Question

1.

CASE STUDY

Australian Motor Execs (AME) is set up as a proprietary company 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 $18,000. In order to reduce their insurance costs, AME will have a LoJack Stolen Vehicle Recovery System installed in each car at a cost of

$1,500 per vehicle. The rental car operation projected by AME will have two locations: one near Hobart airport and the other near Launceston airport. At each location, AME owns an abandoned lot and building where it could store its vehicles. If AME does not undertake the project, the lots can be leased to an auto-repair company for $90,000 per year (total amount for both lots). The $25,000 annual maintenance cost (total for both lots) will be paid by AME whether the lots are leased or used for this project. This discount rental car business is expected to have minimum impact on AME’s regular car rental business in Tasmania, where the net cash flow is expected to fall by only

$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 most advantageous depreciation method set out by the Income Tax Assessment Act. It is assumed that the cars will first be used at the beginning of the next financial year: 1 July 2018.

Before starting this new operation, AME will need to redevelop and renovate the buildings at each airport location. This is expected to cost $220,000 for both locations. AME has also budgeted

$80,000 in marketing costs that will be spent prior the start of operation and during the first two years of operation. In addition, if the project is undertaken, a total new injection of $150,000 in net working capital will be required.

Maeve, the company CFO would like you help her examine the viability of the project for the next five years taking into account the projections of sales and operating costs prepared by AME’s accountants. Given the risk associated with the project, she believes it is reasonable to use a cost of capital of 12% for the evaluation of this project. Further financial data relating to the project can be found in the appendix.

*Question1. Discuss which costs are relevant for the evaluation of this project and which costs are not. Your discussion should be justified by a valid argument and supported by references to appropriate sources.

APPENDIX: Additional information for the case

Initial capital expenditure

Acquisition of the car fleet (including LowJack system): $18,000 + $1,500 per vehicle

Renovation of building at airport locations :$220,000

Injection of net Working capital $150,000

For tax purposes, the cars (including the LowJack system) may be depreciated using either the prime cost or the diminishing value methods as set out in Division 40 of the Income tax Assessment Act (ITAA) 1997. The economic life of 5 years has been approved by the Commissioner of taxation. Maeve indicated to you that the company will retain the method that is the most advantageous to the company from a financial point of view.

Assume that AME is not able to claim any tax deduction for the capital expenditure relating to the renovation of the building until the business is sold. At that time the cost of renovation is taken into account to calculate the capital gain.

Marketing costs

The $80,000 marketing costs will be incurred as follows:

$40,000 immediately before the launch of the new operation (1/7/2018)

$20,000 at the beginning of year 2 (1/7/2019) i.e. end of year 1

$20,000 at the beginning of Year 3 (1/7/2020) i.e. end of year 2

These costs are fully tax deductible in the year they are incurred (assume calendar year).

Revenue projections

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

	Year 1	Year 2	Year 3	Year 4	Year 5
Beginning	1/7/2018	1/7/2019	1/7/2020	1/7/2021	1/7/2022
Ending	30/6/2019	30/6/2020	30/6/2021	30/6/2022	30/6/2023
Revenue ($’000)	900	1,100	1,200	1,250	1,250

Operating costs

Operating variable costs associated with the new business represent 10 % of revenue. Annual operating fixed costs (excluding depreciation) are $1800 per vehicle.

Existing administrative costs are $550,000 per annum. As a result of the new operation these administrative cost will increase by 20 %.

Tax rate

The company is subject to a tax rate of 27.5% on its profits. The capital gain (if any ) on the sale of the business would also be taxed at 27.5%.

Answer 1

Capital used	NO of Cars X Price	19,50,000
Redevelop and renovation cost		2,20,000
Marketing cost		80,000
WORking capital required		1,50,000
Total capital investment		24,00,000
Cost of capital		12%
Expected earning (a)		2,88,000	p.a
rental income (b)		65,000	Note(1) below
Total earning(a+b)		3,53,000
Tax rate 27.5%		97,075
Net earning		2,55,925
Minimum Earning expected in Five years		12,79,625	Result (a)
	2018-19	2019-20	2020-21	2021-22	2022-23	Total
Earning	First year	Second year	Third year	Forth year	Fifth year
Revenue	9,00,000	11,00,000	12,00,000	12,50,000	12,50,000	57,00,000
Operating variable cost(10%)	90,000	1,10,000	1,20,000	1,25,000	1,25,000	5,70,000
Operating fixed cost	1,80,000	1,80,000	1,80,000	1,80,000	1,80,000	9,00,000
depreciation on car	3,90,000	3,90,000	3,90,000	3,90,000	3,90,000	19,50,000
annual manintenance cost	25,000	25,000	25,000	25,000	25,000	1,25,000
marketing cost	40,000	20,000	20,000	0	0	80,000
admin cost (incremental)	1,10,000	1,10,000	1,10,000	1,10,000	1,10,000	5,50,000
Compensation to main business	20,000	20,000	20,000	20,000	20,000	1,00,000
Redevelop and renovation cost						2,20,000
Net Income	45,000	2,45,000	3,35,000	4,00,000	4,00,000	12,05,000
Tax (27.5%)	12,375	67,375	92,125	1,10,000	1,10,000	3,31,375
Profit after tax	32,625	1,77,625	2,42,875	2,90,000	2,90,000	8,73,625	Result (b)
Observation:- there is no benefit in starting new business as the outcome of new business is 873,625 (result b)
which is lower than the 12% cost of capital employed in new business i.e 12,79,625 (result a)
Note(1) below	Amount
Earning by giving the lots on lease	90,000
AMC	25,000
net earning	65,000
Note:- there is not residual value of cars at the end of 5 year. Therefore No sale value of the business.