Question

Tasmanian Motor Rental (TMR) is set up as a proprietary company in car rental industry and is considering whether to enter the discount rental car market in Tasmania. This project would involve the purchase of 100 used late model, mid-sized cars at the average price of $13,500. In order to reduce their insurance costs, TMR will have a LoJack Stolen Vehicle Recovery System installed in each car at a cost of $1,200 per vehicle. The rental car operation projected by TMR will have two locations: one near Hobart airport and the other near Launceston airport. At each location, TMR owns an abandoned lot and building where it could store its vehicles. If TMR does not undertake the project, the lots can be leased to an auto-repair company for $80,000 per year (Total amount for both lots). The $25,000 annual maintenance cost (total for both lots) will be paid by TMR whether the lots are leased or used for this project. This discount rental car business is expected to result in a fall in its regular car rental business by $20,000 per year.

For taxation purposes, the useful life of the cars is determined to be five years and they will be depreciated using the straight-line depreciation method over 5 years with no residual values at the end. It is assumed that the cars will first be used at the beginning of the next financial year: 1 July 2020.

Before starting this new operation, TMR will need to redevelop and renovate the buildings at each airport locations. This is expected to cost $250,000 for both locations. Assume that TMR is not able to claim any annual tax deduction for the capital expenditure to the renovation of the building until the business is sold. TMR has also budgeted marketing costs what will be spent immediately to promote the new business and during the first two years of operation to boost the sales. The estimated costs are $30,000 per year. These costs are fully tax deductible in the year they are incurred. In addition, if the project is undertaken, a total new injection of $250,000 in net working capital will be required. There will be no additional working capital required from the commencement of the operation until the end of the project. The initial networking capital will be recovered in full by the end of year 5.

Revenue projections from the car rental for the next five years are as follows:

	Year 1	Year 2	Year 3	Year 4	Year 5
Beginning	1/7/2020	1/7/2021	1/7/2022	1/7/2023	1/7/2024
Ending	30/6/2021	30/6/2022	30/6/2023	30/6/2024	30/6/2025
Revenue ($ ‘000)	1,092	1,150	1,350	1,500	1,550

Operating variable costs associated with the new business represent 8% of revenue. Annual operating fixed costs (excluding depreciation) are $520 per vehicle. Existing administrative costs are $400,000 per annum. As a result of the new operation, these administrative costs will increase by 15%. The company is subject to a tax rate of 27.5% on its profits.

Catherine, the company CFO would like you to help her examine the viability of the project for the next five years, taking into consideration the projections of sales and operations costs prepared by company’s accountants.

Given the risk associated with the project, she believes it is reasonable to use the cost of equity for the evaluation of this project. TMR’s equity beta is estimated to be 1.1, the Treasury bond yield is 2% and the market risk premium is 10%.

Based on the information in the case study, Catherine has asked you to write a report to TMR’s management advising them as to the best course of action regarding this project. Your report should address the following specific questions asked by TMR’s management:

1. Determine the initial investment cash flow and estimate all cash flows associated with the project over 5 years. It is assumed that where relevant, capital expenditures are expended throughout the year, while cash flows relating to revenue and operating costs occur at the end of the year. You will need to broadly describe the method used for determining those cash flows.
2. Calculate the project’s payback period. Assuming the business will continue at the end of year 5 so ignore the possible terminal value of all assets (Car fleet and premises). Ignore the time value of money for this calculation. Briefly comment on your results.

Answer 1

Year	0	1	2	3	4	5
1.Purchase of Cars(100*13500)	-1350000
2.Installation of LoJack SVR system(100*120)	-120000
3.After-tax cost of opportunity lost on lots'rental income(80000*(1-27.5%))		-58000	-58000	-58000	-58000	-58000
4.After-tax cost of regular business lost (20000*(1-27.5%))		-14500	-14500	-14500	-14500	-14500
5.Redevelopment & renovation costs of buildings	-250000
6.After-tax marketing Costs(30000*(1-27.5%))	-21750	-21750	-21750
7.NWC introd. & recovered	-250000					250000
Operating cash flows:
8.Revenues		1092000	1150000	1350000	1500000	1550000
9.Variable costs(Rev.*8%)		-87360	-92000	-108000	-120000	-124000
10.Fixed costs(100*$ 520)		-52000	-52000	-52000	-52000	-52000
11.Incl.admn. Costs(400000*15%)		-60000	-60000	-60000	-60000	-60000
12.Depn.(1470000/5)		-294000	-294000	-294000	-294000	-294000
13.EBIT( sum 8 to 12)		598640	652000	836000	974000	1020000
14.Tax at 27.5% (13*27.5%)		-164626	-179300	-229900	-267850	-280500
15.NOPAT/Net income (13+14)		434014	472700	606100	706150	739500
16. Add back:depn.(Row 12)		294,000	294,000	294,000	294,000	294,000
17.Operating Cashflow(15+16)		728014	766700	900100	1000150	1033500
17.Total annual FCFs(1+2+3+4+5+6+7+17)	-1991750	633764	672450	827600	927650	1211000
Payback period:
Cumulative FCFs(prev. total+current)	-1991750	-1357986	-685536	142064	1069714	2280714
Payback period in yrs.=
2+(685536/827600)=
2.83
Years

Given that the business will continue at the end of year 5

it would have recovered its investments in less than 3 years & hence, highly feasible & viable & hence RECOMMENDED

About the Cash flows :

$ 120000 costs towards LoJack Stolen Vehicle Recovery System adds to the utility value of the car & hence capitalised & depreciated.

The $25,000 annual maintenance cost (total for both lots) ---is not an incremental cost & hence not considered for this project-decision.

The $ 250000 Redevelopment & renovation costs of buildings, need to be incurred before start of the project & hence considered Yr. 0 cash flow , at its full PV.Will count for capital gain/loss calculations, when sold.

$ 30000 Marketing costs are not capital expenditures.