Applying of the Project of Road King Trucks - Assignment Example

ROAD KING TRUCKS This report presents the analysis of the new project of Road King Trucks. The new project entails the introduction of a new product (transit buses) into its existing product line. The analysis aims at establishing whether Road King Trucks should decide to expand its current product line by including transit buses or not. In answering the six questions, the body of the report is going to discuss the following six issues i) importance of the current energy cost; ii) cash flows of the project; iii) the company’s cost of capital; iv) choice of an engine v) evaluation of the expansion project vi) Project Acceptance or rejection decision Road King Trucks should accept the project as it has a positive NPV and a low payback period. In addition, the company’s IRR is higher than the Road King Trucks cost of capital. Further, the company has a Profitability Index, PI, of greater than one implying that it has a higher per dollar return. Road King Trucks is going to gain $532 million in wealth when the expansion decision implemented, which is a huge amount money on a scale like this. Road King Trucks has a bond rating of AA. This makes its risk relatively low (Groppelli & Nikbakht, (2006). For these reasons, the company should definitely say yes to the expansion decision. Issues and analyses Importance of the current Energy Cost Road King Trucks, Inc. that is a company that manufactures trucks is contemplating on introducing a public transport bus. A recently hired, CEO Michael Livingston organized a meeting with the company’s top engineers and managers to examine introducing into its existing product line a large, public transit bus (Bidgoli, 2004). The new CEO Michael Livingston recognized the opportunity of building these public transit buses due to the escalating prices of fuel, the roads congestion together with the ever increasing parking fees. It is likely that more people are going to use public transportation because the prices of oil keep on rising with no sign of decreasing in the near future. As a result, the public transportations demand is expected to increase and continue into the spring as many people will search for alternative transportation. Road King Trucks should, therefore, adapts itself to the market changes in order to be at the forefront of their field of business (Groppelli & Nikbakht, (2006). The company should go Green by adopting engines that demonstrate immense environmental consciousness to the world (Baker & Powell, 2005). This will attract people that require public transportation thus fulfilling their needs or demands. Transition will undoubtedly be much easier for the company if it avails high-quality public transportation to the targeted riders. Project’s Cash Flows (see the attached Excel file) It is anticipated that the total cash inflows are more than the total cash outflows so that the cost incurred in the progress can be covered. When the production and selling of buses begin in the year three of operation, Road King Trucks is expected to reach positive cash flows (see attached excel file). Years 0-2 shows cash flow of $1100 million which is invested in training, plant and equipment. An annual forecasted average inflation of 3.5 percent is added to all expenses except depreciation that is always a noninflationary number. The same amount of inflation is added to the project’s price per bus. The straight-line method is used to depreciate the factory’s construction as well as the necessary equipment required to produce the transit buses (Bidgoli, 2004). We need to evaluate the net Present Value so as to determine whether the expansion project should be run or not. The total life of the expansion project is approximated at 20 years. An analysis of the two engines   (the Detroit engine and Marcus engine) cash flows indicates that the Detroit engine has an NPV of $1,863,448 while that of the Marcus Engine is $1,897,513,000. Therefore, utilizing the Marcus Engine results to a $4,065,000 more NPV. The cash flow for year 20 is got by adding working capital and operating cash flows together and then subtracting the property’s net salvage value. Cost of capital Capital is usually the source of finance that provides resources to any investment project. Capital may be equity financing or debt financing. Dent financing cost is usually interest rate that is normally the before tax cost of capital. However, after-tax cost of capital is usually interest rate time one minus tax rate [r (1-t)] (Groppelli & Nikbakht, (2006). A yield to maturity or interest rate of 6.5% and a tax rate of 40% implies that the after-tax cost of capital is 3.9% while before tax cost of capital is 6.5%. In the case of equity financing, the cost of capital is usually the dividend. However, the cost of equity is mostly calculated using the capital assets pricing model, CAPM. The cost of capital is a crucial factor used to appraise the economic feasibility of the above expansion opportunity (Baker & Powell, 2005). We need to work out the Weighted Average Cost of Capital, commonly known as WACC, so as to determine the appropriate discount factor for the project. The WACC is the weighted average anticipated cost for the obligations of the business such as debt, common stock and preferred stock which are usually issued by the entity to finance its investments and operations (Bidgoli, 2004). Solution Computation of cost of capital (WACC) Marginal tax rate = 40% Debt ratio = 40% Current yield to maturity of the bond = 6.50% Forecasted average inflation rate = 3.50% Current 10-year treasury notes yield to maturity; risk-free rate of return (Rf) = 4% Beta (β) = 1.15 Market risk premium (Mp) = 5.50% Debt ratio of 40% is found by dividing Total Debt by Total Capital Employed Debt ratio= 40/100 Total