Monday, 11 March 2019
Monday, 18 May 2015
Road King Trucks was established by the Smith brothers in 1880 as the California Wagon Company and it has been manufacturing trucks for almost a century. The company has been looking to evaluate the opportunity of manufacturing “The Transit Bus”. The management has realized that the private vehicles have become very costly and people are becoming more and more aware about environmental impact of using private vehicles. Therefore, the management sees the business opportunity in the manufacture of “The Transit Bus”. Recently hired CEO Michael Livingston has a reputation for successfully identifying new consumer trends, he believes that the rise of gasoline prices will force more and more urbanites to public transportation.
fThe company itself has a history of transformation and adaptability beginning with the Smith Bros. decision to not only seek new technologies but also implementing them to the company. In 1915 with the advent of the truck the Smith Bros. began manufacturing trucks instead of their traditional wagon line. Again in 1940 with a new name, the Road King Truck Co. began manufactruing School Buses; it only seemed fitting that the new transformation will be to adapt to rising energy costs and fuel efficient vehicles.
I have prepared the cost benefit analysis based on the projected financial data provided by various departments within the Company. I have considered the initial investment requirement, annual income and operating cost and financing cost of the project for the purpose of giving my recommendations.
I am of the opinion that the project of manufacture of “The Transit Bus” will increase the overall net present value of the company and thusly recommend a “GO” for this project.
Answer to the Questions:
1. Energy cost situation should be given prime priority. The use of public transport system has continuously declined in the last 5 decades due to the ease of availability for private vehicle ownership. The environment has been badly affected because of wide use of fuels in the private transport vehicles. Moreover, the supply of energy is limited with us. As we use more and more of energy, our future energy gets reduced. The use of public transportation system will help reduce the energy consumption and consequently its cost. Therefore, public transportation system should be used to save the energy.
2. Project’s Cash Flows for the next 20 years are as follows:
Year Project’s Cash Flows
If Detroit Engine is used If Marcus Engine is used
0 -$642,000,000 -$642,000,000
1 -$323,859,746 -$324,947,019
2 $22,711,826 $21,586,498
3 $128,949,056 $127,784,342
4 $195,404,588 $194,199,109
5 $202,086,065 $200,838,394
6 $209,001,393 $207,710,054
7 $216,158,757 $214,822,221
8 $223,566,630 $222,183,315
9 $231,233,778 $229,802,047
10 $239,169,276 $237,687,434
11 $247,382,516 $245,848,810
12 $255,883,220 $254,295,834
13 $264,681,448 $263,038,504
14 $273,787,615 $272,087,168
15 $283,212,497 $281,452,534
16 $292,967,250 $291,145,689
17 $303,063,420 $301,178,104
18 $313,512,955 $311,561,653
19 $324,328,225 $322,308,627
20 $824,250,933 $822,160,649
Notes TO Q2:
A. Negative amounts indicates cash outflow.
B. Historic cost of land and sales realization of this land at the end of 20 years is not relevant in this case as it is not linked with this project.
C. It has been assumed that NWC required for the year will be invested at the end of previous year.
D. It has been assumed that the company will not recover any amount for building at the end of the project life.
E. It has been assumed that the warranty cost will be incurred at the end of the year.
3. The company’s weighted average cost of capital of the company is 7.76% (round off). The weighted average cost of capital of the company has been taken as weighted average of cost of capital of equity and debt. The cost of capital of equity has been derived from the “Capital Asset Pricing Model”. As per the Capital Asset Pricing Model, Risk factor is added to the risk free rate of return to derive the cost of capital of the equity. Generally, risk free rate of return is the rate of return on government treasury. Risk factor is calculated by way of multiplying beta of the company with market premium. In the given case, risk free rate is 4%, market premium is 5.5% and beta of the company is 1.15. Therefore, cost of capital of equity as per Capital Asset Pricing Model is 10.325%. Cost of Debt has been taken as after tax as tax shield is available against interest expense. Interest paid to debt holders is deductible from profit for tax purpose. Therefore, it is appropriate to take after tax cost of debt for the purpose of calculating cost of capital of the company. The cost of debt, which has been assumed to be equal to current year to maturity return, in the given case, is 6.50% and tax rate is 40%. Therefore, after tax cost of debt is 3.90%. The ratio of debt to equity is 0.40. Therefore, we have assign weight of 0.40 to after tax cost of debt and weight of 0.60 to cost of equity to calculate cost of capital of the company. Therefore, Weighted Average Cost of Capital of the company is 7.76%.
