Road King Trucks

Introduction

Michael Livingston has just been appointed as the CEO of Road King Trucks, Inc.  Before he had been the marketing manager for a large manufacturing company and had established a reputation for identifying the new consumer trends.  Road King Trucks Inc. is a California-based truck manufacturing company.  The company is famous for manufacturing large, heavy-duty trucks at a reasonable cost.  One of its greatest achievements is that its trucks can be simply modified or customized for different applications.  Road King Trucks also builds school buses.

The company is considering a growth of its current product line to comprise 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 growing population in California.  The brothers quickly realized that the times were varying, so they started looking for the technologies which would keep them at the front position of their field of business.  In 1915, the Smith brothers decided that they required making trucks as replacements for the wagons, since 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 early 1940’s.  Most manufacturers had been commissioned by government to manufacture different large vehicles to support World War II operations.  Road King Trucks opted to produce buses.  It was a simple decision to create, as the buses would use common parts with company’s trucks, and customers were local governments.  Starting in 1950’s, the school bus business accounted for about 50% of Road King Trucks’ revenues.

The Transit Bus Opportunity

Mr. Livingston conducted a meeting with the firm’s top management, and the chief design and manufacturing engineers to propose his latest product.  He presented an argument which more individuals in United States and Canada would be willing to employ public transportation than before, since people were becoming more environmentally conscious.  Also, recent raises 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 differentiate Road King Trucks from other manufacturers, the proposal included details about the level of comfort, air-conditioning, efficiency, and quietness of operation which 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 company’s trucks.  The frame currently employed 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 rapidly, and at a reasonable cost.  At this point, Mr. Livingston charged the participants in the meeting to produce a financial plan for development and production of a transit bus.

Public Transportation

The use of public transportation had declined steadily since 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 United State and Canada, the target markets for the new bus, had become more and more congested; and parking, that was already very costly, was becoming scarce.

This combination of trends has renewed public’s interest in good and steadfast public transportation.  Several municipalities have been campaigning to their residents and commuters that they must employ public transportation for business commuting, and only use their cars for shopping and weekend activities.  However, these 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 sub-presidents presented the sales and cost forecasts shown in attached exhibits.  The information presented holds 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, however had a higher warranty cost?  This begged the problem:  Which engine must be used?

Issues and Analyses

Mr. Livingston noticed that there was a great deal of eagerness among management group regarding the transit bus opportunity, but his careful nature told him to also seek a more objective viewpoint.  Subsequently, he sought out you to analyze the proposed project and give your recommendations directly to him.  The issues he wants you to address in your analysis and report are the following:

1) How much importance must be given to the energy cost situation?
2) What are the project’s cash flows for the next twenty years?  What suppositions 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 must be used in the bus, and why?
5) Appraise the quality of the project, by using appropriate capital budgeting techniques.
6) Would you suggest that Road King Trucks accept or reject the project?  What are the key factors on which you base your recommendation?

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.

Price per bus                                                $215,000       
Units sold per year                                         12,500       
Labor cost per bus                                       $42,000       
Components & Parts                                    $91,000       
Selling General & Administrative                $225,000,000

NOTE:  Average warranty cost per year per bus for primary five years is $1,000.  The present value of this cost will be employed 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.

Engine choices
Engine    Detroit engines    Marcus engines
Price per engine, including installation                   $21,500         $19,500
Average annual warranty cost per year for five years.   Afterwards, the bus operator will become responsible for the repairs on the buses.*                                                                        $1,350                $1,550

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.  But, Road King Trucks will give a warranty to its customers.  After the initial five years, the bus operators might 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              Year 3
$600 million*          $500 million*      $250 million     *$120 million*

Production and selling of buses starts

* Road King Trucks estimated that it would cost a total of $1, 470 million to construct the factory and purchase the necessary equipment to produce the buses.

Straight line depreciation will be used for the sake of simplicity.
Suppose that the factory and equipment will be sold at the end of the project.  The company anticipates spending about $500,000 demolishing the factory and cleaning the site.  The company expects to sell the equipment 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 to equity ratio equal to 0.6.  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 35%.  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    5.0% ~ 6.0%    5.75% ~ 7.0%    7.0% ~ 8.5%

The company’s current bond has a yield to maturity of about 6%.

Cost of equity:

The current 10-year Treasury notes have a yield to maturity of 2% and the forecast for the S&P 500 market premium is 7.5%.  The company’s overall β is 1.15.

Project Guidance

Below is a list of items you need to quantify and identify to complete the Road King Trucks case

A. For Each Year

1. Revenue
2. Variable costs
a. Labour cost per bus
b. Parts cost per bus
c. Engine costs per bus (2 options)
3. SG&A costs
4. Warranty costs
a. Bus
b. Engine (2 options)
5. Depreciation

B. Project Related

1. Investment costs
2. Building
3. Equipment
4. Clean up costs
5. Salvage costs

C. Cost of Capital

1. Company’s weighted average cost of capital (WACC)
2. Appropriate cost of capital for this project
And, after doing this, you have to form a basis for a go/no go decision on the project, with appropriate support for your decision (think NPV and IRR).