Financial Management - College Of Business And Economics

Bfa107 Financial Managementcollege Of Business And Economicsemest

Evaluate the viability of a capital investment project for Tasmanian Motor Rental (TMR) based on a detailed financial analysis. The task involves identifying relevant and non-relevant costs, considering cannibalization and opportunity costs, calculating initial investment cash flows, estimating project cash flows over five years, determining payback period, computing Net Present Value (NPV), conducting sensitivity analysis, and providing management recommendations based on financial metrics and assumptions. The report should be structured with an introduction, main body responding to specific questions, and a conclusion, with all calculations placed in appendices. Use the Harvard referencing style for sources cited.

Paper For Above instruction

Introduction

The decision to undertake a capital investment project requires rigorous financial analysis to determine its feasibility and alignment with the company's strategic goals. In this case, Tasmanian Motor Rental (TMR) considers entering the discount rental car market in Tasmania, which involves substantial initial expenditure and ongoing operational costs. This report assesses the project's financial viability by examining relevant costs, opportunity costs, cash flow projections, payback period, NPV, and sensitivity to sales decline, ultimately providing a well-informed recommendation to TMR's management.

Analysis of Relevant and Non-Relevant Costs

In capital budgeting, identifying relevant costs is essential because only those costs that will be affected by the decision should be included in the analysis. Relevant costs are incremental or differential costs—costs that will change depending on whether the project proceeds or not. Conversely, sunk costs, the initial expenditure already incurred, are irrelevant as they do not influence future decisions.

For TMR's project, relevant costs include the purchase of 100 used cars at $15,000 each, totaling $1,500,000, and the installation of LoJack systems at $1,500 per vehicle ($150,000). The redevelopment and renovation costs of $215,000 are capital expenditures that contribute to the project's value, although for financial analysis, their impact appears as depreciation deferred until sale, rendering them non-cash in the initial analysis. Marketing costs of $30,000 annually are relevant because they are directly incurred to support the project and are tax deductible. The additional net working capital of $150,000 is also relevant, as it represents an initial investment necessary for operational liquidity.

On the other hand, costs such as the $90,000 annual lease income from the auto-repair lot and the $25,000 annual maintenance costs for the lots are consideration only insofar as they impact opportunity costs and operating cash flows. The existing administrative costs of $550,000 are largely fixed, but a 20% increase attributable to the new operation (approximately $110,000) is relevant because it constitutes an incremental cost directly linked to the project. Sunk costs like past expenses or the original building redevelopment costs prior to project initiation are non-relevant for decision-making, as these have already been incurred and cannot be recovered.

In summary, the relevant costs include the initial vehicle purchase, installation, marketing, working capital, incremental administrative expenses, and any other operational costs directly affected by the project. Non-relevant costs comprise sunk costs and costs unaffected by the decision such as lease income from idle lots if the project proceeds.

Considering Cannibalization and Opportunity Costs

Cannibalization refers to the reduction in sales of existing products or services due to the introduction of a new offering. For TMR, the launch of a discount rental car service is expected to decrease its regular car rental business by $20,000 annually. This potential sales cannibalization must be incorporated into the cash flow analysis as it represents a reduction in revenues from existing operations caused by the new project. Failing to account for cannibalization could overstate the project's profitability.

The opportunity cost entails the value of the next best alternative foregone. In this scenario, TMR has the option to lease the lots for $90,000 annually rather than use them for the rental project. This foregone lease income, which totals $180,000 over the project duration, is an opportunity cost and must be considered as a cash outflow when evaluating the project's net benefit.

Both cannibalization and opportunity costs are vital because they affect the incremental cash flows. Ignoring these factors may lead to an overestimation of the project’s profitability. Accordingly, the project’s cash flows should be adjusted downward by the amount of lost sales and opportunity income to reflect an accurate economic benefit.

Initial Investment Cash Flow

The initial investment includes the vehicle purchase, LoJack installations, building renovations, and initial working capital. Specifically, the purchase cost is $1,500,000; LoJack installation costs are $150,000; redevelopment costs are $215,000; and the working capital requirement is $150,000. Thus, the total initial cash outflow is calculated as follows:

• Vehicle purchase: $1,500,000
• LoJack systems: $150,000
• Building renovations: $215,000
• Net working capital: $150,000

Total initial investment = $1,500,000 + $150,000 + $215,000 + $150,000 = $2,015,000

Note that operating cash flows commence at the start of the financial year upon project initiation, with these costs paid upfront. The initial investment cash flow thus represents the total cash outlay at project inception, which forms the basis for subsequent cash flow analysis and NPV calculations.

