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California Best Trucks
Michael Livingston has recently been hired as the CEO of California Best Trucks, Inc.
Previously he had been the marketing manager for a large manufacturing company and
had established a reputation for identifying new consumer trends. California Best Trucks
Inc. is a California-based truck manufacturing company. The company is well known for
manufacturing large, heavy-duty trucks at a reasonable cost. One of its greatest
achievements is that its trucks can be easily modified or customized for different
applications. California Best Trucks also builds school buses.
The company is considering an expansion of its current product line to include transit
buses. Mr. Livingston feels that 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
California Best Trucks, Inc. was established by the Turner brothers in 1880 as the
California Wagon Company. The firm started manufacturing horse-drawn wagons to
serve the growing population in California. The brothers quickly realized that the times
were changing, so they started looking for the technologies that would keep them at the
forefront of their field of business. In 1915, the Turner 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 was not going to be viable in the longer
The company started making school buses in the early 1940’s. Most manufacturers had
been commissioned by the government to produce different large vehicles to support
World War II operations. California Best Trucks opted to produce buses. It was an easy
decision to make, since the buses would use 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 California Best Trucks’ revenues.
The Transit Bus Opportunity
Mr. Livingston arranged a meeting with the firm’s top management, as well as the chief
design and manufacturing engineers to propose 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 people were becoming more environmentally
conscious. Also, recent increases in fuel costs 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 introduction of a large, public transport bus.
To distinguish California Best 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. California Best Case Analysis Winter 2017 2
Mr. Phillips and Mr. Lopez, the two engineers, reacted enthusiastically and quickly
pointed out that the bus could be based on the company’s trucks. The frame currently
used for building the trucks could be modified 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 transportation had declined steadily since the 1950’s. Most people
were opting to use their personal vehicles for all of their transportation 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 transportation for business commuting, and only
use their cars for shopping and weekend activities. However, such campaigns need to be
supported by making high quality public transportation available to the target riders.
The Decision
Three weeks after the initial meeting, the vice presidents presented the sales and cost
forecasts shown in the attached exhibits. The information presented contains the cost of
production, financing information, and warranty cost estimates. The proposals also
contained two engine options for the engines: The Los Angeles engine, and the California
engine. The Los Angeles engine was more expensive to install, but had a lower warranty
cost. The California 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 great 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 directly to him. The issues he wants you to
address in your analysis and report are the following:
5) How much importance should be given to the energy cost situation?
What are the project’s cash flows for the next twenty years? What assumptions
did you use?
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?
If you decide to go ahead with the project, which of the two engines should be
used in the bus, and why?
Evaluate the quality of the project, by using appropriate capital budgeting
techniques. California Best Case Paper Winter 2017 3
6) Would you recommend that California Best Trucks accept or reject the project?
What are the key factors on which you base your recommendation? Your final report is due in Blackboard on Sunday March 12, 2017 at Midnight
Case details on the following pages. California Best Case Paper Winter 2017 4 Exhibit 1: Sales 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 3.0%
Price per bus
Units sold per year
Labor cost per bus
Components & Parts $95,000
per bus
Selling General &
NOTE: Average warranty cost per year per bus for the first five years is $1,000. The
present value of this cost will be used as a cost figure for each bus. Afterwards, the bus
operator will become responsible the repairs on the buses.
The buses can be produced for twenty years. Afterwards, the designs become obsolete.
Engine choices
Engine Los Angeles
Price per engine, including installation
Average annual warranty cost per year for five $500
years. Afterwards, the bus operator will become
responsible for the repairs on the buses.*
The chosen engine will be installed in every bus and will become a cost figure for each
NOTE: The engine manufacturers are not providing California Best Trucks with any
warranty. However, California Best Trucks will provide a warranty to its customers.
After the initial five years, the bus operators may purchase an extended warranty from
any insurance company that offers such packages. California Best Case Paper Winter 2017 5 Exhibit 2: Investment Needs
To implement the project, the firm has to invest funds as shown in the following table:
Year 0
$1 billion* Year 1
$100 million* Year 2
$100 million* * California Best Trucks estimated that it would cost a total of $1 billion to build the
factory and purchase the necessary equipment to produce the buses. The other $200
million investment, divided equally in years 1 and 2, is for non-depreciable labor training
costs. Such investment is treated as regular business expenses.
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 15% of annual sales. The
investment in NWC will be recovered at the end of the project.
The equipment will be sold for salvage at about $25,000,000 at the end of the project. California Best Case Paper Winter 2017 6 Exhibit 3: Financing Assumptions
The following assumptions are used to determine the cost of capital.
Historically, the company has maintained a debt ratio is 50%. This ratio was used,
because lowering the debt implies giving up the debt tax shield, and increasing it makes
debt service a burden on the firm’s cash flow. In addition, increasing the debt level may
cause a reduced rating of the company’s bonds. The marginal tax rate is 30%. All the
numbers are expressed in today’s dollars. The forecasted average inflation per year is
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 the cost of debt for different rating levels:
Bond rating
Interest cost range AA
5.5% ~ 6.5% A
6.25% ~ 7.5% BBB
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 yield to maturity of 2.50% and the forecast for
the S&P 500 market premium is 9.46%. The company’s overall is 1.35. California Best Case Paper Winter 2017


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