Year 0 $406,000,000 3.50% 1 2 $100,000,000 Investment Annual Inflation Factor Price Per Bus Units Sold Revenue $ $ $ $ $ $ $ $ $ Expenses Labor @$50,000/unit Parts @$95,000/unit Engine @$20,000/unit Gross Margin $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Training Labor Costs Selling General & Admin Exp. Bus Waranty Costs Depreciation Earnings Before Tax $ $ $ $ $ $ $ $ $ $ $ (100,000,000) $ $ $ $ $500,000,000 Taxes Net Income 40% $ $ $ Refurbish Land & Demolish Building Salvage Value of Equipment Contribution of Land & Sale of Land Add Back Depreciation NOWC (Impact Changes in WC) Net Cash Flow $ $ $ $ $ -$406,000,000 $ $ $ $ $ $ $ $ 3 4 $220,000 11,000 $2,420,000,000 5 $227,700 11,000 $2,504,700,000 6 $235,670 11,000 $2,592,364,500 7 $243,918 11,000 $2,683,097,258 $252,455 11,000 $2,777,005,662 $ (550,000,000) $ (569,250,000) $ (589,173,750) $ (609,794,831) $ (631,137,650) $ 1,045,000,000 $ 1,081,575,000 $ 1,119,430,125 $ 1,158,610,179 $ 1,199,161,536 $ 220,000,000 $ 227,700,000 $ 235,669,500 $ 243,917,933 $ 252,455,060 $3,135,000,000 $3,244,725,000 $3,358,290,375 $3,475,830,538 $3,597,484,607 $ (100,000,000) -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ $313,500,000 -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ 8 9 $261,291 11,000 $2,874,200,860 10 $270,436 11,000 $2,974,797,890 11 $279,901 11,000 $3,078,915,816 12 $289,698 11,000 $3,186,677,869 $299,837 11,000 $3,298,211,595 $ (653,227,468) $ (676,090,429) $ (699,753,595) $ (724,244,970) $ (749,593,544) $ 1,241,132,189 $ 1,284,571,816 $ 1,329,531,830 $ 1,376,065,444 $ 1,424,227,734 $ 261,290,987 $ 270,436,172 $ 279,901,438 $ 289,697,988 $ 299,837,418 $3,723,396,568 $3,853,715,448 $3,988,595,489 $4,128,196,331 $4,272,683,202 -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ 13 14 $310,332 11,000 $3,413,649,001 15 $321,193 11,000 $3,533,126,716 16 $332,435 11,000 $3,656,786,151 17 $344,070 11,000 $3,784,773,666 $356,113 11,000 $3,917,240,744 $ (775,829,318) $ (802,983,344) $ (831,087,762) $ (860,175,833) $ (890,281,987) $ 1,474,075,705 $ 1,525,668,355 $ 1,579,066,747 $ 1,634,334,083 $ 1,691,535,776 $ 310,331,727 $ 321,193,338 $ 332,435,105 $ 344,070,333 $ 356,112,795 $4,422,227,115 $4,577,005,064 $4,737,200,241 $4,903,002,249 $5,074,607,328 -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ 18 19 $368,577 11,000 $4,054,344,170 20 $381,477 11,000 $4,196,246,216 21 $394,829 11,000 $4,343,114,834 22 $408,648 11,000 $4,495,123,853 $422,950 11,000 $4,652,453,188 $ (921,441,857) $ (953,692,322) $ (987,071,553) $(1,021,619,058) $ (1,057,375,725) $ 1,750,739,528 $ 1,812,015,412 $ 1,875,435,951 $ 1,941,076,209 $ 2,009,013,877 $ 368,576,743 $ 381,476,929 $ 394,828,621 $ 408,647,623 $ 422,950,290 $5,252,218,584 $5,436,046,235 $5,626,307,853 $5,823,228,628 $6,027,041,630 -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 $ $ -$250,000,000 -$11,000,000 -$250,000,000 -$11,000,000 $ $ $ $ 23 24 $437,753 $ 11,000 0 $4,815,283,000 $ $ $ $ -$250,000,000 -$11,000,000 $ $ -$300,000 $15,000,000 Capital Budget Analysis Investment Equipment Costs Salvage Value of Equipment Demolition & Refurb Costs Historic Cost of Land Maket Value of Land Depreciation/Year Units Sold/Year Sales Price/Unit, Year 1 Annual Change in Price, After 1 Year Labor Cost, Per Unit Annual Change in Variable Cost/Unit, After Year 1 Parts Cost, Per Unit Engine Costs, per Unit Annual Change in Fixed Cost/Unit, After Year 1 Project WACC Tax Rate Working Capital as % of Next Years Sales $1,000,000,000 $15,000,000 $300,000 $3,000,000 $6,000,000 $50,000,000 11,000 3.50% $50,000 3.50% $95,000 $20,000 or $18,000 3.50% 6.47% 40% Weighted Average Cost of Capital WACC Debt to Assets % Equity to Assets % Tax Rate Interest Rate on Debt Risk Free Interest Rate (RFR) Market Premium