Worden Oil Company Gus Worden is the chief operating officer of the Worden Oil C
ID: 2714955 • Letter: W
Question
Worden Oil Company
Gus Worden is the chief operating officer of the Worden Oil Company in Litchfield, Connecticut. The company delivers petroleum products to gasoline stations. Gus has an opportunity to negotiate a new six-year contract hauling for a chain of independent gasoline stations. Since Gus fully employs his tractor-trailer units, the contract would require the purchase of a new “rig” at a cost of $500,000.
The New Rig. To be profitable a rig should log at least 100,000 miles per year. To prolong the rig’s life, Gus would overhaul major systems after four years. This could cost as much as $60,000, but would ensure that the rig would last well beyond six years. The cost of the overhaul is a normal operating expense for tax purposes. After six years Gus would sell the rig for an expected salvage value of $50,000(conservative estimate).
The Accelerated Cost Recovery System classifies the rig as a “five year asset” for depreciation purposes.
Projected Revenues. Gus is uncertain about the revenue that this contract will generate. Since revenue varies directly with the number of gallons delivered, Gus will earn more revenue if the independent gasoline stations experience high sales volume. Hence, if petroleum prices are low, Gus’s volume and revenue should be high. Of course, the price of petroleum is determined by world markets.
Gus’s best estimate is that the rig will deliver 100,000 gallons per day (on average). However, sales could be as low as 88,000 gallon per day or as high as 112,000 gallons. Gus believes that the probability of selling 88,000 gallons or less is no greater than 20%. Similarly, the probability of selling 112,000 gallons or more is no greater than 20%.
Total delivery revenues will depend on how many days per week Gus keeps the rig in service. If the rig runs five days per week, Gus expects to earn delivery revenues of $.025 per gallon. If the rig runs six days per week, Gus expects to earn average delivery revenues of only $.023 per gallon. Price concessions are essential to contract marginal business. Since the rig requires regular preventative maintenance, a seven-day week is not feasible.
Operating Expenses. Most operating expenses are closely related to delivery revenues. Wages and benefits run approximately 35% of revenues. Diesel fuel is 25% of revenues. Regular maintenance expenses average $25,000 per year plus between 7% and 9% of revenues. Insurance, registration and road taxes are fixed at $20,000 per year. Incremental administrative costs are $5000 per year. Finally, Gus will garage the new rig in a bay which the company owns and currently rents out for $20,000 per year.
The firm’s marginal tax rate is 34 percent.
The Cost of Capital. Gus plans to use a 9 percent discount rate to evaluate this investment opportunity. This is the interest rate which he pays on new bank debt. Although Gus has financed other recent investments with retained earnings, he plans to rely entirely on bank debt to finance the new rig.
Worden Oil is 70 percent equity financed and 30 percent debt financed. The stock is owned strictly by family members, who claim that they require a 25 percent return on their investment. However, Gus estimates that historically the company has rarely earned more than a 16 percent return on equity (ROE), and stockholders seem quite satisfied.
Gus’s Decision. Gus has requested your help. Build a spread sheet model projecting the net cash flow that this project will generated over time. Conduct a scenario analysis examining the attractiveness of the project under pessimistic, most likely and optimistic scenarios. Estimate several profitability metrics for each scenario.
Help Gus answer five pressing questions:
1. What discount rate should Gus use to evaluate this project?
2. Should Gus accept the six-year contract?
3. If so, should he operate the rig five days per week or six days?
4. How risky is this project?
5. If Gus chooses to invest, what managerial actions could increase the likelihood that this project will be profitable?
*Use excel to show your findings. Please send your spreadsheet attachment separately so I can check it out.
