Jaden McCoy operated a dairy goat farm in Soddy-Daisy, Tennessee, and was considering expanding the rental of his goats for land clearing. In early 2011, McCoy successfully bid on a job to clear a section of property at a nearby resort. McCoy's goats performed as expected and he earned a small profit in the process. The resort manager was quite happy because the difficult-to-reach areas of the property were cleared on time and on budget at a cost well below what he would have paid for a crew of humans. As a result, the owner asked McCoy if he would be interested in renting his goats to clear other sections of the resort property. McCoy went back to his farm and summarized the revenues and expenses for the resort job, which generated a.modest profit of US\$120.70 for the seven days the goats were on the job (Exhibit 1). While the profits from this job were not very large, McCoy was intrigued by the opportunity to develop this line of business to complement his profits from goat dairy farming. Soddy-Daisy was located in the foothills of the Smoky Mountains, so the terrain in the vicinity was frequently better suited to goats than to humans. McCoy knew goats had proven effective in controlling the spread of kudzu, a fast-growing vine prevalent in Southern states. 1 Several local governments had considered goats as a cost-effective, environmentally sensitive way to maintain large areas of difficult to reach properties within their jurisdictions. McCoy believed renting goats to local governments to control noxious weeds, such as kudzu, provided a virtually untapped market for his goat rental business. For example, the City of Chattanooga, Tennessee had successfully used goats to control kudzu in the past and had included US $20,000 in its 2010-2011 fiscal year budget to hire goats for kudzu control. 2 Page 2 9311B025 McCoy believed his success with the initial goat rental job would lead to additional land clearing work at the resort and - via word of mouth advertising - opportunities for land clearing jobs with other landowners. It did not take much for McCoy to envision a year-round goat rental operation. One advantage of the goats was that their consumption of kudzu and other noxious weeds was not seasonal; goats are able to consume undesired plants throughout the year. At this stage, McCoy needed to decide whether to proceed with expansion. MCCOY'S REVENUES AND COSTS McCoy had charged the resort owner US\$15.00 per day for each goat that he delivered to the resort each day, which he termed one goat-day, to differentiate it from one calendar day. In order to maximize the effectiveness of the goats, McCoy filled his goat trailer to its capacity of 25 goats each day. He bid US\$375.00 per calendar day (25 goat-days at US\$15 per goat-day). By agreement, the owner rented the goats for whole days: the owner was charged the full US $375 daily rental, even if the goats only worked part of the day. It took 25 goats just under seven days to consume all of the plants on the one-acre job site at the resort. McCoy hired a part-time shepherd and his dog to manage the resort job. The shepherd performed all necessary setup work, such as erecting a covered area, a water trough, a mineral lick, and fencing to enclose the site. When the job was complete, the shepherd removed and transported the materials back to McCoy's farm. The trough, covered area and mineral lick cost US\$100; the fence cost US\$0.75 per linear foot. The vinyl fence was not reusable so McCoy delivered it to a local recycle center when the job was complete. During the resort job, McCoy paid the shepherd US\$190 per day to load the goats into a goat trailer each morning, transport the goats to the job site, and, at the end of each day, load the goats back on the trailer and transport them back to McCoy's farm. During the day, the shepherd and his dog made sure the goats were safe from predators and did not wander away from the job site. A summary of the costs incurred on the resort job is provided in Exhibit 2. As MoCoy looked at the numbers from his first goat rental job, he realized he was constrained by the 25 goat capacity of the trailer. He wondered how it would affect profits if he were to upgrade to a trailer with the capacity to transport more goats, McCoy reasoned that because he paid the shepherd a fixed amount of US\$190 per day, increasing the number of goats delivered to the job site would increase his daily revenues and daily contribution margin. McCoy knew larger goat trailers were available; he had located one that could safely accommodate up to 32 goats, approximately 30 per cent more than the capacity of his current trailer. This would increase his rental rate from US\$375 per day to USS480 per day, since he would continue to fill the trailer to capacity when the goats were delivered to the job site. McCoy discussed his ideas with the shepherd, and the shepherd indieated he was interested in working full-time in his capacity as the goat-tender with lis dog. The shepherd said he would be willing to commit to this venture for the same rate he accepted for the resort job. The shepherd insisted on working only five days each week, working 50 weeks during the year to allow for a vacation. McCoy decided to purchase rather than rent a larger trailer to transport his goats. He checked with severa! suppliers and found a trailer with a 32-goat capacity for a cost of USS7,250. The shepherd accompanied McCoy when he inspected the trailer and agreed its capacity would be sufficient for their needs. However, the shepherd pointed out the truck McCoy used for the resort job did not have the power, suspension, or drive train needed to pull the larger trailer loaded with goats. The truck used for the resort job was a spare truck McCoy sometimes used in his farming operation, so McCoy reasoned he would not necessarily need a new truck to pursue the goat rental operation if he continued to use the smaller goat trailer. He would only need a larger truck if he decided to invest in a larger trailer. McCoy knew his old truck would likely need to be replaced in the next five years if he dedicated it to the goat rental operation. McCoy scoured the classified ads in the local newspapers as well as web sites specializing in the sale of used trucks. After some searching, he found a truck that appeared to meet his needs; he and the shepherd went to inspect it. The shepherd agreed that this truck would be more than adequate, but also observed it would require a replacement in five years as well. McCoy decided to make an offer, he and the seller agreed on a price of US $15,000. Taxes and tags on the larger truck and trailer