ACC 543 Week 1 Managerial Accounting and Capital Budgeting Example

Should the Car Wash Chain Build a Fourth Express Tunnel? Net Present Value, Internal Rate of Return, Payback and a Sensitivity Test on Car Volume for a Composite Regional Operator

[Student Name]

University of Phoenix

ACC/543: Managerial Accounting & Legal Aspects of Business

Week 1 Assignment

[Instructor Name]

[Date]

The car wash chain, the site and all figures are composites written for a model paper; methods and research findings come from the sources listed.

A composite operator runs three express car wash tunnels in a growing suburban region, selling single washes and unlimited monthly memberships. A developer has offered a pad site beside a new retail center anchored by a grocery store. The chain's owners must decide whether to build a fourth tunnel for $4.2 million, including land of $1.1 million and a building and equipment of $3.1 million. A capital budget is where managerial accounting stops describing the past and starts committing the company's money to a forecast. This paper analyzes the investment.

Managerial Accounting's Role

Managerial accounting serves internal decision makers with forward-looking, detailed information that need not follow external reporting rules (Garrison et al., 2021). For this decision, the chain's accountant assembled volume data from the existing sites, cost records by site, a construction bid and a traffic study, and built a model of the new site's cash flows. The same accounting records that produce financial statements supply the inputs, but the analysis uses them for a different purpose: choosing among futures.

Estimating the Cash Flows

The traffic study and the chain's experience at similar sites suggest about 118,000 cars a year once the site matures, half from members. Average revenue per car is about $13.20, for annual revenue of about $1.56 million. Cash operating costs, including labor, chemicals, water, electricity, maintenance and marketing, are about $570,000 a year. Operating cash flow before tax is about $990,000.

The building and equipment are depreciated for tax purposes; after bonus depreciation on the equipment and straight-line recovery on the building, average annual tax depreciation over ten years is about $310,000. Taxable income is about $680,000, and at a combined 25% rate, tax is about $170,000. After-tax operating cash flow is about $820,000. The owners use a conservative figure of $760,000 a year for the base case to allow for a slower first year.

At the end of ten years, the land is expected to be worth about $1.4 million and the equipment about $200,000 after tax, a terminal cash flow of $1.6 million.

Net Present Value

The chain's weighted average cost of capital is about 9%, reflecting its bank borrowing and the owners' required return. The present value of $760,000 a year for ten years at 9% is about $4.88 million, and the present value of the $1.6 million terminal flow is about $0.68 million. Total present value is about $5.55 million, and net present value is about $1.35 million. The project is expected to create value.

Internal Rate of Return

At 15%, net present value is about $10,000; at 16%, about minus $164,000. The internal rate of return is therefore just above 15%, well above the 9% cost of capital.

Payback

Cumulative cash flows recover the $4.2 million investment in about five and a half years. Payback ignores the land's value and the cash flows after year six, so it understates the project's worth, but it tells the owners how long their money is at risk, which matters to a family business with limited capital. Graham and Harvey (2001) found that payback remains common among smaller firms whose owners care about liquidity, even though most large firms rely on discounted methods.

Sensitivity to Car Volume

Car volume is the least certain assumption in the whole model. Holding price and costs constant, a 20% shortfall in volume would reduce after-tax cash flow to about $560,000 a year, and net present value would fall to about $70,000, barely positive. A shortfall of about 21% would make the project break even, which is a meaningful cushion but not a large one for a new location. Price is also sensitive: a $1 lower average price would cut net present value by about $0.7 million. The owners are therefore betting mainly on the traffic study and on the grocery anchor drawing customers.

Keeping Financing Out of the Cash Flows

The owners plan to finance 60% of the project with a bank loan. The loan's interest and principal are not subtracted from the project's cash flows, because the 9% cost of capital already reflects the cost of the debt and equity used to fund the chain. Subtracting interest and then discounting at a rate that includes it would count financing costs twice. The loan matters for liquidity, not for whether the tunnel creates value.

Three Scenarios

Beyond single-variable sensitivity, the accountant built three scenarios. In the base case, net present value is about $1.35 million. In an optimistic case, with volume 10% above forecast because the grocery anchor opens early and a competitor stays away, it rises to about $2.0 million. In a pessimistic case, with volume 15% below forecast and costs 5% higher because of wage increases, it falls to about $0.1 million. The project remains marginally positive even in the pessimistic case, which gives the owners some comfort, but the spread shows how much depends on the first two years of volume.

A Post-Audit Plan

Datar and Rajan (2021) recommend comparing actual results with capital budget forecasts after projects are completed, both to improve future estimates and to discourage overly optimistic proposals. The chain will review the new site's volume, price and costs quarterly for its first two years against the forecast and report the comparison to the owners. If volume after eighteen months is more than 15% below forecast, the owners will review pricing and marketing for the site before considering any further expansion.

Qualitative Factors

Several factors do not appear in the cash flows. The new site is five miles from the chain's second tunnel, and some members may shift, reducing that site's revenue; the owners estimate the overlap at about 3% of the new site's volume. The membership program benefits from density, since members value more locations. Water restrictions during drought could limit operations; the new tunnel's reclaim system reduces that risk. A competitor has announced plans in the same area, which could reduce volume below forecast.

Recommendation

The owners should approve the project, subject to two conditions: a signed lease or purchase agreement with the developer that confirms the grocery anchor's opening date and a check of the competitor's permit status before construction starts. If the competitor proceeds within one mile, the analysis should be rerun with a lower volume assumption, since the project's value depends heavily on reaching the forecast car count.

Conclusion

The fourth tunnel has a net present value of about $1.35 million at a 9% cost of capital and an internal rate of return above 15%, with payback in about five and a half years. Its value depends mainly on car volume, which could fall about 21% before the project stops creating value. Managerial accounting supplied both the numbers and the framework for judging how much to trust them.

References

Datar, S. M., & Rajan, M. V. (2021). Horngren's cost accounting: A managerial emphasis (17th ed.). Pearson.

Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2021). Managerial accounting (17th ed.). McGraw Hill.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7