Explanation / Answer
Answer-1 The discount rate that Gus choose should reflect the expectations of the shareholders too. So selecting 9% descount rate is not correct. As the ROE = 16% and interest on bank debt = 9% Also weight of debt in capital structure = 30% and weight of equity in capital structure = 70% Therefore weighted average cost of capital = 30% x 9% + 70% x 16% = 13.90% So the discount rate should be = 13.90% Answer-2 For taking decision of acceptance or rejection we need to find out the NPV of the project: Cost of the rig = $500,000 Cost of overhaul after 4 years or at 5th year = $60,000 Salvage value of rig = $50,000 Tax rate = 34% Depreciation applied on rig is by MACRS of 5 years. So the depreciation schedule is: 5-Year Depreciation 20% $100,000 32% $160,000 19.20% $96,000 11.52% $57,600 11.52% $57,600 5.76% $28,800 No to calculate the revenues we need to do this: rig will deliver = 100000 gallons per day If rig works 5 day a week then unit revenue = $0.025 per gallon If rig works 6 day a week then unit revenue = $0.023 per gallon Now operating expenses are: Wages and benefits = 25% of revenues Regular maintenance = $25,000 plus (7%+9%)/2 = 8% of revenues Insurance, registration etc = $20,000 per year Admin cost = $5,000 per year Rent = $20,000 per year So the schedule of cash flows: Case-1 if the rig works for 5 days a week, then: Year-0 Year-1 Year-2 Year-3 Year-4 Year-5 Year-6 Revenues $650,000.000 $650,000.000 $650,000.000 $650,000.000 $650,000.000 $650,000.000 Operating expenses: Wages and benefits $162,500.000 $162,500.000 $162,500.000 $162,500.000 $162,500.000 $162,500.000 Regular maintenance $77,000 $77,000 $77,000 $77,000 $77,000 $77,000 Insurance $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 Admin cost $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 Rent $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 Cost of overhaul of rig $60,000 Depreciation $100,000 $160,000 $96,000 $57,600 $57,600 $28,800 Earning Before tax $265,500.000 $205,500.000 $269,500.000 $307,900.000 $247,900.000 $336,700.000 Tax (34%) $90,270.00 $69,870.00 $91,630.00 $104,686.00 $84,286.00 $114,478.00 Earning After tax $175,230.000 $135,630.000 $177,870.000 $203,214.000 $163,614.000 $222,222.000 Salvage value $50,000 Cashflows (EAT + Depreciation + salvage value) $275,230.000 $295,630.000 $273,870.000 $260,814.000 $221,214.000 $301,022.000 Initial Investment $500,000 Cash Flows ($500,000) $275,230.000 $295,630.000 $273,870.000 $260,814.000 $221,214.000 $301,022.000 So now we can calculate the NPV of these cash flows at discount rate of 13.9% therefore NPV at 13.9% = $563,089.15 As the NPV is positive so Gus should accept this project. Answer-3 Case-1 if the rig works for 5 days a week, then: Year-0 Year-1 Year-2 Year-3 Year-4 Year-5 Year-6 Revenues $717,600.000 $717,600.000 $717,600.000 $717,600.000 $717,600.000 $717,600.000 Operating expenses: Wages and benefits $179,400.000 $179,400.000 $179,400.000 $179,400.000 $179,400.000 $179,400.000 Regular maintenance $82,408 $82,408 $82,408 $82,408 $82,408 $82,408 Insurance $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 Admin cost $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 Rent $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 Cost of overhaul of rig $60,000 Depreciation $0 $0 $0 $0 $0 $0 Earning Before tax $410,792.000 $410,792.000 $410,792.000 $410,792.000 $350,792.000 $410,792.000 Tax (34%) $139,669.28 $139,669.28 $139,669.28 $139,669.28 $119,269.28 $139,669.28 Earning After tax $271,122.720 $271,122.720 $271,122.720 $271,122.720 $231,522.720 $271,122.720 Salvage value $50,000 Cashflows (EAT + Depreciation + salvage value) $271,122.720 $271,122.720 $271,122.720 $271,122.720 $231,522.720 $321,122.720 Initial Investment $500,000 Cash Flows ($500,000) $271,122.720 $271,122.720 $271,122.720 $271,122.720 $231,522.720 $321,122.720 So now we can calculate the NPV of these cash flows at discount rate of 13.9% therefore NPV at 13.9% = $559,441.79 So as it can be seen the NPV when the rig runs for 6 days a week is less than the NPV when the rig runs for 5 days a week. So Gus should operate the rig for 5 days only. Answer-4 Probability % change in Revenues deviation Deviation square prob x dev sq 20% -12% 0.12 0.0144 0.00288 60% 0 0 0 0 20% 12% -0.12 0.0144 0.00288 Expected change in revenues = 0.0% Variance = 0.00576 Standard devation = 0.075894664 or 7.589% So the risk of this project is 7.589% Answer-5 The decision that Gus can take is to try to control the operating expenses.
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