Paper type: Analysis Pages: 4 (921 words)
This paper is an analysis of Road King Trucks’ new project which is introducing a new product into its product line. I will decide whether run the project or not. Six issues will be discussed as follows 1) importance of energy cost; 2) project’s cash flows; 3) cost of capital; 4) choose an engine 5) evaluation 6) accept or reject.
We should accept the project because of the positive NPV and high IRR. We will gain $532 million in wealth which is a big money on the scale like this.
The company has a bond rating of AA that makes the risk relatively low. So we should definitely say yes.
Importance of Energy Cost
Road King Trucks, Inc. is a truck manufacturing company. The new CEO Michael Livingston arranged a meeting with the firm’s top managers and engineers considering introducing a large, public transit bus into its current product line. As the oil prices keep going high and have no sign of decreasing. Mr. Livingston thought it would lead people more likely to use public transportation. The price of gas has gone up for the 30th day in a row, and with it tempers are rising. Increased demand for public transportation is expected to continue into the spring . The impact of high oil prices makes people more willingly to use public transportation and there will be an increase of riders. The company should adapt itself to the changes of market. Now it is a fashion to be “Green”. People show great environmental consciousness to the world. It is wise to attract people with public transportation and fulfill their demands.
Project’s Cash Flows (see table 1)
We expect inflows are greater than outflows, so to cover the cost occurred in the progress. But to determine whether we should run the project or not, we need to calculate the NPV. I will discuss it later. The total life of the project is 22 years. The production and selling of buses start in year 3. I add inflation on sales and costs in year 4, the year after production and sales begin (Idea comes from Mr. Hasse). Straight line depreciation was used in calculation and depreciation won’t be affected by inflation. The land was accounted for opportunity cost. If we don’t run the project, we can sell it and earn $6 million right now.
Cost of Capital (see table 2)
I used WACC as the discount factor, we expect the rate of return to be higher than it, the same at least. The WACC reflects the average risk and overall capital structure of the entire firm . It’s the required return and it presents how much the company pays for the capital it finances. In this case, the cost of equity is 10.33%, the cost of debt is 6.50%. I calculated WACC using those numbers and got a result of 8.49%.
Choose an Engine (see table 3)
There are two options for engines will be installed on buses. And so are the warranties. The decision should be made according to engines’ quality, effectiveness, etc. But to investors, cost is the main factor. In this case, Detroit engine has an installation cost of $20,000 and a warranty of $1,000 each year for 5 years; the cost of installation of Marcus engine is $2,000 less but the warranty is $1,500 per year. To figure out the cost I calculated the NPVs of each year for 20 years. The NPVs of the warranties for each bus are same at the year it been produced. For example, the warranty of a Detroit engine has a NPV of $4,276 in the year it been produced. (This method is coming from Mr. Hasse. I used to combine the warranty for each year and use those numbers in calculation.) The NPV of installation cost and warranty of Detroit engine is $252,154, which is smaller than the number of Marcus engine, $253,589. So Detroit engine should be used in the bus.
The capital budgeting techniques are used in evaluating the project. The most important two factors are NPV and IRR. NPV determines whether a company can get profit running project through time. The project’s cash flows are discounted by WACC. The difference between the investment in year 0 and the total PV sum of future cash flows is NPV. If it is positive, we should accept the project. In this project it is $532 million. IRR is the rate that makes the NPV zero at the end of project life time. Which means if it’s higher than WACC, the project will be viable. I got an IRR of 12.41% greater than WACC, 8.49%. It fits the situation. Also we can find PI and payback. But they can’t present the whole situation as well as NPV and IRR do. The company has a bond rating of AA. That will be a good thing if we run the project. Investors will bare a relatively low risk. And a overall beta of 1.15 also says the same.
Accept or Reject
If we run the project it will increase the company’s value by $ 532 million. We should accept the project because of the positive NPV and high IRR. Except the numbers, we should consider more than that. The government policies, environmental factors and future economy ought to be added in decision making.
 Gas prices pass $5 in some Southland areas. http://abclocal.go.com/  Ehrhardt and Brigham, 2011. Financial Management: Theory and Practice, 13th Edition. South-Western Cengage Learning, OH Table 2
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Road King Trucks Case Analysis. (2016, Dec 19). Retrieved from https://studymoose.com/road-king-trucks-case-analysis-essay