assumptions that were made about this course of action include reductions in R&D and Direct Labor expenses, increases in cash and cash equivalents as divestment activities siphon funds from other operations, and the selling of common stock to generate the remaining cash necessary to fund the P.P.E. expansion. If you plug in the numbers from Year 3 you can see that Net Income increases to over $11 million, EPS drops from 18.13 EPS to 13.35 and Honda’s Sales to Net Working Capital skyrockets. Under these circumstances it is likely that Honda could support the $15,000,000 expenditure because despite the factor changes Total Sales only dropped by $2 million    

    Assumption B, “Long-Term Debt” seems like the more logical of the two assumptions. Since the company is taking out a loan it will not have subtract funding from other operations to generate cash. This would keep existing operations functioning at the same pace over the five-year period and as a result demand for Honda products would remain constant. While Long-Term debt jumps to about double its existing 2008 amount in year one, over time Honda is able to pay off the loan and eventually even reduce its previous debt amount to $15 million as a result of its new found success in “green” automobiles. Demand remains roughly around 08 amounts in all of Honda’s SBU’s until years four and five when the new plant begins operations and people start to demand the new models. 

2.)        Investments: description of 5 year capital investments required to grow the business in the five year time frame that you are modeling.

     The decision at Honda to expand its facilities is one that does not come lightly. Careful analyses of affected financial areas, future growth potential, financing, and the over all strategic role a new facility will play in the organization have to be considered before any investment is to be made. The idea is that expansion into new facilities offers opportunities for the company to grow its business and operate more efficiently as a result. The recent plant expansion at Hamamatsu is a great example of this because in response to existing inefficiencies Honda decided to consolidate its various transmission related operations and place them under one roof. This decision not only gave the company greater control but also allowed the firm to operate more efficiently by reducing inventory costs and increasing Honda’s ability to match production with demand.

     The decision to build a new plant that will encompass production of alternative energy car components to be retrofitted onto Honda’s existing products is no small investment, however, I believe it to be a necessary one for the company to grow over the next five years and beyond. Alternative energy sources show an extreme amount of potential and the largest benefits will go to the companies that make significant investments in them early.

3.)         Demand Analysis: describe how you have forecast your demand (sales) for the entire 5 year lifespan of the model.

     Demand is one of the key differences between Assumption A and B in the model I have designed. Under Assumption A demand is adversely affected by general reductions in operations where as in Assumption B the L-T loan incursion allows Honda to keep operations constant, in-turn preserving demand roughly around its usual amounts. In both cases, however, demand begins to increase as the new plant is established and begins operations. This of coarse is under the assumption that the new products are a success and Honda can market the effectively.

4.)         Underlying Economics: a description of the fundamental economics underlying your revised multi-year business model.

     The underlying economics of my model are simple. As expenses decrease, more cash become available to fund other initiatives. As Honda begins to tighten funding on its other operations it is able to generate funds that can be used to finance plant expansion. On the other hand, increases in long term debt make the firm unfavorably leveraged which can increase risk and limit the amount of available funds needed to pay of short-term accounts. In the model cash is directly affected in both decisions but in the end begins to increase, as the new plant becomes a success.

     The “Price/Demand Risk Assessment” showcases another fundamental aspect of economics in that as price is increased, decreased, or kept relatively constant demand will decrease, increase, or remain the same accordingly. The table allows users to input any change in price and see the resulting change in demand that would likely occur. Dramatic decreases in average price result in dramatic increases in Demand Units, slight decreases equate to slight increases, large increases cause large decreases and so forth. The changes are then translated to the graphical section of the model where they are visually depicted as percentages of net sales by business and unit sales by SBU. Due to the complexity of the model and the threat of circular reference the price/demand paradigm could not be incorporated into the assumptions. However, with a little more time I’m confident that I could design a few more tables that would allow these figures to directly influence other aspects of the model; it’s just disseminating the flow of data that poses the initial difficulty.

5.)         Risk: description of how risk has been built into at least two variables assumptions/calculations area including expected value and variation for downside variables.