would be an additional 10 per cent of the purchase price of the truck and trailer. The total cost of the larger truck and goat trailer are provided in Exhibit 3. If he bought the larger truck and trailer, McCoy would sell his current truck and trailer for US\$500 immediately, but in five years they would have no resale value. McCoy estimated the larger truck and trailer would have a resale value of approximately US $2,500 at the end of five years. Before purchasing the larger truck and trailer, McCoy took another look at the costs of his goat rental operation (Exhibit 2). He believed the costs incurred for setup (USS100 per job) were representative of the costs he would incur on future jobs. In an effort to reduce the US $0.75 per linear foot cost of fencing, McCoy tried to negotiate a quantity discount based on the amount of business he expected to generate. However, the supplier was not willing to grant a discount until MeCoy had demonstrated the volume of fencing he purchased warranted this deal. MeCoy assumed the average area to be cleared would continue to be one acre of land. Although dimensions would vary based on the shape of the property, McCoy expected the average job would require 962 linear feet of fence. MeCoy now had to get a handle on the variable costs in order to assess the long-term profitability of the goat rental operation. The shepherd had already agreed to the daily rate of USS190 per day; the only remaining variable costs were the costs of transporting the goats to and from the job site each day. Since daily transportation costs were directly related to the distance of the job site from MeCoy's farm, MCCoy decided to assume the average job site would be about 40 miles from his farm, resulting in 80 round-trip miles each day. When McCoy prepared his bid for the resort job, he had estimated transportation costs to be US\$0.63 per mile, which turned out to be equal to the actual costs for the resort job. However, he knew the rate per mile for the larger truck and trailer would likely rise because the larger truck was heavier and had a larger engine, its fuel economy would be much lower. Additionally, the larger truck had a diesel engine and McCoy knew diesel fuel was generally more expensive than regular gasoline. McCoy had done a lot of the repair work on the old truck as a "shade-tree" mechanic. Since he lacked experience with diesel engines, he assumed most of the repairs and maintenance would need to be hired out for the larger truck. After working with the numbers, MeCoy decided to budget transportation costs at USS1.25 per mile for the larger truck. Exhibit 4 provides McCoy's estimates of fixed and variable costs for the goat rental operation. As McCoy began to put his numbers together, he realized the larger trailer would enable him to pursue more jobs each year than the old trailer, since the greater number of goats would reduce the number of days required to complete each job. He was still concerned about the costs associated with the larger truck and trailer though. While he had made a small profit on the resort job, McCoy believed the larger truck and trailer would increase his per job profits, but he was not entirely confident about this venture. He decided to compare the profitability of the goat rental operation using his existing truck and trailer versus the larger truck and trailer. McCoy first had to calculate the number of jobs he could accept each year. Taking more goats to each one-acre job meant each job would finish faster, so he could expect to earn more profit by bidding on more jobs over the year. Knowing the number of jobs and the number of days on each job would also help him determine expenses for transportation, shepherd and dog, setup and fencing. McCoy had always used payback period to evaluate his investments. However, he remembered his accountant telling him about discounted cash flow methods, often used to evaluate investment opportunities. He called his accountant to get a better explanation, who told McCoy to compute the incremental cash flows for each year the asset would be in use, and then discount annual cash flows at McCoy's cost of capital. McCoy could not confirm his cost of capital at the time, so his accountant suggested McCoy use 12 per cent as a conservative estimate. Since the 12 per cent cost of capital was based on a gut feeling, McCoy's accountant also suggested McCoy compute the internal rate of return on the investment. Page 5 9B11B025 Exhibit 1 ACTUAL REVENUES AND COSTS FOR THE RESORT LAND-CLEARING JOB (in U.8. dollars) Per day Project Calendar days needed to complete the project 1 7 Revenues Revenue per calendar day $375.00 Total revenues $2,625.00 Variable costs Transportation costs Round trip distance (miles) 80 Rate per mile $0.63 Transportation costs per calendar day $50.40 Total transportation costs (352.80) Shepherd and dog Rate per calendar day $190.00 Total shepherd and dog costs $134.60$240.40$942.20(1,682.80)(1,330.00) Fixed costs Setup (100.00) Fencing Linear feet Rate per linear foot 962 $0.75 Total fencing costs (721.50) Total fixed costs Profit $120.70(821.50) Source: Case writers' calculations. FIXED AND VARIABLE COSTS FOR RESORT JOB (in U.8. dollars) Source: Case writers' calculations. Exhibit 3 COSTS FOR LARGER TRUCK AND TRAILER (in U.S. dollars) Source: Case writers' calculations. Exhibit 4 ESTIMATED FIXED AND VARIABLE COSTS FOR GOAT RENTAL OPERATION WITH A LARGER TRUCK AND TRAILER (in U.S. dollars) Source. Case writers' calculations. What have you been asked to do? 1. Compute the number of calendar days needed to complete a one-acre job using the current truck/trailer combination and the larger truck/trailer combination. Use the result to calculate the maximum number of jobs McCoy could accept per year using each truck/trailer combination. 2. Using the results from Question 1 , compute the incremental annual revenues (cash flows) if McCoy invests in the larger truck and trailer. Use the model in case Exhibit 1 to compute incremental annual expenses (cash outflows) if McCoy invests in the larger truck and trailer. Determine incremental cash flows for the larger truck and trailer. 3. Using the results from Question 2, prepare a spreadsheet modeling the initial investment and the incremental annual cash inflows and outflows for each of the next five years. 4. Use the incremental annual cash flows computed in question 3, together with other information in the case, to evaluate the investment in the larger truck and trailer. (Hint: Perform payback period, net present value, and internal rate of return. 5. What would you recommend to McCoy regarding the goat rental operation