Tasmanian Motor Rental (TMR) Cost Analysis

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 is the report to advise the TMR’s management to the best of action regarding this project.

The relevant costs attempt to help the manager determine whether the new product can create value. Relevant costs are costs that change with each decision you make. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process. (1) Relevant costs directly affect cash flow, the money coming in and out of a business, which including differential, avoidable, and opportunity costs in different period of the project life cycle including initial investment period, interim operating period, and terminal period. (2), (3, Titman, S., Keown). Therefore; the costs are relevant for the evaluation of this project are shown as the table below.

However, there is an irrelevant cost in the evaluation of this project, which is $25,000 annual maintenance cost. The irrelevant cost is the cost that will not change in the future when you make one decision versus another. The irrelevant cost will continue to happen. (2) Since the annual maintenance cost will be paid by TMR whether the lots are leased or used for this project, which means the company have paid $25,000 annually whether the investment is undertaken, therefore; $25,000 is a sunk cost and not relevant for the evaluation of this project.

Cannibalization is a sales loss occurs when TMR introduces a new service which is the discount rental car in near Hobart airport and Launceston airport that reduces sales of the firm’s existing services. Typically, some of the new product’s sales will come at the expense of the firm’s existing products. Thus, it is essentially to consider the incremental cash outflows from existing product sales that are cannibalized by a newer product since they will affect the calculation of the new investment’s incremental cash flows.(3) In this case, the erosion of profits from TMR’s regular services should be charged to the new rental car project. Even if its competitors would adversely affect the regular services, the lost sales of existing services from the expected new services of rental used car should be subtracted.

Opportunity costs are cash flows that a firm will lose by undertaking the project under analysis. These are cash flows generated by an asset the firm already owns that would be forgone if the project under consideration were undertaken. Opportunity costs should be included in the project costs. (4) In this case, the cost of the abandoned lots located near Hobart airport and Launceston airport that TMR owns should be treated as opportunity cost of the project. Even if TMR does not undertake the project, the lots can be leased to an auto-repair company for $90,000 per year, the space is not free, and the lite product project should consider current market value of the space as the opportunity cost. In result, the opportunity loss $90,000 as lease income need to be taken into account as negative cash flows.

Determine the initial investment cash flow.

Appendices 1:

The initial cash flow is the amount of money paid out or received at the start of a project or investment. In this case, TMR will purchase of 100 used late model, mid-sized cars costs $1,500,000, LoJack Stolen Vehicle Recovery System installation costs $150,000, TMR will also need to redevelop and renovate the buildings cost $215,000. Moreover, if the project is undertaken, the working capital requires $150,000 to start the project. Besides, TMR has also budgeted marketing cost which is $30,000 for the initiation of the project. Since the marketing cost will be paid in time 0, there will be a tax deduction in the year it is incurred which will be $8,250 cash inflow. In conclusion, The TMR have to pay $2,036,750 as the initial investment for this project which is a negative amount and is factored into the profitability of a project during the discounted cash flow analysis that is used to evaluate whether or not undertaking the project is profitable. (5)

Picture of the project:

Time period                                                                                          Years

5

4

2

3

1

0

OCF₅

OCF₃

OCF₂

OCF₄

OCF₁

Operating cash flow:  OCF for years 1 to 5 equals the sum of additional revenue less operating expenses (cash expenses and depreciation) less tax plus depreciation expense

Operating cash flow_t = Operating Profit – Tax + Depreciation expense_t

Appendices 2:

The project produces different revenue in from year 1 to year 5, 850,000; 1,050,000; 1,100,000; 1,250,000; and 1,250,000 respectively. In each year, subtracting all cash operating expenses per year including operating variable, operating fixed cost, increasing in administrative, marketing cost, reduction in rental income, and opportunity cost. Then, subtracting depreciation expenses of 330,000 per year gives an operating profit of 5000; 185,000; 260,000; 395,000; 395,000 respectively from year 1 to year 5. Subtracting tax which takes 27.5% on its profits leaves a net operating profit after tax 3,625; 134,125; 188,500; 286,375; and 286,375 respectively from year 1 to year 5. Finally, adding back depreciation expense gives an operating cash flow of 333,625; 464,125; 518,500; 616,375 respectively from year 1 to year 4. In year 5, continuing add the recovery of initial investment of 150,000 leaves the OCF of year 5 is 766,375.

