The date is Monday, September 20, 2020. Your company, the Regency Petroleum Company, is faced with a critical decision, and your boss has been bragging about you as the person most able to help Regency management carefully evaluate and make the best decision. The Vice President of Operations (your bosses boss!) is also a Cal Poly alumni and counting on you to uphold the schools reputation for providing world class engineers. Regency management is currently considering construction of a new terminal and tank farm facility to supply its customers in Northeast Florida. Regency has been receiving, storing, and distributing Bunker Oil and #2 Heating Oil using facilities leased from the Gateway Oil Company in Jacksonville, Florida. However, Regency just learned that Gateway will likely not renew this throughput agreement when it expires in December 31, 2020.

After investigating a number of possible arrangements (from a top down perspective), Regencys management has concluded that there are basically two feasible alternatives. The company could either construct its own facilities or cease operations in Northeast Florida. Although Regency is reluctant to abandon its customers, the company policy clearly requires that all investments in new facilities must provide a minimum after tax return of 15% (Regencys MARR). Your assignment is to prepare an AR (Appropriations Request) that will enable Regency management to make the best decision. (And remember your bosss AND the VP of Operations credibility is at stake!)

Engineering estimates indicate that the new facilities will cost $25,000,000 to construct and will have a useful life of 20 years. For tax purposes, the new facilities can be depreciated over the MACRS 10-year class life allowed for other petroleum equipment. The terminal is to be built on land leased from the Jacksonville Port Authority. Rent and wharf charges to the Port Authority are expected to total $450,000 per year under the terms of a 10 year lease; and the lease has options to renew for an additional 10 year period at the same rate. If construction is started by July 1, 2021, then Engineering expects that the new facility will be ready for operation by July of 2022. Trucks and other vehicles that are now in use can be used at the new facilities, if it is built. It is estimated that at the end of 2020 this equipment will have a fair market value of $500,000 and a book value of $200,000 depreciable over the following five years using (SL) straight line depreciation method.

New equipment for the facility will also be purchased during the life of the project. The computer system will be upgraded every 5 years (the initial system is included in the initial facility cost of $25.0 million). The cost of each subsequent new computer system is assumed to be $350,000 per installation. Depreciation on these systems will be using MACRS with an appropriate class life for computers. After the new facilities are placed in service, it is expected that some additional equipment replacement (pumps and tanks) will have to take place half-way through the expected life of 20 years. This equipment is expected to cost $1,500,000, and may be depreciated using MACRS with a class life of 10 years. In addition, trucks will have to be purchased every year starting in the first year of operation. They will cost a total of $100,000 each year and will be depreciated with MACRS using a class life of 5 years. The sales volume of Bunker Oil and #2 Heating Oil are expected to total 15.0 million barrels in 2020 (as forecast for the Gateway facilities). In 2021, the sales volume is expected to remain the same as in 2020, and in subsequent years is expected to increase at a rate of about 10% per year for six years at which time the sales volume will be assumed to be level for the remainder of the life of the project.

A profit of 10% is added to Regencys cost of oil when they sell to their own customers. Regencys initial planning shows the forecasted cost of oil to Regency will be $80.00 per barrel (cost of goods sold), but you have seen recently in the news that oil prices have jumped all over the place. You believe that limited supply will probably cause the oil to go up in cost to Regency by about 2.0% per year over a planning horizon of 20 years. Accounting says the effective tax rate for Regency should be considered to be 28%. The company will need some working capital to sustain its operations for either alternative. A general formula for the level of working capital needed has been found to be about 10% of gross sales revenue forecasted for the year. This working capital is needed at the beginning of the year for which the forecast is made.

The level of working capital needed will change depending on the forecasted change in sales revenue. You will need to calculate a schedule for the amount of working capital which will be needed over the 20 years of this project. Working capital is considered an additional necessary investment from after tax dollars, but is not tax deductible. In your cash flow analysis, you will need to distinguish between the following three types of expenditures: 1) expenses (which are tax deductible in the current year); 2) capital investments (which are deductible over multiple years through depreciation), and 3) increases in working capital (which is like a capital investment, but is not deductible). Additional expenses for the project will include operating expenses, which are expected to be $800,000 per year to start, with an increase of 3.0% each year over the life of the project. (Note: depreciation is an expense for tax purposes only.)