Reference no: EM13974573

The attached file is a spreadsheet that is only for "Example" purposes – if needed.?
Road King Trucks - Assessment Project

The Transit Bus Opportunity
The company currently builds trucks and is considering building buses. A cost assessment should be done to see if the bus manufacturing will be at a reasonable cost.

Company Profile
The company starting manufacturing school buses and account for about 50% of Road King Trucks' revenues.

The Decision
Management presented the sales and cost forecasts shown in the Exhibits below. The information presented contains the cost of production, financing information, and warranty cost estimates. The proposals also contained two engine options for the engines: The Detroit engine, and the Marcus engine.

The Detroit engine was more expensive to install, but had a lower warranty cost.
The Marcus engine was less expensive to install, but had a higher warranty cost.
Which engine should be used?

Issues and Analyses
Management feels the transit bus project will be a great opportunity but an analysis and report needs to be produced for the proposed project.

Exhibit 1: Sales and Cost Forecast
The sales forecast is based on projected levels of demand. All the numbers are expressed in today's dollars.

The forecasted average inflation per year is 3.5%

Price per Bus $220,000
Units sold per year 11,000
Labor Cost per Bus $50,000
Components & Parts per Bus $95,000
Selling General & Administrative (fixed) $250,000,000
NOTE: Average warranty cost per year per bus for the first five years is $1,000. The present value of this cost will be used as a cost figure for each bus. Afterwards, the bus operator will become responsible the repairs on the buses.

The buses can be produced for twenty years. Afterwards, the designs become obsolete.

Two Engine Choices:

Engine Detroit Engines Marcus Engines
Price per engine, including installation $20,000 $18,000

Average annual warranty cost per year for five years. Afterwards, the bus operator will become responsible for the repairs on the buses*
$1,000 $1,500
The chosen engine will be installed in every bus and will become a cost figure for each bus.

NOTE: The engine manufacturers are not providing Road King Trucks with any warranty. Road King Trucks will provide a warranty to its customers. After the initial five years, the bus operators may purchase an extended warranty from any insurance company that offers such packages.

Exhibit 2 - Investment Needs

To implement the project, the firm has to invest funds as shown in the following table:

Year 0 Year 1 Year 2
$1 Billion* $100 Million* $100 Million*

* Road King Trucks estimated that it would cost a total of $1 billion to build the factory and purchase the necessary equipment to produce the buses. The other $200 million investment, divided equally in years
1 and 2 is for non-depreciable labor training costs.

Such investment is treated as regular business expenses.

Straight line depreciation will be used for the sake of simplicity.

To facilitate the operation of manufacturing the transit buses, the company will have to allocate funds to net working capital (NWC) equivalent to 10% of annual sales. The investment in NWC will be recovered at the end of the project.

The equipment will be sold for salvage at about $15,000,000 at the end of the project.

Exhibit 3: Financing Assumptions

The following assumptions are used to determine the cost of capital.

Historically, the company has maintained a debt ratio is 40%. This ratio was used, because lowering the debt implies giving up the debt tax shield, and increasing it makes debt service a burden on the firm's cash flow. In addition, increasing the debt level may cause a reduced rating of the company's bonds. The marginal tax rate is 40%. All the numbers are expressed in today's dollars. The forecasted average inflation per year is 3.5%.

Cost of debt:
The company's bond rating is roughly at the high end of the A range. Surveying the debt market yielded the following information about the cost of debt for different rating levels:

Bond Rating AA A BBB
Interest Cost 5.5% ~ 6.5% 6.25% ~ 7.5% 7.5% ~ 9%

The company's current bonds have a yield to maturity of about 6.5%.

Cost of equity:
The current 10-year Treasury notes have a yield to maturity of 2.25% and the forecast for the S&P 500 market premium is 8.75%. The company's overall beta is 1.15.

The assignment

I. Below is a list of items that is needed to identify and quantify:
See attached spreadsheet for examples

A. For Each Year
1. Revenue
2. Variable costs
a. Labor cost per bus
b. Parts cost per bus
c. Engine costs per bus (2 options Detroit Engines or Marcus Engine)

3. Selling, General & Administrative costs
4. Training costs
5. Warranty costs
a. Bus
b. Engine (2 options)
6. Depreciation
7. Working Capital needs

B. Project Related
1. Investment costs

C. Cost of Capital See attached spreadsheet example
1. Company's weighted average cost of capital (WACC) see Exhibit 3

2. Appropriate cost of capital for this project

II. Include a spreadsheet containing all relevant calculations and answers to these 7 questions based from the Exhibit information above.
See attached spreadsheet for Cash Flow and Cost of Capital examples

1) How much importance should be given to the energy cost situation?
2) What are the project's cash flows for the next twenty years? What assumptions did you use?

3) What is the company's cost of capital? What is the appropriate discount factor (which may be different) for you to use in evaluating the bus project?

4) If you decide to go ahead with the project, which of the two engines should be used in the bus, and why?

5) Evaluate the quality of the project, by using appropriate capital budgeting techniques.

6) Would you recommend that Road King Trucks accept or reject the project?
What are the key factors on which you base your recommendation?

7) Should the company do or not do the bus production project? What is the appropriate support for the decision (think NPV and IRR).

Attachment:- wacc-inputs-cash-flow-examples.xlsx