The project contributes 5000; 185,000; 260,000; 395,000; 395,000 respectively from year 1 to year 5 to the firm’s operating profit (before tax), and if the project operates exactly as forecast here then this will be the observed impact of the project on the operating profit on the firm’s income statement. However, in a world where the future is uncertain, this will not be the outcome. (Textbook)

The project’s payback:

Appendices 3:

The payback period shows how quickly the firm can recover its original investment which plays an essential part when evaluating a risky investment as the longer the TMR has to wait to recover its investment, the more things can happen that might reduce or eliminate the benefits of making the investment. In this case, the TMR have to wait up to more than 4 years and 7 months over 5 years doing the project that the project will return its original investment, hence it is risky to undertake an investment.

Appendices 4:

The NPV estimates the amount of wealth the project creates. The NPV criterion simply states that investment projects should be accepted if the NPV of the project is positive and should be rejected if the NPV of the project is negative. (Text book)

The project of TMR requires an initial investment of $2,036,750 and provides future cash flows that have a present value of $394,191.20. Consequently, the project cash flows are $394,191.20 less than the requirement investment.  Since the project’s future cash flows are worth less than the initial cash outlay required to make the investment, the project is not acceptable project.

Using sensitivity analysis, the scenario of a decrease in project sales by 10% annually.

To evaluate the sensitivity of the project’s NPV to uncertainty surrounding the project’s value drivers, we analyze the effects of changes in the value drivers, in this case, the value driver is decreasing in project sales by 10% annually.

The objective of this analyze is to explore the effects of the prescribed changes in the value drivers on the project’s NPV. In this circumstance, we estimate the project’s NPV for estimates of each of the value drivers that deviate 10% from base-case value. The deviations we consider are each in an advance direction. The resulting NPVs are then compared against the base-case NPV in order to determine which value driver has the greatest influence on NVP

Appendices 5:

Appendices 6:

Examination of the worst-case and the base-case scenarios for the project indicates that although the project is expected to produce an NPV of $394,191.20, the NPV might be as low as $123,294.34. It indicates that, even in the worst scenario, the NPV is low but not negative, thus it is not a risky investment opportunity. However, the low NPV also causes particular troublesome to the TMR’s management, they should consider an alternative course of action based on this scenario analysis.

By calculating the project’s payback period and estimating the Net Present Value by using sensitivity analysis, the TMR’s management may go ahead with the investment project. However, as the firm will recover the investment requirements in very late period of the project which approximate 4 years and 7 months whilst the project lasts for 5 years, and the NPV in the worst-case is not negative but it is lower than the base-case by $270,896.86 (394,191.20 – 123,294.34 = 270,896.86) which may cause some troublesome for the firm.

After evaluating what TMR’s management feels are worst-case and base-case estimates of these value drivers, however; we can discover a wider range of possible NPVs by evaluating the best-case of this project. What the managements do not know is the likelihood or probability that the worst-case or the best-case scenario will occur. Moreover, we do not know the probability that the project will lose money. I would love to suggest the firm to use simulation analysis which is a power tool provides the analyst with a discrete number of estimates of project NPVs for a limited number of cases or scenarios.

Preferences:

(1)   Kenton, W., 2019. Relevant Cost. Investopedia. Available at: https://www.investopedia.com/terms/r/relevantcost.asp [Accessed May 18, 2019].

(2)   Anon, Study.com. Available at: https://study.com/academy/lesson/relevant-irrelevant-costs-for-decision-making.html [Accessed May 18, 2019].

(3)   Titman, S., Keown, A.J. & Martin, J.D., 2019. Financial management: principles and applications, Melbourne, VIC: Pearson Australia Group Pty Ltd

(4)   Titman, S., Keown, A.J. & Martin, J.D., 2019. Financial man

(5)   Kenton, W., 2019. Understanding Market Cannibalization. Investopedia. Available at: https://www.investopedia.com/terms/m/marketcannibilization.asp [Accessed May 18, 2019].

(6)   Kenton, W., 2019. Initial Cash Flow. Investopedia. Available at: https://www.investopedia.com/terms/i/initialcashflow.asp [Accessed May 18, 2019].