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Practice Problems Module 1 Solution:

The Big Rig Rental Company, which owns and rents out 50 trucks, is for sale for $350,000. Tom

Grossman, the companys owner, wants you to develop a five-year economic analysis to assist buyers

in evaluating the company.

The current annual rental rate for trucks is $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 in a given 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, until the rental rate drops to the

point where 100 percent of the fleet will 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 constant each

year.

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 ran about $4,800 per truck per year (independent of utilization)

this past year, which includes inspection fees, licenses, and normal maintenance. Big Rig has fixed

office costs of $60,000 per year and paid 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 complicated tax effects: Revenue 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 (NPV) 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.

The NPV can be calculated via Excels NPV function, or by hand. The calculation is:

NPV =

N

X

Cash Flow in Year t

t=0

(1 + Discount Rate)t

Problem 1

In order to begin analyzing the problem, please create an influence chart, using the conventions

described in class, using only and all of the following elements:

Net Present Value: the total value of the investment

Discount Rate: annual discount rate for NPV calculation

Purchase Price: the amount that the company is being purchased for

Selling Price Factor: the amount that the last year revenue will be multiplied by to

calculate the selling price

Selling Price: the amount the company will sell for in five years

Total Income: the annual income amount, before tax

Cash Flow: the final amount of money earned each year after paying taxes

Income Tax: the amount of income tax paid each year

Income Tax Rate: the percentage of total income that is paid in taxes each year

Net Operating Income: the operating revenue minus operating expenses

Operating Expenses: the cost per year to maintain the fleet, pay office expenses, and pay

property taxes

Revenue: the amount of money the company receives from renting out trucks

Rental Rate: the amount that trucks are rented for

Number of Rented Trucks: the number of trucks that are rented per year

Utilization Rate: the fraction of the fleet size that are rented each year

Rental Discount Factor: the amount that the fraction of the fleet size decreases per dollar

increase in rental rate

Incremental Rent Change: the assumed amount of increase/decrease in annual rental

amount that will cause a 7% increase/decrease in truck utilization rate

Incremental Utilization Change: the assumed percent increase/reduction in truck rentals

if annual rental amount changes by $1,200.00

Base Utilization Rate: the assumed percent of truck rentals if the annual rental cost is

$1,200.00

Fleet Size: the number of trucks the company owns

Maintenance Expenses: the annual maintenance cost

2

Maintenance Cost Base: the current maintenance cost per truck per year

Maintenance Cost Growth Rate: the rate at which the maintenance cost is assumed to

increase each year

Office Expenses: the annual office expense incurred

Office Expenses Base: the current office costs

Office Expenses Growth Rate: the rate at which the office expenses are assumed to

increase each year

Property Taxes: the annual property tax paid

Office Expenses Base: the current annual property tax

Office Expenses Growth Rate: the rate at which the property tax rate is assumed to

increase each year

Please be sure to identify the type of each of the elements through the objects that you use to depict

them, by using hexagons for the outcome, rectangles for decisions, upside-down triangles for inputs,

and ovals for auxiliary variables, preferably colored blue, green, purple, and black, respectively. The

outcome should be on the right of the diagram, so that one can read it left to right. The direction

of the arrows should follow the precedence relations required to calculate the elements from one

another.

Solution: See influence chart.pptx

Problem 2

Use your influence chart from the previous problem to create a spreadsheet model, analyzing the

investment decision of buying the company for $350,000.00. What is the base case NPV of the

investment?

Solution: The base case NPV is $20,141.20 as can be seen from the Excel file Module 1 Practice Problem - Solution.xlsx

Problem 3

There are many parameters that have been estimated, to assist in making a base case model.

Perhaps the two most important parameters that are estimated are the selling price factor (currently

estimated at 3) and the annual maintenance growth rate (current estimated at 9%). In reality, the

selling price factor can range anywhere from 2 to 4, and the annual maintenance growth rate can

range anywhere from 7% to 11%.

1. Use Excels scenario manager to input base case, pessimistic, and optimistic scenarios for the

NPV, where in the base case everything is set as in the original problem description, in the

pessimistic case the selling price factor is 2 and the annual maintenance growth rate is 11%,

and finally, in the optimistic case the selling price factor is 4 and the annual maintenance

growth rate is 7%. How much do these parameters affect the NPV?

Solution: Refer to sheet 3.1 in Excel file Module 1 - Practice Problem - Solution.xlsx

2. Holding all else equal, what value for the purchase price is the break-even price?

Solution: $370,141.20, as determined through using Goal Seek in Excel.

3. Holding all else equal, what value for the purchase price would ensure an NPV of at least

$20,000?

Solution: $350,141.20, as determined through using Goal Seek in Excel.

Problem 4

You are now interested in investigating how much the eventual purchasers should charge as the

rental rate.

1. Create a table and a chart showing the NPV, setting the minimum rental rate to $10,000 and

the maximum rental rate to $14,000. Use 100 points.

Solution: Refer to sheets 4.1a and 4.1b in Excel file Module 1 - Practice Problem Solution.xlsx

2. The values used for calculating the rental discount factor is also a best guess value. Suppose, instead, that varying 7% in the rental amount may change the incremental rent change

anywhere from $1,000 to $1,400. Create a chart using this range of values together with the

range of values from the previous problem to see the effect of both of these values changing

concurrently. Use 50 points for each axis, and vary the parameters independently.

Solution: Refer to sheets 4.2a and 4.2b in Excel file Module 1 - Practice Problem Solution.xlsx

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