Companys BETA 60% 40% 40% 6.50% 4% 5.50% 1.15 Cost of Debt After Tax Cost of Debt Stated Rate Tax Effect (1-T) Rate(1-T) 6.50% 60% 3.90% Cost of Equity CAPM Risk Free Rate Market Premium (Market Premium) x BETA BETA 4% 5.50% 6.33% 1.15 10.33% Weighted Average Cost of Capital Weight of Debt to Assets Cost of Debt Cost of Equity 60% 3.90% Weight of Equity to Assets 40% WACC 0.0234 10.33% 0.04132 ~ .06472/ 6.47% WACC Calculations Tax Rate: 40% 10 Year T-Notes YTM: 4.00% Current cost (YTM) of company bonds: 6.50% S&P Market Risk Premium (MRP): 5.50% Company beta: 1.15 Road King D/E: 0.40 Calculations: R-dat = R-d x (1 - Tax Rate): 3.90% D/V = (D/E)/(1+D/E) : 0.2857 R-eq = R-rf + Beta x (MRP): 10.33% E/V = 1 - D/V: 0.7143 WACC = R-dat x D/V + R-eq x E/V : 8.49% WACC Calculations WACC Calculations Warranty Calculations PMT COST OF CAPITAL NO. OF YEARS PRESENT VALUE Detroit Engine 1,000 8.49% 5 $3,941.75 Marcus Engine 1,500 8.49% 5 $5,912.62 Bus Warranty 1,000 8.49% 5 $3,941.75 GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation Year 0 OPERATING SUMMARY Annual Inflation Factor Price per bus Units sold Revenue ($000) 1 2 4 3.5% Expenses Labor @ $50,000/unit Parts @ $95,000/unit Engine (Detroit) @ $20,000/unit Gross Profit ($000) Training Sales/Administration Bus Warranty per unit: Engine Warranty (Detroit) per unit: Depreciation EBIT Taxes @ NOPAT ($000) 3 (100,000) 40% Operating Cash Flow ($000) INVESTMENT SUMMARY Property Plant and Equipment Working Capital @ 10% of Revenue (100,000) (6,000) (400,000) (500,000) 220,000 11,000 2,420,000 227,700 11,000 2,504,700 (550,000) (1,045,000) (220,000) 605,000 (569,250) (1,081,575) (227,700) 626,175 (100,000) (12,500) (43,359) (43,359) (50,000) 355,782 (12,938) (44,877) (44,877) (50,000) 473,484 (142,313) 213,469 (189,394) 284,090 263,469 334,090 (100,000) (242,000) SALVAGE SUMMARY Property GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation Less: Cost Basis Less: Clean up costs Plant & Equipment Gross Salvage Value Less: Taxes @ 40% Net Salvage Value ($000) Incremental Cash Flow ($000) ---> Net Present Value ($000) @ (406,000) 8.49% Internal Rate of Return GJS File: 20180531041445bus_330_project.xlsx ---> ---> (500,000) $ (442,000) 263,469 334,090 2,066,237 21.66% Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 5 6 7 8 9 10 11 12 235,670 11,000 2,592,365 243,918 11,000 2,683,097 252,455 11,000 2,777,006 261,291 11,000 2,874,201 270,436 11,000 2,974,798 279,901 11,000 3,078,916 289,698 11,000 3,186,678 299,837 11,000 3,298,212 (589,174) (1,119,430) (235,670) 648,091 (609,795) (1,158,610) (243,918) 670,774 (631,138) (1,199,162) (252,455) 694,251 (653,227) (1,241,132) (261,291) 718,550 (676,090) (1,284,572) (270,436) 743,699 (699,754) (1,329,532) (279,901) 769,729 (724,245) (1,376,065) (289,698) 796,669 (749,594) (1,424,228) (299,837) 824,553 (13,390) (46,447) (46,447) (50,000) 491,806 (13,859) (48,073) (48,073) (50,000) 510,769 (14,344) (49,756) (49,756) (50,000) 530,396 (14,846) (51,497) (51,497) (50,000) 550,710 (15,366) (53,300) (53,300) (50,000) 571,735 (15,903) (55,165) (55,165) (50,000) 593,495 (16,460) (57,096) (57,096) (50,000) 616,018 (17,036) (59,094) (59,094) (50,000) 639,328 (196,722) 295,084 (204,308) 306,461 (212,158) 318,238 (220,284) 330,426 (228,694) 343,041 (237,398) 356,097 (246,407) 369,611 (255,731) 383,597 345,084 356,461 368,238 380,426 393,041 406,097 419,611 433,597 GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 345,084 356,461 368,238 GJS File: 20180531041445bus_330_project.xlsx 380,426 393,041 406,097 419,611 433,597 Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 13 14 15 16 17 18 19 20 310,332 11,000 3,413,649 321,193 11,000 3,533,127 332,435 11,000 3,656,786 344,070 11,000 3,784,774 356,113 11,000 3,917,241 368,577 