Reference no: EM131455866
THE BIG RIG TRUCK RENTAL COMPANY The Big Rig Rental Company, which owns and rents out 50 trucks, is for sale for $400,000. Tom Grossman, the company’s owner, wants you to develop a five-year economic analysis to assist buyers in evaluating the company. The market rate for truck rentals is currently $12,000 per year per truck. At this base rate, an average of 62 percent of the trucks will be rented each year. Tom believes that if the rent were lowered by $1200 per truck per year utilization would increase by seven percentage points. He also believes that this relationship would apply to additional reductions in the base rate. For example, at a $7,200 rental rate, 90 percent of the trucks would be rented. This relationship would apply to increases in the base rate as well. Over the next five years, the base rental rate should remain stable. At the end of five years, it is assumed that the buyer will resell the business for cash. Tom estimates that the selling price will be three times the gross revenue in the final year. The cost of maintaining the fleet runs about $4,800 per truck per year (independent of utilization), which includes inspection fees, licenses, and normal maintenance. Big Rig has fixed office costs of $60,000 per year and pays property taxes of $35,000 per year. Property taxes are expected to grow at a rate of 3 percent per year and maintenance costs are expected to grow 9 percent per year due to the age of the fleet. However, office costs are predicted to remain level. Profits are subject to a 30 percent income tax. The tax is zero if profit is negative. Cash flow in the final year would include cash from the sale of the business. Because the trucks have all been fully depreciated, there are no complicating tax effects: Revenue from the sale of the business will effectively be taxed at the 30 percent rate. Investment profit for the buyer is defined to be the Net Present Value of the annual cash flows, computed at a discount rate of 10 percent. (All operating revenues and expenses are in cash.) The calculation of NPV includes the purchase price, incurred at the beginning of year 1, and net income from, operations (including the sale price in year 5) over five years (incurred at the end of the year). There would be no purchases or sales of trucks during the five years.
1. Create a base-case model for the Big Rig Truck Case above.
a. Advise Tom Grossman on the price he has set. Assuming that his estimate is correct that a $1200/year change in price will result in a 7% change in utilization, what is the optimal annual price for trucks. (NB: You will need to use either the Analytic Solver Pro or Excel’s built-in Solver (Mac users) to solve this. If the Solver add-in does not show up, install the Solver Add-In. Analytic Solver Platform: Optimize.)
b. Assume that Tyler Advertising proposes spending $30,000/year on ads. They believe that this advertising campaign will increase base utilization by 3%. What change in NPV would result from contracting with Tyler? Should the campaign be adopted?
c. What is the break even cost for Tyler Advertising’s plan? In other words, what is the maximum amount that Grossman should be willing to pay Tyler for the ad campaign?
2. Assume that Grossman has increased the base utilization to 70%. Also assume that you are going to value his business. One way (basically the correct way) to value a business is that a business is worth the NPV of the after-tax cashflows over 5 years, discounted at your discount rate (10% is given in the problem). Do NOT include the selling price of the business in the cash flow stream.
a. How much is the business worth using a 5 year NPV?
b. What assumption does this 5 year NPV make? (Answer online.)
c. It is common to add on a “terminal value” to this type of business valuation. The terminal value assumes that the year 5 cashflows continue on forever. How much is the terminal value of this business?
d. What assumptions does this terminal value make?
e. If you compare the value of the business as a 5 year NPV (an explicit model of each of the 5 years) and compare this to the value obtained using a 5 year NPV model + the terminal value, what fraction of the total value with the terminal value is associated with the (unmodeled) terminal value?
3. Assume that there are a number of uncertainties. The 7% change in demand for every $1,200/year change in rent is uncertain. Grossman believes that the true number is between 5 and 8 percent, with an approximately equal chance of every number between 5% and 8%. In addition, the utilization rate in each year is also uncertain. He believes that utilization will be distributed Normal, with a mean of 70% and a standard deviation of 2%. The maintenance increase is also uncertain. He thinks that the increase will be distributed Normal, with a mean of 7% and a standard deviation of 2%.
a. Run a simulation model using the distributions above. Characterize the distribution of possible business values without a terminal value.
b. Change the two normal distributions to triangular distributions with upper and lower bounds = +/- 3 sd from the mean. Is the effect on your simulation of Big Rig’s value significant (actually significant, not statistically significant). Does the true mean value of the business change? Characterize any changes in the distribution of outcomes.
Answer questions on excel spreadsheet and attach.