Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 64

New Venture Analysis After completing your MBA degree recently, you and your friends decided to evaluate alternative business opportunities. As a result of marketing research the four of you did for a course, you are convinced that an investment in a new home-to-airport transit service in your locale would be a profitable venture. (The region in which the four of you live is surrounded by three airports, the closest of which is 55 miles away.) One strategy would be to provide multiple pick-up and drop-off points, some in suburban locations, and others located downtown and at two area shopping malls. Your research team has gathered the following pertinent information:

• Given the anticipated volume, you anticipate the need for five part-time drivers, at a total payroll cost per year of approximately $100,000 ($20,000 per person).

• You anticipate purchasing six used vans, at a cost of $54,000 each, to support your operation. For tax purposes, these vans will be depreciated using the SL method (3-year life) with no antici­pated salvage value assumed for the depreciation calculation.

• The opportunity cost of capital for an investment of this magnitude and risk is estimated at 12 percent, after tax.

• Additional cash operating expenses per year are estimated as follows: maintenance and repair costs, $6,000 (total); insurance, $2,000 (per van); gasoline, $20,000; and advertising, $5,000.

• Estimates regarding fare receipts are as follows: assume an operating year of 30 weeks; the cost per one-way ticket is $25, while the cost per round-trip ticket is $40; the total number of trips to the airport and back per van per week is estimated as 10; each trip, on average, carries four individuals. Three quarters of all passengers pay the round-trip fare, while the rest of them pay the one-way fare.

Required

1. What is the average annual pretax profit anticipated for this new venture? What is the average annual profit after tax, under the assumed 40 percent income tax?

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2. What is the annual amount of both pretax and after-tax cash flows generated from this proposed investment?

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3. What is the anticipated NPV of this project? If the current anticipated ticket prices per trip are insufficient to make the project desirable in a present-value sense, what selling price is needed (keeping the same $10 differential for two one-way trips versus one round-trip ticket)?

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4. What is the accounting rate of return (ARR) on this investment, using average after-tax earnings as the numerator and average book value of the investment as the denominator of the ARR calculation? What is the anticipated IRR for this investment? What accounts for the difference between these two rates of return?

Step 1 of 4

New Venture Analysis(45-60 minutes)

1. ?The average annual pre-tax profit and after-tax profit (under the assumed 40% income-tax rate) is as follows:

# of passengers/year:

# of operating weeks/year =	30
# of round-trips per van/week =	10
# of round-trips per van/year =	300
# of vans =	6
# of round-trips/year =	1,800
# of trips per round-trip =	2
# of trips per year =	3,600
# of passengers per trip =	4
# of passengers per year =	14,400

        Breakdown, by passenger type:??????

% of one-way passengers =	25.00%
Total passengers/year =	14,400	3,600
% of two-way passengers =	75.00%
Total passengers/year =	14,400	10,800

?    Revenues:???????

        From one-way passengers:???????

             # of one-way passengers/year =??  3,600??

             one-way fare/passenger/trip =??$25.00 ? $90,000?

       From round-trip passengers:???????

             # of RT passengers/year = ??10,800??

             one-way fare/passenger/trip =??$20.00 ?$216,000?$306,000

    Expenses:???????

       Depreciation:???????

           Annual Depreciation/Van =???$18,000 ??

           # of vans =??????6?$108,000 ?

       Payroll:???????

           # of drivers =??????5??

           Annual payroll cost/driver =??$20,000 ?$100,000 ?

       Maintenance =???????    $6,000 ?

       Insurance:???????

           # of vans =??????6??

           Insurance cost/year/van =???   $2,000 ?  $12,000 ?

       Gasoline ?????? ?  $20,000 ?

        Advertising =?????    ??    $5,000 ?$251,000

    Pre-tax Income ?????????  $55,000

    Less: Income Taxes (@ 40%)???????  $22,000

    After-tax Income =???????             $33,000