11,000 4,054,344 381,477 11,000 4,196,246 394,829 11,000 4,343,115 (775,829) (1,474,076) (310,332) 853,412 (802,983) (1,525,668) (321,193) 883,282 (831,088) (1,579,067) (332,435) 914,197 (860,176) (1,634,334) (344,070) 946,193 (890,282) (1,691,536) (356,113) 979,310 (921,442) (1,750,740) (368,577) 1,013,586 (953,692) (1,812,015) (381,477) 1,049,062 (987,072) (1,875,436) (394,829) 1,085,779 (17,632) (61,162) (61,162) (50,000) 663,455 (18,250) (63,303) (63,303) (50,000) 688,426 (18,888) (65,519) (65,519) (50,000) 714,271 (19,549) (67,812) (67,812) (50,000) 741,020 (20,234) (70,185) (70,185) (50,000) 768,706 (20,942) (72,642) (72,642) (50,000) 797,361 (21,675) (75,184) (75,184) (50,000) 827,018 (22,433) (77,816) (77,816) (50,000) 857,714 (265,382) 398,073 (275,370) 413,055 (285,708) 428,562 (296,408) 444,612 (307,482) 461,224 (318,944) 478,416 (330,807) 496,211 (343,086) 514,628 448,073 463,055 478,562 494,612 511,224 528,416 546,211 564,628 GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 448,073 463,055 478,562 GJS File: 20180531041445bus_330_project.xlsx 494,612 511,224 528,416 546,211 564,628 Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 21 22 408,648 11,000 4,495,124 422,950 11,000 4,652,453 (1,021,619) (1,941,076) (408,648) 1,123,781 (1,057,376) (2,009,014) (422,950) 1,163,113 (23,219) (80,539) (80,539) (50,000) 889,484 (24,031) (83,358) (83,358) (50,000) 922,366 (355,794) 533,690 (368,946) 553,419 583,690 603,419 (353,496) (1,226,185) (1,000,000) (1,000,000) 242,000 9,276 GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation (3,000) (300) 15,000 20,976 (8,390) 12,586 583,690 858,005 GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation Year OPERATING SUMMARY Annual Inflation Factor 0 1 2 4 3.5% Price per bus Units sold Revenue($000) Expenses Labor @ $50,000/unit Parts @ $95,000/unit Engine (Marcus) @ $18,000/unit Gross Profit ($000) (100,000) Training Sales/Administration Bus Warranty per unit: Engine Warranty (Marcus) per unit: Depreciation EBIT ($000) Taxes @ NOPAT ($000) 3 40% Operating Cash Flow ($000) (100,000) 220,000 11,000 2,420,000 227,700 11,000 2,504,700 (550,000) (1,045,000) (198,000) 627,000 (569,250) (1,081,575) (204,930) 648,945 (100,000) (12,500) (43,359) (65,039) (50,000) 356,102 (12,938) (44,877) (67,315) (50,000) 473,816 (142,441) 213,661 (189,526) 284,289 263,661 334,289 INVESTMENT SUMMARY Property Plant and Equipment Working Capital @ 10% of Revenue (6,000) (400,000) (500,000) (100,000) (242,000) SALVAGE SUMMARY Property Less: Cost Basis GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation Less: Clean up costs Plant & Equipment Gross Salvage Value Less: Taxes @ 40% Net Salvage Value ($000) Incremental Cash Flow ($000) ---> Net Present Value ($000) @ (406,000) 8.49% Internal Rate of Return GJS File: 20180531041445bus_330_project.xlsx ---> ---> (500,000) $ (442,000) 263,661 334,289 2,068,234 21.67% Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 5 6 7 8 9 10 11 235,670 11,000 2,592,365 243,918 11,000 2,683,097 252,455 11,000 2,777,006 261,291 11,000 2,874,201 270,436 11,000 2,974,798 279,901 11,000 3,078,916 289,698 11,000 3,186,678 (589,174) (1,119,430) (212,103) 671,658 (609,795) (1,158,610) (219,526) 695,166 (631,138) (1,199,162) (227,210) 719,497 (653,227) (1,241,132) (235,162) 744,679 (676,090) (1,284,572) (243,393) 770,743 (699,754) (1,329,532) (251,911) 797,719 (724,245) (1,376,065) (260,728) 825,639 (13,390) (46,447) (69,671) (50,000) 492,149 (13,859) (48,073) (72,110) (50,000) 511,124 (14,344) (49,756) (74,634) (50,000) 530,764 (14,846) (51,497) (77,246) (50,000) 551,090 (15,366) (53,300) (79,949) (50,000) 572,129 (15,903) (55,165) (82,748) (50,000) 593,903 (16,460) (57,096) (85,644) (50,000) 616,440 (196,860) 295,289 (204,450) 306,675 (212,305) 