“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.
1) What will be the net capital spending in the current year associated with switching to the new business? Briefly explain in words and show all calculations and formulas.
2) In the form of a table with “year0”, “year1”, “year2”, etc. in the top row show your calculations of the total cash flow for each year and all of its important components (like we did in class). Briefly explain in words and show all calculations and formulas.
3) Based on your calculations in 2.), what is the current value of the catamaran rental project? Is the project worth it? Briefly explain in words and show all calculations and formulas.
4) “Ocean Adventures Co.” is concerned about the recent increase in prices for catamaran cleaning supplies. It is interested in finding out how the current value of the project may be affected if this price increase would raise the company’s cost of rental for each machine from $8 to $10 dollars. What will be the percentage change in the project’s current value in such case? Is it sensitive to changes in the rental costs? Explain all changes that will take place in the table you made for question 2.
For questions #5~#7 assumes that there is no increase in rental costs described in question #4.
5.) 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.)
6) (Continuing question 5.), would the current expected value be different if “Ocean Adventures Co.” had an option to shut the sailing catamaran rental business down and sell all used catamarans at the end of the first year if it turns out unsuccessful? If yes, what would be the value (in dollars) of this option? Explain all changes that will take place in the table you made for question 2.
7) Since the market price for used catamarans is rising by 10 percent each year, the company’s manager is wondering whether delaying shutting the business down under the unsuccessful scenario by one year would be more profitable. What would be the value (in dollars) of the option to delay shutting the business down by one additional year (i.e, shutting down at the end of year 2 instead of at the end of year 1)? Would the delay be worth it? Explain and show all calculations.