A car rental company is considering setting up a division to provide chauffeur driven limousines for weddings and other event. The proposed investment will include the purchase of a fleet of 20 limousines at a cost of $200 000 each. It is estimated that limousines will have a useful life of five years and a resale value of $30 000 each at the end of their useful life. The company uses^,_:; the straight line method of depreciation.

Revenue and variable costs

Each limousine will be hired to customers for $800 per day. The variable costs, including fuel, cleaning and the chauffeur’s wages, will be $300 per day. The limousines will be availabl_e for hire 350 days of the year A market specialist was hired at a

cost of $20 000 to estimate the demand for the limousines in Year 1. The market specialist estimated that each limousine will

be hired for 260 days in Year 1 and that the number of days’ hire will increase by ten days each year for the remaining life of the project.

:Fixed costs

Each limousine will incur fixed costs, including maintenance and depreciation, of $45 000 a year. The administration of the.division is expected to cost $300 000 each year. The garaging of the limousines will not require any additional investment but,. will utilize existing facilities for which there is no other use. The head office will charge the division an annual fee of 10 per Ce4_i: of sales revenue for the use of these facilities.

Taxation

The company’s financial director has provided the following taxation information:

Tax depreciation: 25 per cent per annum of the reducing balance, with a balancing adjustment in the year of disposal. The limousines will be eligible for tax depreciation.

Taxation rate: 30 per cent of taxable profits. Half of the tax is payable in the year in which it arises, the balance is paid in the

following year.

Other ira_formation

Ignore inflation.

The company uses a cost of capital of 12 per “Cent per annum to evaluate projects of this type.

Requited:

(a) Evaluate whether the company should go ahead with the project: You should use net present value as the basis of your

evaluation.

(14 ii arts)

The company is also carrying out a review of its existing car rental business. The company is deciding whether it should replace the cars that it uses after one, two or three years. The cars will not be kept longer than three years due to the higher riSE of

breakdowns.

The estimated relevant cash flows for the three possible options for each car can be obtained from the following information:

Cash                  Residual

outflows                    value

Year                     $                           $

0                 (30 OM

1                    (1500)                 21000

(2700)                 15 000

3                    (3600)                   9000

The company uses a cost Of capital of 12 per cent for decisions of this type.

Required:

(h) Calculate, using the annualized equivalent method, whether the cars should be replaced after one, two or three years. You should ignore taxation and inflation.

(7 marks)

(d_e Explain-the limitations of the annualized equivalent method for making decisions to replace non-current assets.