318,458 (220,436) 330,654 (228,851) 343,277 (237,561) 356,342 (246,576) 369,864 345,289 356,675 368,458 380,654 393,277 406,342 419,864 GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 345,289 356,675 GJS File: 20180531041445bus_330_project.xlsx 368,458 380,654 393,277 406,342 419,864 Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 12 13 14 15 18 19 299,837 11,000 3,298,212 310,332 11,000 3,413,649 321,193 11,000 3,533,127 332,435 11,000 3,656,786 344,070 11,000 3,784,774 356,113 11,000 3,917,241 368,577 11,000 4,054,344 381,477 11,000 4,196,246 (749,594) (1,424,228) (269,854) 854,537 (775,829) (1,474,076) (279,299) 884,445 (802,983) (1,525,668) (289,074) 915,401 (831,088) (1,579,067) (299,192) 947,440 (860,176) (1,634,334) (309,663) 980,600 (890,282) (1,691,536) (320,502) 1,014,921 (921,442) (1,750,740) (331,719) 1,050,444 (953,692) (1,812,015) (343,329) 1,087,209 (17,036) (59,094) (88,641) (50,000) 639,765 (17,632) (61,162) (91,744) (50,000) 663,907 (18,250) (63,303) (94,955) (50,000) 688,894 (18,888) (65,519) (98,278) (50,000) 714,755 (19,549) (67,812) (101,718) (50,000) 741,521 (20,234) (70,185) (105,278) (50,000) 769,224 (20,942) (72,642) (108,963) (50,000) 797,897 (21,675) (75,184) (112,776) (50,000) 827,574 (255,906) 383,859 (265,563) 398,344 (275,557) 413,336 (285,902) 428,853 (296,608) 444,913 (307,690) 461,535 (319,159) 478,738 (331,030) 496,544 433,859 448,344 463,336 478,853 494,913 511,535 528,738 546,544 GJS File: 20180531041445bus_330_project.xlsx 16 17 Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 433,859 448,344 463,336 GJS File: 20180531041445bus_330_project.xlsx 478,853 494,913 511,535 528,738 546,544 Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation 20 21 22 394,829 11,000 4,343,115 408,648 11,000 4,495,124 422,950 11,000 4,652,453 (987,072) (1,875,436) (355,346) 1,125,262 (1,021,619) (1,941,076) (367,783) 1,164,646 (1,057,376) (2,009,014) (380,655) 1,205,408 (22,433) (77,816) (116,724) (50,000) 858,289 (23,219) (80,539) (120,809) (50,000) 890,079 (24,031) (83,358) (125,037) (50,000) 922,982 (343,316) 514,973 (356,032) 534,047 (369,193) 553,789 564,973 584,047 603,789 (353,496) (1,000,000) (1,000,000) 242,000 9,276 (3,000) GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King Trucks: Bus Project Evaluation (300) 15,000 20,976 (8,390) 12,586 564,973 584,047 858,375 GJS File: 20180531041445bus_330_project.xlsx Created: 4/19/2010 Revised: 5/31/2018 Road King ROAD KING TRUCKS CASE ANALYSIS BUS 500D ANTHONY L. HUBBLE UNIVERSITY OF LA VERNE Summary: 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. The 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 Road King Trucks Introduction Michael Livingston has recently been hired as the CEO of Road King Trucks, Inc. Previously he had been the marketing manager for a large manufacturing company and had established a reputation for identifying new consumer trends. Road King Trucks Inc. is a California-based truck manufacturing company. The company is well known for manufacturing large, heavy-duty trucks at a reasonable cost. One of its greatest achievements is that its trucks can be easily modified or customized for different applications. Road King Trucks also builds school buses. The company is considering an expansion of its current product line to include transit buses. Mr. Livingston feels that due to high gasoline prices, commuters will be more willing to consider using mass transit instead of using their cars to commute to work. Company Profile Road King Trucks, Inc. was established by the Smith brothers in 1880 as the California Wagon Company. The firm started manufacturing horse-drawn wagons to serve the growing population in California. The brothers quickly realized that the times were changing, so they