Reference no: EM131936595

Introduction

Michael Livingston has recently been hired as the CEO of Road King Trucks, Inc. Previously he had been the marketing manager for a large manufacturing company and had established a reputation for identifying new consumer trends. Road King Trucks Inc. is a California-based truck manufacturing company.

The company is well known for manufacturing large, heavy-duty trucks at a reasonable cost. One of its greatest achievements is that its trucks can be easily modified or customized for different applications. Road King Trucks also builds school buses. The company is considering an expansion of its current product line to include transit buses. Mr. Livingston feels that due to high gasoline prices, commuters will be more willing to consider using mass transit instead of using their cars to commute to work.

Company Profile

Road King Trucks, Inc. was established by the Smith brothers in 1880 as the California  Wagon Company. The firm started manufacturing horse-drawn wagons to serve the growing population in California. The brothers quickly realized that the times were changing, so they started looking for the technologies that would keep them at the forefront of their field of business. In 1915, the Smith brothers decided  that they needed to make trucks as replacements for the wagons, because trucks were starting to serve the same uses as wagons, and the wagon industry was not going to be viable in the longer term.

The company started making school buses in the early 1940's. Most manufacturers had been commissioned by the government to produce different large vehicles to support World War II operations. Road King Trucks opted to produce buses. It was an easy decision to make, since the buses would use common parts with the company's trucks, and the customers were local governments. Starting in the 1950's, the school bus business accounted for about 50% of Road King Trucks' revenues.

The Transit Bus Opportunity

Mr. Livingston arranged a meeting with the firm's top management, as well as the chief design and manufacturing engineers to propose his new product. He presented an argument that more individuals in the United States and Canada would be willing to use public transportation than before, because people were becoming more environmentally conscious. Also, recent increases in fuel costs seemed to be long lasting. 

This was an opportunity to get people hooked on transit buses, as he put it. The proposal under consideration was for the introduction of a large, public transport bus. To distinguish Road King Trucks from other manufacturers, the proposal included details about the level of comfort, air-conditioning, efficiency, and quietness of operation that needed to be developed.

Mr. Phillips and Mr. Lopez, the two engineers, reacted enthusiastically and quickly pointed out that the bus could be based on the company's trucks. The frame currently used for building the trucks could be modified to accommodate buses at a relatively low cost. The marketing vice president, Mr. Chen, pointed out that a marketing analysis could be done quickly, and at a reasonable cost. At this point, Mr. Livingston charged the participants in the meeting to produce a financial plan for the development and production of a transit bus.

Public Transportation

The use of public transportation had declined steadily since the 1950's. Most people were opting to use their personal vehicles for all of their transportation needs. Recently, however, most of the metropolitan areas in the United State and Canada, the target markets for the new bus, had become more and more congested; and parking, which was already very expensive, was becoming scarce.

This combination of trends has renewed the public's interest in good and reliable public transportation. Several municipalities have been campaigning to their residents and commuters that they should use public transportation for business commuting, and only use their cars for shopping and weekend activities. However, such campaigns need to be supported by making high quality public transportation available to the target riders.

The Decision

Three weeks after the initial meeting, the vice presidents presented the sales and cost forecasts shown in the attached exhibits. 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. This begged the question: Which engine should be used?

Issues and Analyses

Mr. Livingston noticed that there was a great deal of enthusiasm among the management group about the transit bus opportunity, but his cautious nature told him to also seek a more objective viewpoint. Consequently, he sought out you to analyze the proposed project and provide your recommendations directly to him.

The issues he wants you to address in your analysis and report are the following:

(1) What is the company's cost of capital? What is the appropriate discount factor  for you to use in evaluating the bus project? Identify and define the formulas.

(2) Evaluate the quality of the project, by using appropriate capital budgeting techniques, NPV and IRR.

(3) Would you recommend that Road King Trucks accept or reject the project? Justify your decision by discussing the key factors on which you base your recommendation?

Exhibit 1: Sales & 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 2.5%.

Price per bus $225,500
Units sold per year 7,750
Labor cost per bus $52,000
Components & Parts $94,000
Selling General & Administrative $250,000,000

NOTE: Average warranty cost per year per bus for the first five years is $1,100. 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 fourteen years. Afterwards, the designs become obsolete.

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.

Exhibit 2: Investment Needs

To implement the project, the firm has to invest funds as shown in the following table: Year 0 $400 million* plus land the company bought for $5 million.

Year 1 $284 million* Year 2 Production and selling of busses starts * Road King Trucks estimated that it would cost a total of $684 million to build the factory and purchase the necessary equipment to produce the buses. Use straight line depreciation of $684 million over 12 years for the sake of simplicity: $57 million.

The company will have to allocate funds to net working capital (NWC) for parts inventories equivalent to 8% of annual sales, spent in year 1 and sold off in year 13 at the end of the project.

Assume that the land, factory, and equipment will be sold at the end of the project. The company expects to spend about $300,000 demolishing the factory and cleaning the land. The company expects to sell the land for its current value. The equipment will be sold for salvage at about $15,000,000.

Exhibit 3: Financing Assumptions

The following assumptions are used to determine the cost of capital. Historically, the company tried to maintain a debt ratio equal to 0.28. 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.

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 range 5% ~ 6% 6% ~ 7% 7% ~ 8.5%

Cost of equity:

The current 10-year Treasury notes have a yield to maturity of 3% and the forecast for the S&P 500 market premium is 6%. The company's overall beta is 1.2.

Beta analysis:

Company Road King Trucks

Overall Beta 1.2

Debt to equity 0.4

Percentage of income from trucks 50

Company Red Bird

Overall Beta 1.2

Debt to equity 0.3

Percentage of income from trucks 45

Company General Trucks

Overall Beta 1.3

Debt to equity 0.5

Percentage of income from trucks 90

Company Universal Transports

Overall Beta 1.32

Debt to equity 0.45

Percentage of income from trucks 95

Company Trucks Inc.

Overall Beta 1.2

Debt to equity .35

Percentage of income from trucks 85

Company International Trucks.

Overall Beta 1.09

Debt to equity 0.25

Percentage of income from trucks 85

Road King Trucks Excel Spreadsheet
Below is a list of items you need to identify and quantify:
A B C D E F-P
Unit Year Year Year Years
Data 0 1 2 [sales begin] 3-13
Price
Units
Revenue
Labor cost per bus
Parts cost per bus
Engine costs per bus
Bus Warranty
Engine Warranty
SG&A costs
Depreciation
EBIT
Taxes
NOPAT
Depreciation Add Back
Operating Cash flow
Investment costs:
Land
Plant and Equipment
Working Capital [year 1 subtract, year 13 add back]
Salvage Summary: year 13
Land
Building clean-up costs
Equipment salvage costs
Total Salvage Value
Taxes
Net Salvage Value
TOTAL CASH FLOWS
Net Present Value using company's weighted average cost of capital (WACC)
Internal Rate of Return
NPV(rate,D34:P34)+C34
IRR(C34:P34)