     One of the most important features of the model I have created is its flexibility. Just about every primary variable such as C.O.G.S., Rate information, Loan specifications, Revenue, Debt, Assets, etcetera can be manipulated and then translated into the rest of the model. Increases in price by a large enough amount have the demand risk built right into the table. Complex formulas are intertwined with cells tied together in sometimes double-digit amounts so that specific data will adjust every related account and provide users with a system wide picture of how simple changes can make big differences. While the Price/Demand Risk Assessment table is the primary representation of how risk can adversely affect the organization, the Adjustable Summary Data table also deals with risk in that changes to primary variables will affect every secondary variable and ultimately allow users to see which changes present the most risk. For example, if Honda decides to increase its R&D expense by 1.10% its Net Income drops by over a million dollars and its common stock EPS drops by almost 20%. While these numbers are not meant to be completely accurate they prove that R&D, which is a variable expense with Total Sales, is a highly volatile expense percentage and should be monitored carefully. The same can be said about any other account on the Adjustable Summary Data table for is any factor is varied to a considerable degree users are able to see directly how changes in one critical area affect the others. My only regret is that I could not model Total Sales directly into my projected demand for each assumption. Total Sales of each assumption must be viewed in the graphical section of the model and then applied to the summary data after the factor changes have been inputted. 

6.)        Scenario Analyses: a description of three different scenarios (sensitivity) analyses, including what you have learned from the model (findings) and how the key variables impact your model.

     This question is a great follow up to the previous one. The initial idea of my model was to have all of the information tied together in one wholly seamless model. Assumption and Price/Demand risk would not be left out; rather they would show the exact factor changes that would result from a system wide change dictated by the scenario manager. At the time I even tailored by Summary Data to encompass exactly 32 different factors in 32 different cells, which was the maximum amount the scenario manager can manipulate at one time. However, as I later found out the Scenario Manager takes all of your formulas and makes them solid-state so that they no longer control the rest of the formulas you have attached them to. This made it impossible to have a set of scenarios that could be categorized as “Successes”, “Failures”, or “Possible Considerations.” But despite the Scenario Manager’s incompatibility I was able to create a model, although slightly more complex, that allows users to input any scenario the want and see the direct effect it will have on the organization.

     One of the most significant scenarios to be considered at Honda is a price change in any of its products. Take Automobiles for example. At an average price of $24,143.43 the company generates approximately $94.5 million USD, which represents 80% on Honda’s Net Sales. If a decision were made that increased the average price of Honda automobiles by $857, making it an even $25,000, Net Income would increase by almost $4 million dollars and Common Stock EPS would jump 34% to $24.61 per share. This doesn’t mean that consumers would have to pay an extra $900 on every vehicle- the price is an average. Honda could increase the price primarily on its luxury vehicles because this demographic of consumers is less affected by changes in price and only slightly raise the costs of its other vehicles. The same principle can be applied the firm’s entire product line. A $40 USD increase in the average price of motorcycles would increase revenues by half a million dollars. This represents how sensitive revenues are to price changes and showcases how small decisions can have big impacts.

     Another scenario to be considered is a change in the Minority Interest Rate. This amount is surprisingly volatile as a 2% increase results in an increase of $100 k dollars in total liabilities and a pretty significant EPS drop. It is not unlikely that a slight change in rates will occur and Honda needs to be aware of rate change impacts.

     A final scenario to consider is if demand doesn’t pick up after the new plant is established. If demand stays the same or even drops Honda faces significant losses in income but more importantly the long-term unprofitability of the new plant. This venture is a large commitment by the company and its success rest on its ability to stimulate demand. If demand cannot be generated Honda might have to abandon the plant expansion early before it cant recoup the majority of its losses.  Whatever the scenario may be, this model is designed to show the interrelated affects of certain financial information and translate those changes in a comprehensive manner. Numbers and figures do not accurately represent any particular circumstance; rather they provide a framework that supports financial modeling.

7.)          Economies of scale/scope/learning curve identify at least one major assumption based on one of the concepts and describe the impact on the outcome of the model.

     Such a significant plant expansion at Honda would yield tremendous benefits to the organization. Honda is already known for its dynamic operational strategy and is considered by many as the one company furthest along the engine production learning curve. A major part of its success is the company’s comprehensive collection of SBU’s that range from small two stroke weed whacker engines all the way up to high performance Formula 1 racing engines. Honda is actually the only producer of generic Formula 1 engine components because the company is produces the best engines and is the only producer with an economy of scale large enough to supply them at price no other competitor can match. Affordability without sacrificing quality is a major theme that drives Honda Motor Company and it is my belief that P.P.E. expansion into the production of alternative energy engine components is an inevitable change coming to the company. This type of expansion would likely result in Honda gaining proprietary knowledge that would further advance their position along the learning curve and ultimately contribute to the firm’s scaled economy as the world latches on to these new technologies.