started looking for the technologies that would keep them at the forefront of their field of business. In 1915, the Smith brothers decided that they needed to make trucks as replacements for the wagons, because trucks were starting to serve the same uses as wagons, and the wagon industry was not going to be viable in the longer term. The company started making school buses in the early 1940’s. Most manufacturers had been commissioned by the government to produce different large vehicles to support World War II operations. Road King Trucks opted to produce buses. It was an easy decision to make, since the buses would use common parts with the company’s trucks, and the customers were local governments. Starting in the 1950’s, the school bus business accounted for about 50% of Road King Trucks’ revenues. The Transit Bus Opportunity Mr. Livingston arranged a meeting with the firm’s top management, as well as the chief design and manufacturing engineers to propose his new product. He presented an argument that more individuals in the United States and Canada would be willing to use public transportation than before, because people were becoming more environmentally conscious. Also, recent increases in fuel costs seemed to be long lasting. This was an opportunity to get people hooked on transit buses, as he put it. The proposal under consideration was for the introduction of a large, public transport bus. To distinguish Road King Trucks from other manufacturers, the proposal included details about the level of comfort, air-conditioning, efficiency, and quietness of operation that needed to be developed. Mr. Phillips and Mr. Lopez, the two engineers, reacted enthusiastically and quickly pointed out that the bus could be based on the company’s trucks. The frame currently used for building the trucks could be modified to accommodate buses at a relatively low Bus Fin 330 Spring 2018: Road King Trucks Rev 3.doc Last Revised: 2/2010 cost. The marketing vice president, Mr. Chen, pointed out that a marketing analysis could be done quickly, and at a reasonable cost. At this point, Mr. Livingston charged the participants in the meeting to produce a financial plan for the development and production of a transit bus. Public Transportation The use of public transportation had declined steadily since the 1950’s. Most people were opting to use their personal vehicles for all of their transportation needs. Recently, however, most of the metropolitan areas in the United State and Canada, the target markets for the new bus, had become more and more congested; and parking, which was already very expensive, was becoming scarce. This combination of trends has renewed the public’s interest in good and reliable public transportation. Several municipalities have been campaigning to their residents and commuters that they should use public transportation for business commuting, and only use their cars for shopping and weekend activities. However, such campaigns need to be supported by making high quality public transportation available to the target riders. The Decision Three weeks after the initial meeting, the vice presidents presented the sales and cost forecasts shown in the attached exhibits. The information presented contains the cost of production, financing information, and warranty cost estimates. The proposals also contained two engine options for the engines: The Detroit engine, and the Marcus engine. The Detroit engine was more expensive to install, but had a lower warranty cost. The Marcus engine was less expensive to install, but had a higher warranty cost. This begged the question: Which engine should be used? Issues and Analyses Mr. Livingston noticed that there was a great deal of enthusiasm among the management group about