Capital budgeting and Investment decisions

Part 1
Capital budgeting and Investment decisions [20 marks]
Bay of Plenty Transport (BOPT) is evaluating the replacement of its fleet of buses. The existing fleet consists of 10 buses with a seating capacity of 50 each. They were purchased five years ago at a cost of $400,000 per bus. BOPT management is now proposing to replace all 10 buses with a fleet of eight new buses with a seating capacity of 65 each. The cost of the new buses is $600,000 each and is expected to last for the next seven years before another replacement decision is made.
The average occupancy rate is 70% of the capacity of the buses and this is expected to be the same for both the existing and new buses. Each bus (existing and new) is estimated to run on average 350 days a year for 10 trips per day averaging 100 km each day. Average fare revenue per passenger per trip is $5 for year 1.
If the existing buses are to be replaced, they can be sold for $50,000 per unit today or $5,000 seven years later. It is also estimated that the new buses can be sold for $60,000 each at the end of seven years. The company has a depreciation policy of straight-line over eight years for this type of fixed asset.
The following are estimated running costs for the existing and new buses for year 1:
Existing buses
New buses
Variable cost / km
$8
$7
Relevant fixed cost / bus / year
$20,000
$15,000
Inflation is estimated to be 2% year on year. Revenue and costs are expected to increase at the inflation rate. It is also expected that working capital will increase by $150,000 recoverable at the end of the project.
Corporate tax rate is 28%. The company’s cost of capital is 13% and it has a policy of requiring a payback period of not more than three years for capital investments.
Required
a) Determine the relevant incremental cash flows for the replacement of the existing fleet of buses. (13 marks)
b) Calculate the payback period, net present value and the internal rate of return of this project. (7 marks)

Part 2
Lease versus Buy decisions [20 marks]
As the Finance Director of BOPT, you have started work on the financing of the new
buses in anticipation that management approves the project. You are considering two
options: borrowing to purchase the new buses, or to enter into a financial lease arrangement
with a finance company.
A bank has agreed to accept a 10% down payment and provide a loan on the balance
at 10% interest to be repaid in full in seven equal installments at the end of each year.
A finance company has offered to purchase the new buses and then lease the new
buses to BOPT at $850,000 per year for seven years payable at the beginning of each
year plus an end-of-lease payment of $200,000 for the company to take ownership of
the fleet at the end of the lease.
Company tax rate, cost of capital and depreciation policy are the same as those
used in Part 1.
Required
a) Calculate the annual payment for the bank loan and prepare a schedule of loan
repayments. (4 marks)
b) Determine the after-tax cash flows and the PV of cash flows for the bank loan
option. (10 marks)
c) Determine the after-tax cash flows and the PV of the cash flows for the leasing
option. (6 marks)



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