Motomation Pty Ltd plans to acquire several retail automotive parts stores as part of its expansion program. Motomation carries out en extensive review of possible acquisitions prior to making any decision to approach a specific company. Projections of future financial performance are one of the aspects of such a review. One form of projection relies heavily on using past performance (normally 10 prior years) to estimate future performance.
Currently, Motomation is conducting a review of Atlas Auto Parts, a regional chain of retail automotive parts stores. Among the financial data to be projected for Atlas is the future rental cost for its stores. The schedule below presents the rent and revenues (both in millions of dollars) for the past 10 years.
The following three methods were trialled for estimating future rental expense:
A regression analysis using time as the independent variable was performed. The resulting formula is as follows:
Rental expense = 0.93 + 0.0936T
where T = the year
The annual rental expense was related to annual revenues, using regression analysis. The formula for predicting rental expense in this case is as follows:
Rental expense = 0.5597 + 0.02219X
where X is equal to revenues divided by 1,000,000 (for example, X for Year 10 is 60).
Rental expense was calculated as a percentage of revenues using the average for the 10 year period.
1. Calculate for each of the three methods the rental expense estimate for Atlas Auto Parts for the next year, assuming the projected revenue will be the same as the Year 10 revenue (that is, $60 million).
2. Discuss the advantages and disadvantages of each of the three methods for estimating the rental expense for Atlas Auto Parts.
3. Identify one method from A, B or C that you would recommend Motomation to use in order to estimate rental expense. Explain why you selected this method, using the two criteria for evaluating regression equations outlined in the chapter.
4. Suggest another method which may improve the estimate 0f future rental expense.