the transit bus opportunity, but his cautious nature told him to also seek a more objective viewpoint. Consequently, he sought out you and your team to analyze the proposed project and provide your recommendations directly to him. The issues he wants you to address in your analysis and report are the following: 1) 2) 3) 4) 5) 6) How much importance should be given to the energy cost situation? What are the project’s cash flows for the next twenty years? What assumptions did you use? What is the company’s cost of capital? What is the appropriate discount factor (which may be different) for you to use in evaluating the bus project? If you decide to go ahead with the project, which of the two engines should be used in the bus, and why? Evaluate the quality of the project, by using appropriate capital budgeting techniques. Would you recommend that Road King Trucks accept or reject the project? What are the key factors on which you base your recommendation? Your final report is Scheduled to be due at the beginning of class on May 31, 2018 Bus Fin 330 Spring 2018: Road King Trucks Rev 3.doc Last Revised: 2/2018 Exhibit 1: Sales and Cost Forecast The sales forecast is based on projected levels of demand. All the numbers are expressed in today’s dollars. The forecasted average inflation per year is 3.5% . Price per bus $220,000 Units sold per year 11,000 Labor cost per bus $50,000 Components & Parts $95,000 Selling General & $250,000,000 Administrative NOTE: Average warranty cost per year per bus for the first five years is $1,000. The present value of this cost will be used as a cost figure for each bus. Afterwards, the bus operator will become responsible the repairs on the buses. The buses can be produced for twenty years. Afterwards, the designs become obsolete. Engine choices Engine Detroit engines Marcus engines Price per engine, including installation $20,000 $18,000 Average annual warranty cost per year for five $1,000 $1,500 years. Afterwards, the bus operator will become responsible for the repairs on the buses.* The chosen engine will be installed in every bus and will become a cost figure for each bus. NOTE: The engine manufacturers are not providing Road King Trucks with any warranty. However, Road King Trucks will provide a warranty to its customers. After the initial five years, the bus operators may purchase an extended warranty from any insurance company that offers such packages. Bus Fin 330 Spring 2018: Road King Trucks Rev 3.doc Last Revised: 2/2018 Exhibit 2: Investment Needs To implement the project, the firm has to invest funds as shown in the following table: Year 0 $400 million* plus the land the company owns*** Year 1 $500 million* Year 2 $100 million* $100 million ** Year 3 $100 million ** Production and selling of buses starts * Road King Trucks estimated that it would cost a total of $1 billion to build the factory and purchase the necessary equipment to produce the buses. ** The other $200 million investment, divided equally in year 2 ($100M) and year 3 ($100M), is for non-depreciable labor training expenses. Such investment/expenses are treated as regular business expenses. *** The factory will be built on a parcel of land which Road King Trucks owns. The land was purchased ten years ago for $3 million and is currently valued at $6 million. Straight line depreciation will be used for the sake of simplicity. To facilitate the operation of manufacturing the transit buses, the company will have to allocate funds to net working capital (NWC) equivalent to 10% of annual sales. The investment in NWC will be recovered at the end of the project. Assume that the land, factory, and equipment will be sold at the end of the project. The company expects to spend about $300,000 demolishing the factory