Question

CASH FLOW AND CAPITAL BUDGETING Aus Car Execs (ACE) is set up as a sole trader and is analysing whether to enter the discount used rental car market. This project would involve the purchase of 100 used, late-model, midsized automobiles at the price of $9,500 each. In order to reduce their insurance costs, ACE will have a LoJack Stolen Vehicle Recovery System installed in each automobile at the cost of $1,000 per vehicle. ACE will also utilise one of their abandoned lots to store the vehicles. If ACE does not undertake this project, they could sublease this lot to an auto repair company for $80,000 per year. ACE will pay the $20,000 annual maintenance cost on this lot whether the lot is subleased or used for this project. Also, if this project is undertaken, the net working capital will increase by $50,000. For taxation purposes, the useful life of the automobiles is determined to be six years, and they will be depreciated using the diminishing value method. Each car is expected to generate $4,800 a year in revenue and have operating costs of $1,000 per year. Starting six years from now, one-quarter of the fleet is expected to be replaced every year with a similar fleet of used cars. This is expected to result in net cash flow (including acquisition costs) of $100,000 per year continuing indefinitely. This discount rental car business is expected to have a minimum impact on ACE’s regular rental car business where the net cash flow is expected to fall by only $25,000 per year. ACE expects to have a marginal tax rate of 32%. Based on this information, answer the following questions.

1. What is the initial cash flow (fixed asset expenditure) for this discount used rental car project?

2. Is the cost of installing the LoJack System relevant to this analysis?

6. Estimate the net cash flow for each of the next six years.

7. How are the possible cannibalisation costs considered in this analysis?

8. How does the opportunity to sublease the lot affect this analysis?

9. What do you estimate as the terminal value of this project at the end of year 6 (use a 12% discount rate for this calculation)?

Answer 1

Solution:

1) The initial fixed asset expenditure would be 9500 X 100 + 1000 X 100 = 10500 X 100 = 10,500,00

2) Yes the cost of installing LoJack System is relevant to the analysis ,since being a one time cost and having a major effect on the operating expense of the project, it will be capitalized.

6) Year 0 - 10500

Diminishing value method dep = (2 / Useful life) * Beg book value = 2/6 X 10500

Year 1 : Cash Flows = Net Inflows - Net Outflows - Dep

= (4800-1000) X 100 - First Year dep = 3800 X 100 - 350000 = 30000

Second Year dep = 2/6 * 350000 = 116666.7

Year 2 : Cash Flows = = (4800-1000) X 100 - Second Year dep = 3800 X 100 - 116666.7 = 263333.3

Third Year dep = 2/6 * 116666.7 = 38888.89

Year 3 : Cash Flows = = (4800-1000) X 100 - Third Year dep = 3800 X 100 - 38888.89 = 341111.1

Fourth Year dep = 2/6 * 38888.89 = 12962.96

Year 4 : Cash Flows = = (4800-1000) X 100 - Fourth Year dep = 3800 X 100 - 12962.96 = 367037

Fifth year dep = 2/6 * 12962.96 = 4320.988

Year 5 : Cash Flows = = (4800-1000) X 100 - Fifth Year dep = 3800 X 100 - 4320.988 = 375679

Sixth Year dep = 2/6 * 4320.988 = 1440.329

Year 6 : Cash Flows = = (4800-1000) X 100 - Sixth Year dep = 3800 X 100 - 1440.329 = 378559.7

7) Cannibalization is basically an externality having a negative effect on the current project of a company due to addition of the additional project, in the question it is clearly mentioned that the addition of discount rental car business is expected to have a minimum impact on ACE’s regular rental car business where the net cash flow is expected to fall by only $25,000 per year i.e. cannibalization will have a minimal impact.