Case: 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 com¬pany'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 $1,200 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: Rev-enue 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.
Case: MEDICAL SUPPLIES FOR BANJUL*
You are the team leader of a unit of a U.S. nonprofit orga-nization based in Banjul, Gambia (capital city). The nonpro¬fit's mission is to ensure that rural populations worldwide have access to health and sanitation-related supplies. Due to the sudden departure of one of your team leaders, you are taking over responsibility for ordering certain medical sup¬plies for three villages. Each village consists of four groups:
• Senior citizens (those over 65)
• Children (population 12 and under)
• Teens (those aged 13-19)
• The population aged 20-65
The medical supplies required by each village include bandages (types A, B, and C), medical tape, and hearing aids. Children need type A bandages; teens need type B bandages; and adults (i.e., everyone else), need type C bandages. All members of the population use the same kind of medical tape. Only senior citizens require hearing aids. The former team member explained to you that a good rule of thumb is to ensure that at all times a village should keep in stock two bandages per person and hearing aids for 5 percent of the senior citizen population. Cost and packaging information for the products is as follows:
• Type A bandages come in packages of 30. Each package costs $3.00.
• Type B bandages come in packages of 30. Each package costs $5.00.
• Type C bandages come in packages of 30. Each package costs $6.00.
• Medical tape comes in rolls of 2 feet each. You usually use one roll per package of bandages. One roll costs $2.50.
• Hearing aids are sold in single units (1 per package) and are $5.00 each.
Your unit's budget does not enable you to purchase more supplies than you need in a given quarter. At the end of every quarter, one of your team members provides you with the population count by age group for the village and the stocks remaining in each village.
The former team member completed this cumbersome task by hand every quarter. However, owing to your other responsibilities, you will have no more than a few minutes to spend on this task on a quarterly basis-doing it by hand is out of question. In addition, you may be transferred to another post in three to six months, so you may have to pass on the responsibility to a successor before too long.
It is 6:00 a.m. Monday morning. You have three hours left at the city headquarters until you leave to begin two weeks of fieldwork in the villages without computer access. The initial order must be placed by next Friday, so you will have to take care of procuring a check from the finance officer and placing the order before you leave. Other team members are beginning to arrive, but the office is still quiet. Everything else on your plate can wait until you return. Yet, something else could pop up at any moment, so you have to work quickly. You don't have the latest population or stock figures yet, but the team member who has them will arrive at 8:30 a.m.
*Contributed by Manisha Shahane.
Case: REID'S RAISIN COMPANY
Located in wine country, Reid's Raisin Company (RRC) is a food-processing firm that purchases surplus grapes from grape growers, dries them into raisins, applies a layer of sugar, and sells the sugar-coated raisins to major cereal and candy companies. At the beginning of the grape-growing season, RRC has two decisions to make. The first involves how many grapes to buy under contract, and the second involves how much to charge for the sugar-coated raisins it sells.
In the spring, RRC typically contracts with a grower who will supply a given amount of grapes in the autumn at a fixed cost of $0.25 per pound. The balance between RRC's grape requirements and those supplied by the grower must be purchased in the autumn, on the open market, at a price that could vary from a historical low of $0.20 per pound to a high of $0.35 per pound. (RRC cannot, however, sell grapes on the open market in the autumn if it has a surplus in inventory, because it has no distribution system for such purposes.)
The other major decision facing RRC is the price to charge for sugar-coated raisins. RRC has several customers who buy RRC's output in price-dependent quantities. RRC negotiates with these processors as a group to arrive at a price for the sugar-coated raisins and the quantity to be bought at that price. The negotiations take place in the spring, long before the open market price of grapes is known.
Based on prior years' experience, Mary Jo Reid, RRC's general manager, believes that if RRC prices the sugar-coated raisins at $2.20 per pound, the processors' orders will total 750,000 pounds of sugar-coated raisins. Furthermore, this total will increase by 15,000 pounds for each penny reduction in sugar-coated raisin price below $2.20. The same relationship holds in the other direction: demand will drop by 15,000 for each penny increase. The price of $2.20 is a tentative starting point in the negotiations.
Sugar-coated raisins are made by washing and drying grapes into raisins, followed by spraying the raisins with a sugar coating that RRC buys for $0.55 per pound. It takes 2.5 pounds of grapes plus 0.05 pound of coating to make one pound of sugar-coated raisins, the balance being water that evaporates during grape drying. In addition to the raw materials cost for the grapes and the coating, RRC's proces¬sing plant incurs a variable cost of $0.20 to process one pound of grapes into raisins, up to its capacity of 1,500,000 pounds of grapes. For volumes above 1,500,000 pounds of grapes, RRC outsources grape processing to another food processor, which charges RRC $0.45 per pound. This price includes just the processing cost, as RRC supplies both the grapes and the coating required. RRC also incurs fixed (overhead) costs in its grape-processing plant of $200,000 per year.
Mary Jo has asked you to analyze the situation in order to guide her in the upcoming negotiations. Her goal is to examine the effect of various "What-if?" scenarios on RRC's profits. As a basis for the analysis, she suggests using a contract purchase price of $0.25, with a supply quantity of 1 million pounds from the grower, along with a selling price of $2.20 for sugar-coated raisins. She is primarily interested in evaluating annual pretax profit as a function of the selling price and the open-market grape price. She believes that the open-market grape price is most likely to be $0.30.
Requriments:
1. Refer to the Medical Supplies for Banjul case. Design a spreadsheet that will enable you to request the required funds from your team's finance officer, order supplies from the home office, and ensure dissemination of appropriate quantities to each village. Your final order to the home office should specify the number of packages required of each item.
2. Refer to the Reid's Raisins case. Design a spreadsheet that will allow the firm to project profit for base-case condi-tions; the open market grape price is $0.30.
b. What is the breakeven value of the open-market grape price?
c. Construct a table showing how profit varies as a function of the price set for raisins. Cover a range from $1.80 to $2.80 in steps of $0.10.
d. Construct a tornado chart for the analysis in (a). List the relevant parameters in descending order of their impact on annual profit.
3. Refer to the Big Rig Rental Company case. Design a spreadsheet that will provide the owner with the five-year economic analysis requested.
a. What is the Net Present Value of the firm's cash flows over the five-year period?
b. Construct a tornado chart for the analysis in (a). List the relevant parameters in descending order of their impact on the Net Present Value.
c. What is the internal rate of return for the cash flows in (a)?
d. Construct a table to show how profit varies with the base rental rate, currently $1,000 per month.