Cash Flow and Capital Budgeting

Aus Car Execs (ACE) is set up as a sole trader and is analysing whether to enter the discount used rental car market. This project would involve the purchase of 100 used, late-model, mid-sized automobiles at the price of $9,500 each. In order to reduce their insurance costs, ACE will have a LoJack Stolen Vehicle Recovery System installed in each automobile at a cost of $1,000 per vehicle. ACE will also utilise one of their abandoned lots to store the vehicles. If ACE does not undertake this project they could sublease this lot to an auto repair company for $80,000 per year. The $20,000 annual maintenance cost on this lot will be paid by ACE whether the lot is subleased or used for this project. In addition, if this project is undertaken, net working capital will increase by $50,000.

For taxation purposes, the useful life of the automobiles is determined to be 5 years, and they will be depreciated using the diminishing value method. Each car is expected to generate $4,800 a year in revenue and have operating costs of $1,000 per year. Starting 6 years from now, one-quarter of the fleet is expected to be replaced every year with a similar fleet of used cars. This is expected to result in a net cash flow (including acquisition costs) of $100,000 per year continuing indefinitely. This discount rental car business is expected to have a minimum impact on ACEs regular rental car business where the net cash flow is expected to fall by only $25,000 per year. ACE expects to have a marginal tax rate of 32%.

1. Estimate the net cash flow for each of the next 6 years.

2. How are possible cannibalisation costs considered in this analysis?

3. How does the opportunity to sublease the lot affect this analysis?

4. What do you estimate as the terminal value of this project at the end of year 6 (use a 12% discount rate for this calculation)?

5. Applying the standard discount rate of 12% that ACE uses for capital budgeting, what is the NPV of this project? If ACE adjusts the discount rate to 14% to reflect higher project risk, what is the NPV?