Road King Trucks Introduction Michael Livingston has recently been hired as the

Road King Trucks
Introduction Michael Livingston has recently
been hired as the CEO of
Road King Trucks Inc.
Previously he had been the
marketing manager for a large manufacturing company and
had established a reputation fo
r identifying new consumer trends. Road King Trucks Inc.
is a California-based truck manufacturi
ng company. The company is well known for
manufacturing large heavy-dut
y trucks at a reas
onable cost. One of its greatest
achievements is that its trucks can be eas
ily modified or customized for different
applications. Road King Truc
ks also builds school buses. The company is considering an expansion of
its current product line to include transit buses. Mr. Livingston
feels th
at due to high gasoline prices commuters will be more willing to
consider using mass transit instead
of using their cars to commute to work. Company Profile Road King Trucks Inc. was established by th
e Smith brothers in 1880 as the California
Wagon Company. The firm started manufactu
ring horse-drawn wa
gons to serve the
growing population in California. The brothe
rs quickly realized
that the times were
changing so they started looking for the t
echnologies that would keep them at the
forefront of their field of business. In 1915
the Smith brothers decided that they needed
to make trucks as replacements for the wagons because trucks were
starting to serve the
same uses as wagons and the wagon industry wa
s not going to be vi
able in the longer
term. The company started making school buses in
the early 1940?s. Most manufacturers had
been commissioned by the government to produ
ce different large vehicles to support
World War II operations. Road King Trucks opt
ed to produce buses. It was an easy
decision to make since the buses would us
e common parts with the company?s trucks
and the customers were local governments
. Starting in the 1950?s the school bus
business accounted for about 50% of Road King Trucks? revenues. The Transit Bus Opportunity Mr. Livingston arranged a meeting with the
fi
rm?s top management as well as the chief
design and manufacturing engineers to pr
opose his new product. He presented an
argument that more individuals in the United
States and Canada would be willing to use
public transportation than before because pe
ople were becoming more environmentally
conscious. Also recent increases in fuel cost
s seemed to be long lasting. This was an
opportunity to get people hooked on
transit buses as he put it. The proposal under consideration was for the in
troduction of a large
public transport bus.
To distinguish Road King Trucks from other
manufacturers the proposal included details
about the level of comfort air-conditioning
efficiency and quietness of operation that
needed to be developed.
GJS File: Road King Trucks Rev 2.doc
Last Revised: 4/30/2010 Mr. Phillips and Mr. Lopez the two
engineer
s reacted enthusiastically and quickly
pointed out that the bus coul
d be based on the company?s tr
ucks. The frame currently
used for building the trucks could be modifi
ed to accommodate buses at a relatively low cost. The marketing vice president Mr. Chen pointed out that a
marketing analysis
could be done quickly and at
a reasonable cost. At this
point Mr. Livingston charged
the participants in the meeting to produce
a financial plan for the development and
production of a transit bus. Public Transportation The use of public transporta
tion had declined steadily si
nce the 1950?s. Most people
were opting to use their persona
l vehicles for all of their tr
ansportation needs. Recently
however most of the metropolitan areas in
the United State and Canada the target
markets for the new bus had become more
and more congested; and parking which was
already very expensive was becoming scarce. This combination of trends has renewed the
public?s interest in good and reliable public
transportation. Several municipalities have
been campaigning to their residents and
commuters that they should use public tr
ansportation for business commuting and only
use their cars for shopping and w
eekend activities. However
such campaigns need to be
supported by making high quality public transp
ortation available to the target riders. The Decision Three weeks after the in
itial meeting the vice presidents
presented the sales and cost
forecasts shown in the attached exhibits. The information presented
contains the cost of
production financing informati
on and warranty cost estimates. The proposals also
contained two engine options for the engines:
The Detroit engine and the Marcus engine.
The Detroit engine was more expensive to in
stall but had a lower warranty cost. The
Marcus engine was less expensive to install
but had a higher warranty cost. This begged
the question: Which engine should be used? Issues and Analyses Mr. Livingston noticed that there was a grea
t deal of enthusiasm among the management
group about the transit bus opportunity but his
cautious nature told him to also seek a
more objective viewpoint. Consequently he
sought out you to analyze the proposed project and provide your
recommendations direc
tly to him. The issues he wants you to
address in your analysis
and report are the following: 1) How much importance should be gi
ven to the energy cost situation?
2) What are the project?s cash flows for th
e next twenty years? What assumptions
did you use?
3) What is the company?s cost of capital?
What is the appropriate discount factor
(which may be different) for you to
use in evaluating the bus project?