Generally, the appropriate discount factor to be used for evaluating any project is weighted average cost of capital. The discount factor is the cost of funding the project. The capital investment project should cover at least the cost of funds invested in the project. The discount factor takes into consideration interest payments required to be made to the bond holders. Moreover, it takes in to account the minimum expected return of equity holders. We can accept the project if the net present value of cash flows from the project is positive at this discounted rate. Therefore, we will use discount factor of 7.76% to evaluate the bus project.
4. The discounted Cash Flows of the project under both the options are as under:
Year Discounted Cash Flows
If Detroit Engine is used If Marcus Engine is used
0 -$642,000,000 -$642,000,000
1 -$298,630,865 -$298,686,275
2 $21,390,300 $21,337,080
3 $104,808,715 $104,757,599
4 $146,601,801 $146,552,706
5 $140,697,778 $140,650,624
6 $135,034,969 $134,989,679
7 $129,603,276 $129,559,776
8 $124,393,040 $124,351,259
9 $119,395,021 $119,354,892
10 $114,600,380 $114,561,838
11 $110,000,661 $109,963,642
12 $105,587,770 $105,552,215
13 $101,353,961 $101,319,812
14 $97,291,823 $97,259,024
15 $93,394,259 $93,362,756
16 $89,654,475 $89,624,218
17 $86,065,968 $86,036,907
18 $82,622,510 $82,594,598
19 $79,318,138 $79,291,329
20 $185,773,848 $185,748,099
Total $1,126,957,828 $1,126,181,778
The initial cost (including installation) of Detroit engine is $20,000 and that of Marcus engine is $18,000. The initial cost of Detroit engine is higher. However, warranty cost of Detroit Engine is lower as compared to Marcus engine. Warranty Cost of Detroit engine is $1,000 per year per bus whereas it is $1,500 per year per bus.
It can be seen from the above table that the net present value of the project is higher if the Detroit engine is used. The net present value of the project is $1,126,957,828 if the Detroit engine is used and the same is $1,126,181,778 if Marcus engine is used. Therefore, Detroit engine should be used. The incremental cash flow of using Detroit engine instead of Marcus engine is $776,050.
5. The quality of the project is very good as the net present value of the project is $1,126,957,828. The payback period of the project is also 9 years and 2 months under both the options. The payback period of 9 years and 2 months can be said to be very healthy when the life of the project is 20 years. The company will be able to generate large amount of profits from this investment. The management has undertaken through analysis of the project and figures of sales, cost, investment and cost of capital has been taken from different department heads after careful consideration. The company is already engaged in the manufacture and sales of buses for about a century. It will be able to use the same platform of truck to manufacture the transit bus. As per the assessment of the management, there are no major operational risks associated with the project. The cost of capital of the project is also low which will help company to generate large free operating cash flows from the project.
6. I would recommend that Road King Trucks should accept the project as it has very good net present value and the payback period of the project is very low. I have considered the following factors for my recommendation:
- High Net Present Value of the project
- Lower Cost of Capital of the project
- Low payback period of the project
- Increasing importance of public transport system in the wake of increasing environment issues and cost of private vehicles
- Experience of the company in manufacturing Trucks
- Fact that the company will be able to use the existing platform of Truck to manufacture the Transit Bus
- Production, Marketing and Financial evaluation undertaken by the management of the company.................
Subscribe to:
Posts (Atom)