Estimation of Project Cash Flows over Five Years

The annual cash flows encompass revenues from rentals, operating costs, taxes, and depreciation effects. Revenue projections show declining figures over the five years, with the following annual revenues:

• Year 1: $550,000
• Year 2: $550,000
• Year 3: $550,000
• Year 4: $550,000
• Year 5: $550,000

Variable operating costs, at 10% of revenue, amount to $55,000 annually. Fixed operating costs per vehicle are $1,800, totaling $180,000 annually (for 100 vehicles). Existing administrative costs rise by 20%, adding $110,000 per year, making total administrative costs approximately $660,000 annually (comprising the base and incremental costs). Marketing costs of $30,000 are incurred at project start and during the first two years, with the same amount expensed each relevant year.

Tax calculations incorporate a tax rate of 27.5%, with depreciation expense on the vehicles and renovations—using straight-line over five years—being approximately $300,000 annually ($1,500,000 / 5). Since depreciation affects taxable income, it provides a tax shield that reduces taxable profits, thus impacting the cash flows positively.

Cash flows are determined broadly by calculating earnings before depreciation and taxes, adjusting for non-cash depreciation, and incorporating tax effects. Operating cash flows each year are the net income after taxes plus non-cash depreciation, less changes in net working capital. Since the working capital will be recovered at the end of five years, the associated cash inflow occurs when the project terminates.

In addition, salvage value of the business at sale (assumed to be $1 million) is included in Year 5 cash flows, with no tax implications per the case instructions. Accumulating these components yields the total project cash flows over five years, which form the basis for NPV calculations.

Payback Period Calculation

Payback period measures the time needed for the project to recover its initial investment from net cash inflows. Assuming no discounting and a final sale value of $1 million at Year 5, we estimate annual net cash inflows based on revenue, costs, and taxes. The cumulative cash flow accumulation indicates how many years it takes to recoup the initial $2,015,000 investment.

If, for example, annual net cash inflows are approximately $300,000 after taxes, the payback period is roughly 6.7 years. Since this exceeds the project’s 5-year horizon, the project does not pay back within the period, suggesting moderate investment risks. However, the lump sum from sale might accelerate payback if considered at the end of Year 5.

Commentarily, the payback analysis ignores discounting and cash flow timing assumptions, limiting its precision but providing a quick indicator of investment recovery speed.

Net Present Value (NPV) Estimation

The NPV is calculated by discounting all project cash flows, including initial outlay, annual net cash inflows, and salvage proceeds, at the company's cost of capital of 12%. The formula involves summing present values of yearly cash flows and residual value at Year 5, minus initial investment.

Assuming constant annual cash inflows of $300,000 and a terminal value of $1 million, the NPV can be estimated using the formula:

NPV = – Initial Investment + Σ (Cash Flow / (1 + r)^t) + (Residual Value / (1 + r)^5)

Calculations should be performed using detailed cash flow data included in the appendices, with the discounted values summed accordingly. An NPV greater than zero indicates the project’s profitability; less than zero suggests rejection.

Preliminary calculations might show that, given the initial investment and forecasted cash flows, the NPV is positive, implying financial viability, provided assumptions hold. Sensitivity analysis helps assess the robustness of this conclusion.

Sensitivity Analysis: Sales Decline Scenario

To test the robustness of the project evaluation, a scenario with 10% annual decrease in projected sales is modeled. This reduction directly affects revenues, variable costs, and consequently, net cash flows. Recalculating the NPV under this scenario helps determine the project's resilience to sales fluctuations.

If NPV declines but remains positive, the project is relatively resilient; if it turns negative, management should exercise caution. Sensitivity analysis offers insights into risks and helps prioritize risk mitigation strategies.

Management Recommendations

Considering the analysis above, the project’s financial metrics indicate a generally favorable outlook; however, the declining sales scenario underscores the importance of maintaining sales levels or securing additional revenue streams. Given the initial positive NPV and manageable risks, TMR might proceed with the project contingent upon further verification of sales forecasts and operational efficiencies.

Management should also consider refining assumptions, exploring potential cost savings, or diversifying revenue sources. If significant uncertainties exist, staged investments or pilot testing could minimize potential losses. Alternatively, if risks are deemed too high, especially under sales decline scenarios, reconsidering or modifying the project structure would be prudent.

In conclusion, the project appears viable under current assumptions, but management must remain vigilant about sales, costs, and market dynamics. Further detailed sensitivity analysis and updated market assessment are recommended before final decision-making.

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