4) If you decide to go ahead with the project which of the two engines
should be
used in the bus and why?
5) Evaluate the quality of the project
by using appropriate capital budgeting
techniques. GJS File: Road King Trucks Rev 2.doc
Last Revised: 4/30/2010 6) Would you recommend that Road King Truc
ks accept or reject the project? What
are the key factors on which you base your recommendation? Your final report is due in Blackboard
on Thursday December 15 @ 3:00 PM. also
please bring a hard copy of you
r paper to class on December 15. GJS File: Road King Trucks Rev 2.doc
Last Revised: 4/30/2010 Exhibit 1: Sale
s and Cost Forecast The sales forecast is based on projected levels
of demand. All the numbers are expressed
in today?s dollars. The forecasted
average inflation per year is 3.5%
.
Price per bus $220000 Units sold per year 11000 Labor cost per
bus $50000 Components & Parts $95000 Selling General &
Administrative
$250000000 NOTE: Average warranty cost per year pe
r bus for the first five years is $1000. The
present value of this cost will be used as
a cost figure for each bus
. Afterwards the bus
operator will become responsib
le the repairs on the buses.
The buses can be produced for twenty years.
Afterwards the desi
gns become obsolete.
Engine choices Engine Detroit engines Marcus engines Price per engine incl
uding installation $20000 $18000 Average annual warranty cost per
year for five
years. Afterwards the bus operator will become
responsible for the repairs on the buses.*
$1000 $1500 The chosen engine will be installed in every
bus and will become a cost figure for each
bus. NOTE: The engine manufacturers are not
providing Road King Trucks with any
warranty. However Road King Trucks will pr
ovide a warranty to its customers. After
the initial five years the bus operators ma
y purchase an extende
d warranty from any
insurance company that offers such packages. GJS File: Road King
Trucks Rev 2.doc
Last Revised: 4/30/2010 Exhibit 2: Investment NeedsTo implement the project the firm has to inve
st funds as shown in the following table: Year 0 Year 1 Year 2 Year 3 $400 million*
plus the land the
company owns**
$500 million* $200 million* $100 million
Production and selling
of buses starts * Road King Trucks estimated that it would co
st a total of $1 billio
n to build the factory
and purchase the necessary equipment to
produce the buses. The other $200 million
investment divided equally in
years 2 and 3 is for non-depreci
able labor training costs.
Such investment is treated as regular business expenses. ** The factory will be built on a parcel of land which Road King Trucks
owns. The land
was purchased ten years ago for $3 million and is currently valued at $6
million.
Straight line depreciation will be used for the sake of simplicity. To facilitate the operation of manufacturing the transit buses the
company will have to
allocate funds to net working capital (NWC)
equivalent to 10% of
annual sales. The
investment in NWC will be recovered at the end of the project. Assume that he land factory and equipment will
be sold at the end of the project. The
company expects to spend about $300000 demolis
hing the factory and
cleaning the land.
The company expects to sell the land for its cu
rrent value plus the inflationary effects on
its price. The equipment will be sold for salvage at about $15000000. GJS File: Road King Trucks Rev 2.doc
Last Revised: 4/30/2010 Exhibit 3: Financing Assumptions The following assumptions are used to
determine the cost of capital. Historically the company tried to maintain a de
bt to equity ratio e
qual to 0.40. This ratio
was used because lowering the debt implies gi
ving up the debt tax shield and increasing
it makes debt service a burden on the firm?s ca
sh flow. In additi
on increasing the debt
level may cause a reduced rating of the company?s bonds. The marginal
tax rate is 40%.
All the numbers are expressed in today?s dol
lars. The forecasted average inflation per
year is 3.5%. Cost of debt: The company?s bond rating is roughly at the high
end of the A range. Surveying the debt
market yielded the following information about th
e cost of debt for different rating levels: Bond rating AA A BBB Interest cost range 5.5%
~ 6.5% 6.25% ~ 7.5% 7.5% ~ 9%
The company?s current bonds have a
yield to maturity of about 6.5%. Cost of equity: The current 10-year Treasury notes have a yiel
d to maturity of 4% and the forecast for the
S&P 500 market premium is 5.5%. The company?s overall is 1.15. analysis: Company Road King
Trucks
Red
Bird
General
Trucks
Universal
Transports
Trucks
Inc.
International
Trucks Overall 1.15 1.2 1.3 1.32 1.2 1.09 Debt to equity 0.4 0.3 0.5 0.45 0.35 0.25
Percentage of
income from
trucks
50 45 90 95 85 85