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 $13,500. In order to reduce their insurance costs,

TMR will have a LoJack Stolen Vehicle Recovery System installed in each car at a cost of $1,200 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

store its vehicles. If TMR does not undertake the project, the lots can be leased to an auto-repair company

for $80,000 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 2020.

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

locations. This is expected to cost $250,000 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 what will be spent immediately to promote the new business and

during the first two years of operation to boost the sales. 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 $250,000 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

1/7/2020

1/7/2021

1/7/2022

1/7/2023

1/7/2024

Ending

30/6/2021

30/6/2022

30/6/2023

30/6/2024

30/6/2025

Revenue ($ '000)

1,092

1,150

1,350

1,500

1,550

Operating variable costs associated with the new business represent 8% of revenue. Annual operating fixed

costs (excluding depreciation) are $520 per vehicle. Existing administrative costs are $400,000 per annum.

As a result of the new operation, these administrative costs will increase by 15%. The company is subject to

a tax rate of 27.5% on its profits.

Semester 1, 2020

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

five years, taking into consideration 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 the cost of equity for the

evaluation of this project. TMR's equity beta is estimated to be 1.1, the Treasury bond yield is 2% and the

market risk premium is 10%.

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 and estimate all cash flows associated with the project

over 5 years. It is assumed that where relevant, capital expenditures 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.

4.

Calculate the project's payback period. Assuming the business will continue at the end of year 5 so

ignore the possible terminal value of all assets (Car fleet and premises). Ignore the time value of

money for this calculation. Briefly comment on your results.

5.

Estimate the Net present value (NPV) and internal rate of return (IRR) of the project, assuming that

the initial investment is entirely funded by equity capital (retained earnings and new share issue).

Assume further that 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. Briefly comment on

your results and make appropriate remarks on the assumptions made for these calculations if

necessary.

6.

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

annually. Briefly comment on your results.

7.

Produce an estimate of change in cost of equity (and discount rate of the project) given the current

situation of COVID-19 in Australia. How the NPV of the project would change? What is your

recommendation.

8.

In view of your answer to Point 4 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