CASE STUDY

Tasmanian Motor Rental (TMR) is set up as a proprietary company in car rental industry 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 $15,000. In order to reduce their insurance costs, TMR

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 TMR will have two locations: one near Hobart airport and the other near

Launceston airport. At each location, TMR owns an abandoned lot and building where it could sotre its

vehicles. If TMR 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 TMR whether the lots are leased or used for this project. This discount rental car business is expected to

result in a fall in its regular car rental business by $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 straight-line depreciation method over 5 years with no residual values at the end. It is assumed that

the cars will first be used at the beginning of the next financial year: 1 July 2019.

Before starting this new operation, TMR will need to redevelop and renovate the buildings at each airport

locations. This is expected to cost $215,000 for both locations. Assume that TMR is not able to claim any

annual tax deduction for the capital expenditure to the renovation of the building until the business is sold.

TMR has also budgeted marketing costs which will be spent at the initiation of the project and also during

the first two years of operation. The estimated costs are $30,000 per year. These costs are fully tax deductible

in the year they are incurred. In addition, if the project is undertaken, a total new injection of $150,000 in net

working capital will be required. There will be no additional working capital required from the

commencement of the operation until the end of the project. The initial networking capital will be recovered

in full by the end of year 5.

Revenue projections from the 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) 850 1,050 1,100 1,250 1,250

Operating variable costs associated with the new business represent 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 profits.

Catherine, the company CFO would like you to help her examine the viability of the project for the next five

years, taking into account the projections of sales and operations costs prepared by company'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.

Your tasks:

Based on the information in the case study, Catherine has asked you to write a report to TMR's management

advising them as to the best course of action regarding this project. Your report should address the following

specific questions asked by TMR's management:

1. 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

2. How are possible cannibalization and opportunity costs considered in this analysis?

3. Determine the initial investment cash flow.

4. Estimate all cash flows associated with the project over 5 years. It is assumed that where relevant,

capital expenditures and marketing costs are expended throughout the year, while cash flows relating

to revenue and operating costs occur at the end of the year. You will need to broadly describe the

method used for determining those cash flows.

5. Calculate the project's payback period. Assuming the business could be sold at the end of the five

years for $1 million. This figure includes the value of the car fleet, premises and capital gain from the

business. Ignore any possible tax consequences of selling the business and also ignore the time value

of money for this particular calculation. Briefly comment on your results

6. Estimate the Net present value (NPV) of the project, assuming that the initial investment could be

sold at the end of the five years for $1 million. This figure includes the value of the car fleet, premises

and capital gain from the business. Ignore any possible tax consequences of selling the business.

Briefly comment on your results and make appropriate remarks on the assumptions made for these

calculations if necessary.

7. Using sensitivity analysis, recalculate NPV using the scenario of a decrease in project sales by 10%

annually. Briefly comment on your results.

8. In view of your answer to Point 5 to point 7 above, advise TMR's management as to whether they

should go ahead with the investment project. In your recommendations, you may wish to suggest

possible refinements in the method used for evaluating this project.