     As Honda established itself as the world’s leading (if not foremost producer) of alternative energy vehicles by creating the new facility and aligning itself with major suppliers, its revenues would likely skyrocket only to be offset by the large initial investment. The model would have to encompass supplier relations, new product lines, and likely some form of division between fossil fuel and alternative energy products and components. This division would allow the company to see how successful the new SBU is in direct comparison with its existing operations.

Project Phase III Narrative: Honda Motor Company

     For this modeling project I have decided to create a basic financial model that maps some of the most critical aspects of the Honda Motor Company. The reason I have done this is to provide users with a broad financial analysis and help them understand how incremental changes in specific financial datum will impact other areas of the business to the benefit or the detriment of the entire company. Through the use of formulas, tables, and charts I have attempted to illustrate a hypothetical situation where Honda decided to take out a $15,000,000 loan to fund the development of a new facility that would produce vehicles powered by hydrogen fuel cells. The model uses certain realistic assumptions based on existing empirical data so while it is not meant to be 100% accurate it does provide a useful tool to aid in managerial decision making.

     Through my experience in developing the model I gained certain insights into the company that have helped me better understand how the industry in general works and while Honda has a notably wider focus on other manufacturing activities, these insights are likely applicable to the majority of other industrial manufacturers. Probably the most significant finding of the model was the inelasticity of Honda prices against changes in Raw Materials costs. As is likely the case for many auto manufacturers, Honda gets around this by expanding upstream and acquiring stake in raw materials providers so they have more bargaining power and control over prices. Nevertheless, Honda’s costs are extremely susceptible to changes in its major raw material prices so the company must do what it can to secure supply and hedge its losses should a major price spike occur.   

     Another important factor of the model is the sensitivity of consumers to product price increases. A Price/Demand Risk Assessment formula calculates the changes in demand that result from significant increases or decreases in individual product prices; large jumps in price drop demand according to their severity where as price decreases denote demand increases. Using this feature of the model managers can determine how much markup they want to apply to specific products and find a medium between Total Unit Sales and Average Per Unit Costs.  The conclusion based on the model suggest that if Honda were to make significant investments in alternative energy sources and increase production to encompass “green” automobiles, then the company would show consecutive increases in Total Revenues and likely remain a major automotive and power production competitor for years to come.   

     With as primary focus in auto manufacturing and a significant existing market share, Honda has no problem sustaining its Cash Flow over time. Even with a minimum Cash Balance of $5,000,000 Honda maintains an Excess Cash Balance significant enough to cover any unexpected cash requirements that might appear.

     Once the model was taken out over a 5-year period I incorporated some Adjustable Data that would allow users to forecast changes in demand. Based on industry average Annual Unit Increases of between 2% and 5%, each of Honda’s primary SBU’s generate an increasing amount of revenue. Based on these assumptions (all of which can be adjusted) we can see that as Hondas Operating Income increases the company’s Expense Percentage of Income actually decreases over time as unit sales begin to trump manufacturing expenses. It seems that if Honda could continue to make slight increases in total unit sales over time, through advertising or product incentives, the company could actually use lower production costs to generate more sales- like the snake eating its own tail the company could secure its long-term sustainability by keeping demand high and lowering costs with the excess revenue amounts (I would explain this more but it’s 11:30 and I have to submit this NLT 11:55!)

     Prices are driven by total unit production costs and a Markup % determined by the user. Increases in Markup might increase revenues but too much will lower demand.

     The first few tabs of the model provide infinite Scenario Analysis options but some of the one I thought were most critical were the maximum increases to Markup percentages that would not result in decreased demand and the changes to total production costs that result from increased Raw Materials expenses. The former showed that Markup on Motorcycles is the most flexible because Honda has a devoted consumer following that would likely shoulder increased prices based on the value they perceive with the product. The latter shows that Honda should maintain its supply chain relations and secure as far into the future as it can. This way, dramatic changes in Raw Materials costs would have (as) an immediate effect on Honda as it will its competition.

     The Balanced Scorecard incorporated in the model provides a reference to some important “Value” based metrics that the company should monitor. These metrics allow Honda to see how much value consumers associate with the company and accordingly determine how elastic they are to price fluctuations.   

     The Future Opportunity tab of the model allows users to model any changes in demand and the resulting changes in revenue that might occur as Honda launches a new “green” line of automobiles. Based on the assumptions provided it seems the company would do well to make early and significant investments in alternative energy sources.

*Note- Please take your time to really explore the model professor Nix because I worked really hard on this and stuck with it throughout the semester. I didn’t want to let it go and I did my best to create something that’s functional and (hopefully) meets all the requirements of the assignment. Thanks again for understanding and I’ll see you on Thursday.