Question
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
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
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