Question

ECO Vietnam is planning to improve the transportation to Gia Bic Village by providing more ecofriendly option. The current fuel powered bus has been used for the past 4 years and was originally planned to be used for 10 years. It costed $1,000,000 to acquire, and was being depreciated straightline over 8 year period. However, it was found that the fuel powered bus began to emit black CO2 gases, and would violate their mission and vision as an ecotourism provider. The company would therefore like to investigate two mutually exclusive projects in order to replace the fuel powered bus. One option is an electric bus and another option is a hybrid electric bus. Both should be able to fit around 40 ecotourists. They have already conducted and paid $20,000 for an assessment of the potential of using electric and hybrid electric buses in ecotourism operations. The board of directors usually would like to gain back the investment amount within 5 years. The current fuel powered bus can be sold to another tourism operator at a salvage value of $170,000 if a new bus is acquired. The current corporate tax rate is 20%.

A new electric bus for use in protect areas cost $6,500,000, while the charging station for the bus costs $5,000 including installation. The firm’s financing costs are $32,000 per year. Administrative and legal fees associated with the capital acquisition are expected to be $9,000 and $4,000, respectively. The economic life of the investment is 7 years and will depreciate straight-line to a zero value over 10 years. Management team expects the electric bus can be sold after 7 years at a price of $2,000,000. ECO Vietnam expects the electronic bus will reduce fuel expenses by $980,000 annually, with additional revenues of $75,000 per year. Hopefully, with the word-of-mouth, more ecotourist will be attracted to visit this village, and should bring in 11% growth in revenues per year. Electricity fees initially are $80,000 and are expected to grow at 3% each year. To support the use of environmentally friendly transportation, the government will subsidize $50,000 annually for the first 5 years to companies not using fuel-powered buses.

The other option, a second hand hybrid electric bus costs $2,800,000, including maintenance fees. Administrative and legal fees associated with this acquisition are expected to be $5,000 and $8,000, respectively. The economic life of the investment is 5 years and will depreciate on a five-year MACRS to a salvage value of $0. Management team expects the hybrid electric bus can be salvaged at the end of it’s economic life at price of $280,000. ECO Vietnam believes fuel expenses will be reduced by $670,000 annually, with a 3% decrease in savings per year as the battery becomes less efficient.

Additional revenues will be the same as the electric bus of $75,000 per year, with a 11% growth in revenues per year. Electricity fees start at $15,000 and are expected to grow at 3% each year. For this kind of hybrid bus, additional spare parts of $5,000 will need to be prepared immediately, and accounts payable will increase about $3,000 annually once the bus is in use.

Year	5-year MACRS
1	20.00%
2	32.00%
3	19.20%
4	11.52%
5	11.52%
6	5.76%

Currently ECO Vietnam has 20,000 zero coupon bonds with 10 year maturity, selling for 40% of the par value, 1,500,000 share of common stock, selling for $18 per share, with a beta of 1.3. Market risk premium is 6.50%, and the risk-free rate is 1.25%. The bus project is a little bit less risky than the company’s usual projects, so ECO Vietnam determined to apply an adjusted factor of -3% to the cost of capital. Given the above information about the projects and the cost of capital for ECO Vietnam, do all the calculations that are necessary in order to make a value creating decision. The general format is up to you, as long as all the components for making such decision are present. You should focus on using the right methods, rather than on getting the right answer.

Explain your recommendation to the board of directors

Answer 1

Electric bus
Year	0	1	2	3	4	5	6	7
Cost of bus	-6500000
Cost of Chg.station incl.installn.	-5000
Admn .fees	-9000
Legal fees	-4000
1.Total investment	-6518000
2.ATCF on salvage (new bus --wkgs. 1)								1991080
2.a.ATCF on salvage of Old Bus In Year 0(wkgs.-2)	236000
Incremental revenues & costs
savings in fuel expenses		980000	980000	980000	980000	980000	980000	980000
Addl.Revenues		75000	83250	92407.5	102572.3	113855.3	126379.4	140281.09
Electricity fees		-80000	-82400	-84872	-87418.2	-90040.7	-92741.9	-95524.18
Govt.subsidy		50000	50000	50000	50000	50000
Depn.(6518000/10)		-651800	-651800	-651800	-651800	-651800	-651800	-651800.00
3.Incl.EBT		373200	379050	385735.5	393354.2	402014.6	361837.4	372956.91
4.Tax at 20%(3*20%)		-74640	-75810	-77147.1	-78670.8	-80402.9	-72367.5	-74591.38
5.Incl.EAT(3-4)		298560	303240	308588.4	314683.3	321611.7	289469.9	298365.53
6.Add back:Depn		651800	651800	651800	651800	651800	651800	651800.00
7.Incl.OCF(5+6)		950360	955040	960388.4	966483.3	973411.7	941269.9	950165.53
7a. Depn. Tax shields lost on old bus		-25000	-25000	-25000	-25000
8.Total FCFs(1+2+2a+7+7a)	-6282000	925360	930040	935388.4	941483.3	973411.7	941269.9	2941245.53
9.PV F at WACC 6.24%(1/1.0624^Yr.n)	1	0.94127	0.88598	0.83394	0.78496	0.73886	0.69546	0.65461
10.PV at 6.24%(8*9)	-6282000	871009	823996.8	780059.6	739027.1	719210.9	654614.8	1925372.86
11.NPV (sum of Row 10)	231291.1
12.IRR(Of Row 8)	7.12%