and cleaning the land. The company expects to sell the land for its current value, plus the inflationary effects on its price. The equipment will be sold for salvage at about $15,000,000. Bus Fin 330 Spring 2018: Road King Trucks Rev 3.doc Last Revised: 2/2018 Exhibit 3: Financing Assumptions The following assumptions are used to determine the cost of capital. Historically, the company tried to maintain a debt to equity ratio equal to 0.40. This ratio was used, because lowering the debt implies giving up the debt tax shield, and increasing it makes debt service a burden on the firm’s cash flow. In addition, increasing the debt level may cause a reduced rating of the company’s bonds. The marginal tax rate is 40%. All the numbers are expressed in today’s dollars. The forecasted average inflation per year is 3.5%. Cost of debt: The company’s bond rating is roughly at the high end of the A range. Surveying the debt market yielded the following information about the cost of debt for different rating levels: Bond rating Interest cost range AA 5.5% ~ 6.5% A 6.25% ~ 7.5% BBB 7.5% ~ 9% The company’s current bonds have a yield to maturity of about 6.5%. Cost of equity: The current 10-year Treasury notes have a yield to maturity of 4% and the forecast for the S&P 500 market premium is 5.5%. The company’s overall  is 1.15.  analysis: Company Overall  Debt to equity Percentage of income from trucks Road King Trucks 1.15 0.4 50 Red Bird 1.2 0.3 45 Bus Fin 330 Spring 2018: Road King Trucks Rev 3.doc General Trucks 1.3 0.5 90 Universal Transports 1.32 0.45 95 Trucks Inc. 1.2 0.35 85 International Trucks 1.09 0.25 85 Last Revised: 2/2018 MEMORANDUM To: BUSINESS FINANCE 330 SPRING 2018 Subject: Road King Trucks: Project Deliverables Here is what I expect for your individual projects: 1. A report broken down into the following sections: - Summary results and recommendations—up front, concise, and to the point. Answers to the 6 questions asked—devote a paragraph to each, with individual headings Attached Excel exhibits which are readable and understandable (I suggest using an easy to read font – Times New Roman or Arial font in 12 pitch for the spreadsheet(s), because it is plain and easy to read) • Excel Spreadsheet printout(s) showing your calculations of o Operating Cash Flows o Incremental Cash Flows, including investment and salvage o Warranty costs o WACC o NPV and IRR • Any other supporting exhibits you feel are relevant - A thumb drive containing your spreadsheet file, including all supporting elements. I want to get a sense of how well you used the power of the Excel program to make your calculations. 2. A simple typed report is adequate. I do not need fancy graphics or covers. - Use 12 pitch, Times New Roman or Arial font for the body of the report. - Single spacing is preferred and will allow you more than enough space to complete your report in less than 5 pages. - You should refer back to your exhibits for data or calculations, keeping raw data or calculation details out of the main body of the report. - Make sure your team members are listed on a cover sheet, as well as the project title and the date. The cover page does not count against the 5-page limit. - I am a stickler for grammar, punctuation, and spelling. Proof read your document well. Remember, you are selling your recommendations on this project to the CEO, so presentation is very important. Lastly, please get your report to me on time, which is at the beginning of class on Thursday May 31. 2018. No late reports will be accepted, so plan accordingly. If you have any questions, feel free to bring them up after class sessions or email me. Bus Fin 330 Spring 2018: Road King Trucks Project Deliverables.doc
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