Question

Tasmania car rental company (TMR), a proprietary company, is considering whether to enter Tasmania's discount rental car market. The program will involve buying 100 used cars, midsize cars, and midsize cars at an average price of $15,000. To reduce their insurance costs, TMR will install a LoJack recovery system on each vehicle, which costs $1,500. TMR expects the rental service to have two locations: one near Hobart airport and one near Launceston airport. At each location, TMR has an abandoned lot and building where vehicles can be stored. If TMR does not take on the project, the lot can be leased to a car repair company for $90,000 a year (two lots in total). Whether leased or used for the project, TMR will pay an annual maintenance cost of $25,000 (two batches total). The discount car rental business is expected to reduce its regular car rental business by $20,000 a year.

For tax purposes, the life of the car is set at five years and will be depreciated over five years using the straight-line method, with no residual value. Assume the car will be in use at the beginning of the next fiscal year: July 1, 2019.

Before starting the new business, TMR will need to redevelop and renovate the buildings at each airport. The estimated cost for both locations is $215,000. Suppose that TMR is unable to claim any annual tax relief on capital expenditure on building refurbishment before selling the business. TMR also budgeted for marketing costs, which will be used when the project is launched and for the first two years of operation. The estimated cost is $30,000 per annum. These expenses are fully tax-deductible in the year they are incurred. In addition, the project would require a full injection of $150,000 in net working capital. No additional working capital is required from start to finish. The initial network capital will be fully recovered at the end of year 5.

The income forecast of car rental in the next five years is as follows:

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

	Year 1	Year 2	Year 3	Year 4	Year 5
Beginning	1/7/2019	1/7/2020	1/7/2021	1/7/2022	1/7/2023
Ending	30/6/2020	30/6/2021	30/6/2022	30/6/2023	30/6/2024
Revenue ($’000)	900	1,100	1,200	1,250	1,250

Operating costs

Operating variable costs associated with new business are 10% of revenue. Annual operating fixed costs (excluding depreciation) are $1,800 per vehicle.

Existing administrative costs are $550,000 per annum. As a result of the new operation. These administrative costs will increase by 20%. The company is subject to a tax rate of 27.5% on its profit.

Catherine, the chief financial officer of the company would like you to help her examine the feasibility of the project in the next five years, taking into account the sales and operating cost projections prepared by the company's accountants. Given the risks associated with the project, she thinks it is reasonable to use a 12% cost of capital to evaluate the project.

Your Tasks:

Based on the information in the case study, Catherine asked you to write a report to TMR's management about the best course of action for the project. Your report shall address the following specific issues raised by TMR's management:

1. Discuss which costs are relevant to the evaluation of the project and which are not. Your discussion should be supported by valid arguments and references to appropriate sources.

2. How are the possible internecine and opportunity costs taken into account in this analysis?

3. Determine the initial investment cash flow.

4. Estimate all cash flows related to the project over 5 years. Assume that, in the relevant case, capital expenditures and marketing costs are consumed throughout the year, while cash flows related to revenue and operating costs occur at the end of the year. You need to broadly describe the methods used to determine these cash flows.

5. Calculate the payback period of the project. Suppose the business could be sold for millions of dollars at the end of five years. This figure includes the value of car fleets, homes and capital gains for businesses. Ignore any tax consequences that may arise from the sale of the business and ignore the time value of this particular currency calculation. Briefly comment on your results.

6. Estimate the net present value (NPV) of the project, assuming that the initial investment can be sold for $1 million at the end of five years. This figure includes the value of car fleets, homes and capital gains for businesses. Ignore any possible tax sequence for the sale of the business.

Briefly comment on your results and, if necessary, make appropriate comments on the assumptions of these calculations.

7. Using sensitivity analysis, the NPV was recalculated using a scenario that reduced project sales by 10% per year. Briefly comment on your results.

8. In view of your answers to points 5 to 7 above, please inform TMR management whether to proceed with the investment project. In your recommendations, you may wish to suggest possible improvements for this project.

Answer 1

	1	Costs relevant to the evaluation of the project
		Relevant Costs:
	X	Cost of used cars=100*15000=	$1,500,000
	X	Lojack Recovery Sytem=100*1500	$150,000
	X	Opportunity cost of loss of lease income	$90,000
	X	Annual maintenance cost	$25,000
	X	Annual Depreciation cost	$330,000	(1500000+150000)/5
	X	Redevelop and renovate buildings	$215,000
	X	Marketing cost per year for first two years	$30,000
	X	Change in net working capital	$150,000
	X	Operating Variable Cost (10% of Revenue)
	X	Operating fixed costs per annum	$180,000	(1800*100)
	X	Increase in administrative costs	$110,000	(20%*550000)
	X	Reduction of regular car rental business	$20,000
	2	Opportunity cost of loss of lease income to be take into account as negative cash flows
		Initial Working Capital is taken into account as negative cash flow
		Release of Working Capital at the end of project is taken into account as positive cash flow
	3	INITIAL INVESTMENT CASH FLOW
		Cost of used cars=100*15000=	($1,500,000)
		Lojack Recovery Sytem=100*1500	($150,000)
		Redevelop and renovate buildings	($215,000)
		Initial Working capital	($150,000)
		Initial Investment Cash flow	($2,015,000)
	4	All cash Flows related to the project:
	N	Year	0	1	2	3	4	5
	A	Initial investment cash flow	($2,015,000)
		Operating Cash Flows:
	B	Revenue		$900,000	$1,100,000	$1,200,000	$1,250,000	$1,250,000
	C	Operating Variable Cost (10% of Revenue)		$90,000	$110,000	$120,000	$125,000	$125,000
	D	Operating fixed costs per annum		$180,000	$180,000	$180,000	$180,000	$180,000
	E	Increase in administrative costs		$110,000	$110,000	$110,000	$110,000	$110,000
	F	Annual maintenance cost		$25,000	$25,000	$25,000	$25,000	$25,000
	G	Annual Depreciation cost		$330,000	$330,000	$330,000	$330,000	$330,000
	H	Marketing cost per year for first two years		$30,000	$30,000	$0	$0	$0
	I	Reduction in regular business income		$20,000	$20,000	$20,000	$20,000	$20,000
	J=B-C-D-E-F-G-H-I	Profit before tax		$115,000	$295,000	$415,000	$460,000	$460,000
	K=J*27.5%	Tax expenses		$31,625	$81,125	$114,125	$126,500	$126,500
	L=J-K	Net Income		$83,375	$213,875	$300,875	$333,500	$333,500
	P	Add:Depreciation (non cash expense)		$330,000	$330,000	$330,000	$330,000	$330,000
	Q=L+P	Operating Cash Flows:		$413,375	$543,875	$630,875	$663,500	$663,500
	R	Opportunity cost of loss of lease income		($90,000)	($90,000)	($90,000)	($90,000)	($90,000)
	S	Release of initial working capital						$150,000
	T=A+Q+R+S	NET CASH FLOW	($2,015,000)	$323,375	$453,875	$540,875	$573,500	$723,500
		Cumulative Net Cash Flow	($2,015,000)	($1,691,625)	($1,237,750)	($696,875)	($123,375)	$600,125
	U	Net Cash Flow with Salvage value of 1million	($2,015,000)	$323,375	$453,875	$540,875	$573,500	$1,723,500	SUM
	V=U/(1.1^N)	Present Value of Net Cash flow(discount rate10%)	($2,015,000)	$293,977	$375,103	$406,367	$391,708	$1,070,158	$522,314
	5	Payback Period =Period at which cumulative cash flow=Zero
		Payback Period in Years=4+(123375/723500)	4.17	Years
		Net Present Value (assuming discount rate10%)	$522,314