Question 1
Garmen Technologies Ltd operates a small chain of speciality retail shops throughout Victoria and Tasmania. The company markets technology-based consumer products both in its stores and over the Internet, with sales split roughly equally between the two channels of distribution. The company's products range from radar-detection devices and GPS mapping systems used in cars to home-based weather monitoring stations. The company recently began investigating the possible acquisition of a regional warehousing facility that could be used both to stock its retail shops and to make direct shipments to the firm's online customers. The warehouse facility would require an expenditure of $250,000 for a rented space in Port Melbourne, and would provide a source of cash flow spanning the next 10 years. The estimated cash flows are as follows:
|
Year
|
Cash Flow
|
Year
|
Cash Flow
|
|
0
|
$(250,000)
|
6
|
$65,000
|
|
1
|
60,000
|
7
|
65,000
|
|
2
|
60,000
|
8
|
65,000
|
|
3
|
60,000
|
9
|
65,000
|
|
4
|
60,000
|
10
|
90,000
|
|
5
|
(45,000)
|
|
|
Then negative cash flow in year 5 reflects the cost of a planned renovation and expansion of the facility. Finally, in year 10, Garmen estimates some recovery of its investment at the close of the lease, and consequently a higher-than-usual cash flow. Garmen uses a 12% discount rate in evaluating its investments.
(a) As a preliminary step in analysing the new investment, Garmen's management has decided to evaluate the project's anticipated payback period. What is the project's expected payback period? Jim Garmen, CEO, questioned the analyst performing the analysis about the meaning of the payback period because it seems to ignore the fact that the project will provide cash flows over many years beyond the end of the payback period. Specifically, he wanted to know what useful information the payback provides. If you were the analyst, how would you respond to Mr Garmen?
(b) In the past, Garmen's management has relied almost exclusively on the IRR to make its investment choices. However in this instance, the lead financial analyst on the project suggested there may be a problem with the IRR because the sign on the cash flows changes three times over its life. Calculate the IRR for the project. Evaluate the NPV profile of the project for discount rates of 0%, 20%, 50% and 100%. Does there appear to be a problem of multiple IRRs in this range of discount rates? To demonstrate your explanation, draw a graph of the discount rate versus the NPV using the 4 given discount rates.
(c) Calculate the project's NPV. What does the NPV indicate about the potential value created by the project? Describe to Mr Garmen what NPV means, recognising that he was trained as an engineer and has no formal business education
Question 2
The Queensland Land and Cattle Company (QL&CC) is one of the largest cattle-buyers in the country. It has buyers at all the major cattle auctions throughout eastern Australia who buy on the company's behalf and then have cattle shipped to Longreach, Queensland, where they are shorted by weight and type before being shipped off to feed lots in Queensland. The company has been considering the replacement of its trucks with a newer, more fuel-efficient fleet for some time, and a local Peterbilt dealer has approached the company with a proposal. The proposal would call for the purchase of 10 new trucks at a cost of $100,000 each. Each new vehicle would be depreciated toward a salvage value of $40,000 over a period of five years. If QL&CC purchases the trucks, it will sell its existing fleet of 10 trucks to the Peterbilt dealer for their current book value of $25,000 per unit. The existing fleet will be fully depreciated in one more year but is expected to be serviceable for five more years, at which time the vehicles would be worth only $5,000 per unit as scrap.
The new fleet is much more fuel-efficient and will require only $200,000 in fuel costs compared to $300,000 for the existing fleet. In addition, the new fleet will require minimal maintenance over the next five years, equal to an estimated $150,000 compared to the almost $400,000 that is currently being spent to keep the older fleet running.
(a) What are the differential operating cash flow savings per year during years 1 to 5 for the new fleet? The firm pays tax at a 30% marginal tax rate.
(b) What is the initial cash outlay required to replace the existing fleet with new trucks?
(c) Draw a timeline for the replacement project cash flows for years 0 to 5.
If QL&CC requires a 15% discount rate for new investments, should the fleet be replaced?