Question

Introduction

You have recently been hired as the CFO of bus company AQR. AQR Inc. is a bus manufacturing company. The company is well known for manufacturing large and reliable bus at a reasonable cost. One of its greatest achievements is that its buses can be easily modified or customized for different applications.

The company is considering an expansion of its current product line to include transit buses. You feel that due to high gasoline prices, commuters will be more willing to consider using mass transit instead of using their cars to commute to work.

The Decision

AQR’s president presented the sales and cost forecasts shown in the attached exhibits. The information presented contains the cost of production, financing information, and warranty cost estimates. The proposals also contained two engine options for the engines: The Detroit engine, and the Marcus engine. The Detroit engine was more expensive to install, but had a lower warranty cost. The Marcus engine was less expensive to install, but had a higher warranty cost. This begged the question: Which engine should be used?

Issues and Analyses

You noticed that there was a great deal of enthusiasm among the management group about the transit bus opportunity, but your cautious nature told you to also seek a more objective viewpoint. Consequently, you sought to analyze the proposed project and provide your recommendations directly to CEO. The issues you want to address in your analysis and report are the following:

What are the project’s cash flows for the next 18 years? What assumptions did you use?

What is the company’s cost of capital? What is the appropriate discount factor (which may be different) for you to use in evaluating the bus project?

If you decide to go ahead with the project, which of the two engines should be used in the bus, and why?

Evaluate the quality of the project, by using appropriate capital budgeting techniques.

Would you recommend that AQR accept or reject the project? What are the key factors on which you base your recommendation?

Exhibit 1:   Sales and Cost Forecast

The sales forecast is based on projected levels of demand. All the numbers are expressed in today’s dollars.

Price per bus	$220,000
Units sold per year	12,250
Labor cost per bus	$32,500
Components & Parts	$86,500
Selling General & Administrative	$200,000,000
NOTE: Average warranty cost per year per bus for the first five years is $2,000. The present value of this cost will be used as a cost figure for each bus. Afterwards, the bus operator will become responsible the repairs on the buses.
The buses can be produced for 15 years. Afterwards, the designs become obsolete.

Engine choices

Engine	Detroit engines	Marcus engines
Price per engine, including installation	$18,500	$17,500
Average annual warranty cost per year for five years. Afterwards, the bus operator will become responsible for the repairs on the buses.*	$1,250	$1,350
The chosen engine will be installed in every bus and will become a cost figure for each bus.

Exhibit 2: Investment Needs

To implement the project, the firm has to invest funds as shown in the following table:

Year 0	Year 1	Year 2	Year 3
$500 million*	$250 million*	$250 million*	$100 million* Production and selling of buses starts

Straight line depreciation will be used for the sake of simplicity.

Assume that the factory and equipment will have $0 residual value at the end.

Exhibit 3: Financing Assumptions

The following assumptions are used to determine the cost of capital.

Historically, the company tried to maintain a debt to equity ratio equal to 0.40. This ratio was used, because lowering the debt implies giving up the debt tax shield, and increasing it makes debt service a burden on the firm’s cash flow. In addition, increasing the debt level may cause a reduced rating of the company’s bonds. The marginal tax rate is 35%.

Cost of debt:

The company’s bond rating is roughly AAA. Surveying the debt market yielded the following information about the cost of debt for different rating levels:

The company’s current bonds have a yield to maturity of about 4.25%.

Cost of equity:

The current 10-year Treasury notes have a yield to maturity of 2.25% and the forecast for the S&P 500 market premium is 7.5%. The company’s overall b is 1.25.

Project Guidance

Below is a list of items you need to identify and quantify to complete the case

A. For Each Year

1.Revenue

2.Variable costs

a Labor cost per bus

b Parts cost per bus

c. Engine costs per bus (2 options)

3. SG&A costs

4. Warranty costs

a.Bus

b.Engine (2 options)

5. Depreciation

B. Project Related

1. Investment costs

2. Building

3. Equipment

4. Clean up costs

5. Salvage costs

C. Cost of Capital

1. Company’s weighted average cost of capital (WACC)

2. Appropriate cost of capital for this project

And, after doing this, you have to form a basis for a go/no go decision on the project, with appropriate support for your decision (think NPV and IRR).

Answer 1

Cost of Equity (Ke) = i.e. 2.25 + 1.25 (7.5 - 2.25) i.e. 8.81

Cost of Debt (Kd) = Cost of Debt (1-t) i.e. 4.25 (1-0.35) i.e. 2.76 %

Overall Cost of Capital = ( Ke * We)+( Kd * Wd) i.e. (8.81 * .60) + (2.76 * .40) i.e. 6.39 %

Total Revenue from the project each year = Price Per Bus * Units sold i.e. $ 220,000 * 12250 i.e. 2695 Million/year

Labour Cost per Bus = $ 32500

Parts Cost per Bus = $86500

Machines :

Engine	Detroit engines	Marcus engines	For First 5 Years
Price per engine, including installation	$18,500	$17,500
Average annual warranty cost per year for five years. Afterwards, the bus operator will become responsible for the repairs on the buses.*	$1,250	$1,350
Each Year Cost (5 years)	$19,750	$18,850
Engine	Detroit engines	Marcus engines	For Next 13 years
Price per engine, including installation	$18,500	$17,500
Each Year Cost (10 years)	$18,500	$17,500
Total for 15 years	$283,750	$269,250
Rank	2	1

Marcus Engines are to be used as these will be less Costilier

SG & A Cost = $200 Million

Warranty Cost (Bus) = $ 2000 (for 5years)

Warranty Cost (Engine) for first 5 years =

Detroit engines	Marcus engines
$1,250	$1,350

Depreciation = ( 250 +250+100) / 15 = $40 Mllion