Year	0	1	2	3	4	5
Second-hand hybrid bus
Cost of bus	-2800000
Admn .fees	-5000
Legal fees	-8000
1.Total investment	-2813000
2.ATCF on salvage (wkgs.--3)						256405.8
2.a.ATCF on salvage of Old Bus In Year 0(wkgs.-2)	236000
3.NWC introduced & recovered(3000-5000)	2000					-2000
Incremental revenues & costs :
Savings in fuel expenses		670000	649900	630403	611490.9	593146.2
Addl.Revenues		75000	83250	92407.5	102572.3	113855.3
Electricity fees		-15000	-15450	-15913.5	-16390.9	-16882.6
Govt.subsidy		50000	50000	50000	50000	50000
Depn.(MACRS)		562600	900160	540096	324057.6	324057.6
3.Incl.EBT		1342600	1667860	1296993	1071730	1064176
4.Tax at 20% (3*20%)		-268520	-333572	-259399	-214346	-212835
5.Incl.EAT (3-4)		1074080	1334288	1037594	857383.9	851341.1
6.Add back:Depn		-562600	-900160	-540096	-324058	-324058
7.Incl.OCF(5+6)		511480	434128	497498.4	533326.3	527283.5
7a. Depn. Tax shields lost on old bus		-25000	-25000	-25000	-25000
8.Total FCFs(1+2+2a+3+7+7a)	-2575000	486480	409128	472498.4	508326.3	781689.3
9.PV F at WACC 6.24%(1/1.0624^Yr.n)	1	0.94127	0.88598	0.83394	0.78496	0.73886
10.PV at 6.24%(8*9)	-2575000	457906.6	362479.2	394036.2	399016.1	577555.7
11.NPV (sum of Row 10)	-384006
12.IRR (of row 8)	0.98%

Weighted average cost of Capital calculations:

WACC=(Wt.d*kd)+(Wt.e*ke)

Cost of zero-coupon bond=

assuming semi-annual compounding,

(1000*40%)=1000/(1+r)^20

Solving the above,

before-tax semi-annual cost of the bond= 4.69%

So,before-tax annual cost of the bond=(1+4.69%)^2-1=

9.60%

After-tax annual cost=Before-tax cost*(1-Tax Rate)

ie.9.6%*(1-20%)=

7.68%

Cost of Equity :

As per CAPM,

ke=RFR+(beta*mkt.risk premium)

ie.1.25%+(1.3*6.50%)=

9.70%

Now,		Wt. to total
Market value of Zero coupon bond= 20000* $ 400=	8000000	22.86%
Mkt. Value of common stock=(1500000*18)	27000000	77.14%
Total market value	35000000	100%
So, WACC= (22.86%*7.68%)+(77.14%*9.70%)=
9.24%
Adjustment factor= -3%
so, WACC for the bus project= 9.24%-3%=6.24%

Workings-1
After-tax salvage of electric bus
Total cost	6518000
Acc. Depn.(651800*7)	4562600
Carrying value	1955400
Salvage	2000000
Gain on salvage	44600
Tax on gain at 20%	8920
ATCF on salvage	1991080

Workings-2
ATCF on salvage of Old Bus In Year 0
Cost	1000000
Less; acc. Depn.(1000000/8*4)	500000
Carrying value	500000
salvage value	170000
Loss on salvage	330000
Tax saved on loss	66000
After-tax CF on salvage of old bus	236000

Workings-3
After-tax salvage of hybrid bus
Total cost	2813000.00
Acc. Depn.(651800*7)	2650971.20
Carrying value	162028.80
Salvage	280000.00
Gain on salvage	117971.20
Tax on gain at 20%	23594.24
ATCF on salvage	256405.76