Question

Parramatta Scenic Cruises Pty Ltd (PSC) is a family-owned ferry business that operates on Sydney’s Parramatta River. Jane Jetson founded the company when she arrived in Australia and remains the Chief Executive Officer. Jane’s two children, Judy and Elroy, occupy key management roles in PSC. Judy Jetson is the Chief Financial Officer and Elroy Jetson is the tax accountant. PSC reported sales of $11 million for the 2017 financial year.

2) PSC is investigating a proposal to renew part of their fleet that involves replacing an existing ferry with a new, faster, 330-seat ferry costing $3 million. Judy is concerned that the net profit of the new ferry won’t generate a fast enough payback period. Therefore, she has discussed her concerns with Jane. Jane carefully explains to Judy the many reasons that profitability is not a good measure of financial success. Judy then prepares to conduct a rigorous cost-benefit analysis to ensure that the new ferry is financially viable.

3) Last month, Judy and Jane paid for a study by SeaWay Consulting P/L at a cost of $487,000 and the study concluded that the large and growing tourism market will generate sufficient demand for a new ferry. Today, PSC must decide if they will proceed with the investment in the new ferry and the associated sale of their existing ferry.

4) Elroy is really excited about the new ferry. It is a 34-metre, 119 tonnes displacement ferry capable of 35 knots with two cabins and four outside decks with a capacity for 330 passengers. According to the Australian Taxation Office (ATO) the new ferry has a sixteen-year life for taxation purposes.

5) NSW Maritime requires that all vessels have a Certificate of Operation that indicates that the vessel has been inspected and found to comply with the minimum standards set out in NSW maritime legislation. The compulsory certificate is required before PSC commences operations with the new ferry. Certification requires PSC to spend $200,000 on safety equipment. The certificate expires four years later at which time the ferry must be recertified and the safety equipment replaced at an estimated cost of $200,000. Recertification must occur every four years.

6) Because of limitations on the number of vessels at particular wharves on the Parramatta River the new ferry will replace an existing ferry. Even though the new ferry has an effective life of fifteen years, the Jetson family will operate the ferry for ten years only. Jane has arranged for the sale of the existing ferry for $300,000 today. If they don’t proceed with the new ferry PSC will continue to operate the existing ferry for ten years. The existing ferry was purchased six years ago for $2 million. Elroy states that the annual depreciation expense of $200,000 per annum is based on the ten-year tax life at the time of purchase. The existing ferry has a current book value of $800,000.

7) Elroy has suggested that because the new ferry is analysed over a ten-year time period they need to ensure that they recover all the costs they have incurred to date. Therefore, he recommends the $487,000 SeaWay Consulting fee be allocated equally over the ten-year analysis period.

8) PSC will borrow $2 million using a secured ten-year interest-only loan at an interest rate of 5% per annum to partly finance the new ferry. The loan requires annual interest payments of $100,000 starting in one year’s time. Today, inventory will need to increase by $110,000 to $610,000. Accounts receivable will increase to $750,000 from the current figure of $660,000.

9) At the moment PSC is leasing their Harris Park wharf facility to an unrelated entity for $85,000 p.a. The introduction of the new ferry will require that PSC use the wharf on a full-time basis. In this case, PSC must terminate the lease agreement. There is debate among the family members if this lease agreement is an example of a sunk cost or not.

10) At the moment, the existing ferry generates annual cash sales of $1,400,000. This sales figure is predicted to remain constant for each of the next ten years. The new ferry is predicted to generate cash sales in year one of $1.8 million in year 1 and this sales forecast is anticipated to increase by 4% per annum for the foreseeable future.

11) Judy has gathered some information regarding current and expected costs. At the moment, fixed costs are $400,000 per annum. Fixed costs would rise to $500,000 in year one with the new ferry. PSC is confident that they can reduce the increase in fixed costs by 2% p.a. after the first year. Wages expense is currently $900,000 each year and is predicted to increase to $1.4 million with the introduction of the new ferry. Judy reminds the family about the importance of incremental cash flow items when performing a financial analysis.

12) The current annual maintenance cost of the existing ferry is $63,000. The new ferry will require no maintenance in the first three years of its life because it is covered by a manufacturer’s three-year warranty. However, after the warranty expires in year 4 the annual maintenance expense will be $87,000. Jane has advised that PSC has an insurance policy that will insure any number of the company’s vessels at a fixed annual fee of $145,000.

13) It costs $175,000 a year to operate PSC’s head office and marina on the Parramatta River at Harris Park. With careful management PSC believes they will not require any additional personnel in headquarters if they purchase the new ferry. In any case, the annual head office operating expense will increase by just 2% each year.

14) The ATO classifies the safety equipment required for the Certificate of Operation as a business expense, and that expenses incurred in running PSC are tax deductible in the year the expense is incurred.

15) SeaWay Consulting’s report estimates that the new ferry will have a market value of $1 million in ten years’ time. The existing ferry has a book value of $800,000 today and can be sold for $300,000 today. PSC will use these sale proceeds to distribute a $300,000 dividend to its shareholders today. SeaWay Consulting advises that in ten years’ time the existing ferry would be worthless.

16) The company tax rate is 30% and the required rate of return is 12%.

Capital Budgeting Information

Present an itemised breakdown (and the total) for each of the following:

1. The cash flows at the start.

2. The cash flows over the life.

3. The cash flows at the end.

4. The NPV of the new ferry and an explanation of your recommendation.

Answer 1

The calculations are shown in excel as follows: