Question

A private school is considering the purchase of six school buses to transport students to and from school events. The initial cost of the buses is $600,000. The life of each bus is estimated to be 5 years, after which time the vehicles would have to be scrapped with no salvage value. The school’s management team has derived the following estimates for annual revenues and cost for the next 5 years.

	Year 1	Year 2	Year 3	Year 4	Year 5
Revenue	330,000	330,000	350,000	380,000	400,000
Driver Cost	33,000	35,000	36,000	38,000	40,000
Repairs	8,000	13,000	15,000	16,000	18,000
Other cost	130,000	135,000	140,000	136,000	142,000
Annual Depreciation	120,000	120,000	120,000	120,000	120,000

The buses would be purchased at the beginning of the project (i.e., in Year 0) and all revenues and expenditures shown in the table above would be incurred at the end of each relevant year.

Because schools are exempt from taxes, the school’s corporate tax rate is 0 percent. A business consultant has advised management that they should use a weighted average cost of capital (WACC) of 10.5% to evaluate this project.

• Prepare a table showing the estimated net cash flows for each year of the project. Explain all steps involved in your calculation of the Year 1 estimated net cash flow.
• Calculate the project’s Payback Period. Explain in your own words, all steps involved in the calculation process.
• Calculate the project’s Internal Rate of Return (IRR). Explain in your own words, all steps involved in the calculation process.
• Calculate the project’s Net Present Value (NPV). Explain in your own words, all steps involved in the calculation process.

Which of the three evaluation techniques that you computed (i.e., payback period, IRR and NPV), should the firm use to make its decision of whether or not to accept this project? Why did you choose this technique? Is one of these techniques better than the others and if so, why?

Finally, what are some risk factors inherent in this capital budgeting analysis? Make a list of at least three items that could cause the outcome of this project to be substantially worse than management currently expects (as reflected in their revenue and cost estimates, WACC estimate, etc.). Fully explain each of the risk factors you identify.

Answer 1

Income = revenue - driver cost - repairs - other cost - depreciation

net cash flow = income + depreciation (depreciation is added back to income to calculate cash flow since depreciation is a non-cash expense)

The estimated net cash flows are :

Payback period is the time taken for the cumulative net cash flows to equal the initial investment. The cumulative cash flow in year 4 ($655,000) exceeds the initial investment of $600,000 in year 4. Hence, the payback period is between 3 and 4 years. The cumulative cash flow at the end of year 3 is $465,000. The net cash flow in year 4 is $190,000. Hence, the exact payback period is calculated as :

3 + (($600,000 - $465,000) / $190,000) = 3.71 years

IRR is calculated using the IRR function in Excel, with inputs being the array of cells containing the net cash flows. IRR is 12.42%

NPV is the sum of present values of each net cash flow. Each net cash flow is discounted back to the present using the discount rate of 10.5%, which is the WACC. For example, present value of 3rd year's net cash flow = $159,000 / (1 + 10.5%)^3

NPV is $30,966

NPV should be used to evaluate the project. This is because payback period does not take into account time value of money and does not measure profitability. IRR can give conflicting and multiple results. NPV is the best measure as it indicates whether the project creates value or not.

Risk factors that could cause the project outcomes to be worse :

• The salary cost could increase due to union bargaining, statutory requirements, or inflation
• Repairs cost could increase due to poor driving, poor maintenance or other unexpected factors
• Revenue could be lower due to students opting for other means of transport