Capital employed = 100 Equity Capital (E) is therefore = 60 Debt capital (D) is therefore = 40 Cost of equity (Ke) = Rf+ (β*Mp) = 4 %+( 1.15*5.5%) = 10.33% Cost of debt (kd) = Bonds Current yield*(1-rate of tax) = 6.5 %*( 1-0.40%) = 3.90% Weighted Average Cost of Capital = (Kd*(D/ (D+E))) + (Ke*(E/ (E+D))) (Baker & English, 2011). = (3.9 %*( 40/100)) + (10.33 %*( 60/100)) = 7.76% Road king Truck has a total initial investment of approximately $1200 million, out of which $200 million is believed to be got from working capital. Equity and debt provide the remaining $1000 million in the above ratio (60:40). The projects appropriate discount factor is, therefore, 7.76%. The whole amount is not required at the beginning of the project; however, the project is financed steadily in three years time hence the rate of interest is calculated appropriately. The cost of capital of the Road King Trucks is 7.76% as shown above. Choice of an engine Road King Trucks has two engines and warranties to select from when determining the best engine for the company. The two engines have the following data Detroit Engine Marcus Engines Initial Costs per unit 20000 18000 Warranty costs per year 1000 1500 Present value of the warranties $3,873.13 $5,809.69 Warranty period 5 year 5 year Calculation of PV of the total cost of engine $24,018.09 $24,027.14 Based on the present values of the total cost of the engine and warranty cost, it is evident that the most affordable route is Detroit engine (Baker & Powell, 2005). However, when the entire cost of the engine as well as the purchase of the actual engine itself is analyzed, the Marcus engine appears to be the most appropriate engine for the company. Computation of Capital budgeting techniques The two engines needs to be evaluated using capital budgeting techniques in order to determine the cost-effective engine. The capital budgeting techniques used are Internal Rate of Return, payback period, profitability index and Net Present Value (Baker & English, 2011). The Net present values for Detroit engine is $1,863,448 while that of Marcus Engine is $1,897,513,000. The Internal Rate of Return for Detroit Engine 21.71% while the IRR for Marcus Engines is 21.73%. From the two capital budgeting techniques, the better investment is undoubtedly the Marcus Engine (Bidgoli, 2004). Even though it is better to buy the Detroit Engine because it will cost lesser than the Marcus engine, the better investment is the Marcus Engine because it will result to higher returns than the Detroit Engine as shown by higher IRR and NPV. Evaluation of the expansion project Using the cash flows in the excel file as well as financial calculators, the Road King Trucks will have the following values of the capital budgeting techniques in case the expansion project is implemented. IRR = 13.27% NPV = $784,246,998.21 Payback period = 7.20 years Profitability index = (Total cash flows Present value/Present value of total cash outflows) = 1.78 Project Acceptance or rejection decision Having determined the projects cash flows, Internal Rate of Return and Net Present Value for this expansion project, it is in order to for the Road King Trucks to accept the expansion project. These are some of the reasons to hold this opinion. The companys payback period of 7.20 years implies that it is going to realize its initial investment in only 7.20 years. In addition, the company has positive Net Present Value and an internal Rate of Return that is more than the cost of capital (Peterson & Fabozzi, 2002). This, therefore, implies that the Road King Trucks is going to get higher returns when the expansion project is implemented. This expansion project will increase the Road King Trucks’ value by approximately $1,897,513,000. This will undoubtedly provide an increase in the wealth of the Stockholders. Summary of results and recommendations From the analysis of the data that was provided, the company should accept the project it holds because of the following reasons. Firstly, the company has a positive NPV of approximately $784,246,998.21. Secondly, it has an Internal Rate of Return of about 13.27%, which is far greater than the company’s cost of capital. The expansion project is, therefore, very profitable (Bidgoli, 2004). Road king Truck should adopt the following strategies in order to save its energy consumption and increase sales volume. The first suggestion regards the style or design of the trucks. The company need not design and sell only one truck because it is expensive and unwise. Road King Truck should design a series of truck parts and components just like Tangram that have designed thousands of unique graphics from just seven different parts (Baker & Powell, 2005). Series of truck designs implies that the company will assemble different styles to its customers thus increasing its sales volume. This will also help the company to put to use idle resources thus reducing wastages in return. The next suggestion is that the company needs to develop more energy efficient models to cut on the gasoline consumption. This will ensure that the company saves some amount of money despite the high gasoline prices thus increasing the profits to the company (Peterson & Fabozzi, 2002). References Peterson, P. P., & Fabozzi, F. J. (2002). Capital Budgeting: Theory and Practice. Hoboken: John Wiley & Sons. Khan, M. Y., & Jain, P. K. (2007). Financial management. New Delhi:Tata McGraw-Hill. Baker, H. K., & English, P. (2011). Capital budgeting valuation:Financial analysis for todays investment projects. Hoboken, N.J:Wiley. Groppelli, A. A., & Nikbakht, E. (2006). Finance. Hauppauge, N.Y: Barrons. Baker, H. K., & Powell, G. E. (2005). Understanding Financial Management: A Practical Guide. Oxford: Blackwell Pub. Bidgoli, H. (2004). The Internet encyclopedia. Hoboken: J. Wiley & Sons. Read More