“Ocean Adventures Co.” is located near a beautiful beach in Southern California
ID: 2773244 • Letter: #
Question
“Ocean Adventures Co.” is located near a beautiful beach in Southern California and has been known for its surf board rentals for many years (this is a fictional company, by the way). The company’s manager has been contemplating for a long time to, at least temporarily, shut the surf board business down and switch to something more unusual, even if risky.
The company’s manager initially spent a month researching the potential of a new business idea. This cost him $5,000 about a year ago. In addition, he recently hired a group of local consultants, to whom he paid $20,000, to analyze the local market regarding the potential of a new project. Very soon the consultants came up with a recommendation to sell all surf boards and replace the surf board rental with a sailing catamaran rental business.
To start the new business, the company will need to purchase 60 brand new sailing catamarans at $10,000 per each. Unlike surf boards, catamarans are more durable and it takes 15 years for each to fully depreciate (under MACRS). “Ocean Adventures Co.” is currently planning to keep the new business for 7 years, and to shut the project down and sell all catamarans at the end of the 7th year. Currently, used catamarans can be sold in the market for an average of $1,500 per machine, and due to the growing popularity of this sport the price for used catamarans is expected to rise at an annual rate of 10 percent.
“Ocean Adventures Co.” currently owns 400 surf boards, half of which were purchased ten years ago for $1,000 a piece and the remaining half five years ago for the same price. Each could be sold today at the market price of $300 a piece. Each surf board’s normal economic life is ten years and each board depreciates at a constant rate each year to a zero book value at the end of its life.
The company expects that each year it will be able to rent each sailing catamaran to 500 customers at the price of $20 per person per hour. It assumes that each person will ride a catamaran for exactly an hour at a time. The company is hoping that the business will become very popular among the locals and so the number of customers would be increasing by 100 people each year. Miscellaneous fixed costs are expected to equal $20,000 each year. The cost of maintaining each catamaran will cost the company $8 per each catamaran rental. In order to cover unforeseen repair expenses, the company would need to immediately set aside $5,000 in cash, and it would need to increase this amount by $500 each following year. At the end of the final year of the sailing catamaran project the money would be recovered as the cash buffer would no longer be needed.
The corporate tax rate is 34%.
The riskiness of this project requires an 8% annual rate of return.
5.) (5 points) In addition, the company’s manager considers the worst case scenario under which the catamarans would not be able to attract enough customers. His guess is that the chance that this may happen is 20 percent. Under this worst case scenario, only 100 customers would be interested in renting each catamaran in year 1, and once the failure of the business is known to the locals the number of customers will drop to zero in all following years starting year two. If, however, the business is a success, the number of catamaran rentals will follow the initially assumed pattern (i.e., 500, 600, 700, …). Since allowing for this possible scenario changes the company’s expected number of customers for each year, how would it affect (in dollars) the current value of the project? (Assume the initial $8, not $10, unit cost of rental to the company.)
Explanation / Answer
Assume that project will succeed. Annual Depreciation Depreciation Fixed Maintenance Net Income Tax After Tax Year Income MACRS Amount Cost Cost @34% Income 1 600000 5% 30000 20000 480 549520 186836.8 362683 2 720000 9.50% 57000 20000 480 642520 218456.8 424063 3 840000 8.55% 51300 20000 480 768220 261194.8 507025 4 960000 7.70% 46200 20000 480 893320 303728.8 589591 5 1080000 6.93% 41580 20000 480 1017940 346099.6 671840 6 1200000 6.23% 37380 20000 480 1142140 388327.6 753812 7 1320000 5.90% 35400 20000 480 1264120 429800.8 834319 After tax Adback Provision Solvage Net pv factor Present Year Income Depreciation For Repair Value cashflow at 8% Value 0 -600000 0 -5000 -605000 1.00000 -605000 1 362683 30000 -5500 387183 1.08000 418157.9 2 424063 57000 -6000 475063 1.16640 554113.7 3 507025 51300 -6500 551825 1.25971 695140.8 4 589591 46200 -7000 628791 1.36049 855463.5 5 671840 41580 -7500 705920 1.46933 1037229 6 753812 37380 -8000 783192 1.58687 1242828 7 834319 35400 -8500 175385 1036604 1.71382 1776557 Total 5974489 Assume that project will fail Annual Depreciation Depreciation Fixed Maintenance Net Income Tax After Tax Year Income MACRS Amount Cost Cost @34% Income 1 120000 5% 30000 20000 480 69520 23636.8 45883 After tax Adback Provision Solvage Net pv factor Present Year Income Depreciation For Repair Value cashflow at 8% Value 0 -600000 0 -5000 -605000 1.00000 -605000 1 45883 30000 -5500 90000 160383 1.08000 173213.9 Total -431786 Situation Success Faillure Total Present Value of Income 5974489 -431786 5542703 Probability 80% 20% 100% Expected Return 4779591 -86357.2 4693234 Expected Present value of the project is $4,693,234
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