The Mini-case

Blitz Rental Cars (BRC) Ltd. is analyzing whether to enter the discount used rental car market. The project would involve the purchase of 100 used, late-model, mid-sized automobiles at the price of $10,500 each. In order to reduce its insurance costs, BRC will have a LoJack Stolen Vehicle Recovery System installed in each automobile at a cost of $1,200 per vehicle. BRC will also utilize one of its abandoned lots to store the vehicles. If BRC does not undertake this project, it could lease this lot to an auto repair company for $90,000 per year. The $25,000 annual maintenance cost on this lot will be paid by BRC whether the lot is leased or used for this project. In addition, if this project is undertaken, net working capital will increase by $40,000.

The automobiles will qualify as a 5-year class asset under the modified accelerated cost recovery system (MACRS), however, the BRC prefers using the double declining balance method for valuation purpose (assume $1,000 salvage value). Each car is expected to generate $3,800 a year in revenue and have operating costs of $800 per year. Starting 4 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 $110,000 per year continuing indefinitely. This discount rental car business is expected to have a minimum impact on BRCs regular rental car business where the net cash flow is expected to fall by only $15,000 per year. BRC expects to have a marginal tax rate of 35%. The market value of the companys debt and equity is $500 million and $1,500 million, respectively. The company has to pay a 10% interest (per annum) on its borrowings. The cost of equity is 8%.

Required Write a report to the management of the company advising whether the discount used rental car project would be viable. Give reasons for your decision. Identify all relevant information and show calculations in support of your recommendation.