question archive Sovrano Café is considering a major expansion of its business
Sovrano Café is considering a major expansion of its business
Subject:ManagementPrice:3.87 Bought8
Sovrano Café is considering a major expansion of its business. The details of the proposed expansion project are summarized below:
o The company will have to purchase $800,000 equipment, that require installation cost and transportation cost equal $150,000.
o The project has an economic life of 6 years.
o The cost can be depreciated using straight line method.
o At t = 0, the project requires that the account receivable to increase by $200,000 and the inventory by $350,000 while the account payable to increase by $400,000
o The project’s salvage value at the end of 6 years is expected to be
$160,000.
o The company forecasts that the project will generate $725,000 in sales the
first 3 years and $650,000 in sales during the last 3 years
o Each year the project’s operating cost excluding depreciation is expected
to be 50% of sales revenue.
o The company’s tax rate is 40%
o The company already pays marketing expenses equal 80,000.
o The project’s cost of capital is 10%
What do you recommend?
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Answer:
To check the feasibility of the project, we will calculate NPV of the project @10% discounting rate. (Because the project’s cost of capital is 10%)
|
Particulars |
Year 1 ($) |
Year 2 ($) |
Year 3 ($) |
Year 4 ($) |
Year 5 ($) |
Year 6 ($) |
|
Revenues |
725,000 |
725,000 |
725,000 |
650,000 |
650,000 |
650,000 |
|
(-) operating expense (50% of revenues) |
725,000 * 0.50 = (362,500) |
725,000 * 0.50 = (362,500) |
725,000 * 0.50 = (362,500) |
650,000 * 0.50 = (325,000) |
650,000 * 0.50 = (325,000) |
650,000 * 0.50 = (325,000) |
|
Contribution |
362,500 |
362,500 |
362,500 |
325,000 |
325,000 |
325,000 |
|
(-) Depreciation (working note a) |
(131666.67) |
(131666.67) |
(131666.67) |
(131666.67) |
(131666.67) |
(131666.67) |
|
PBT |
230,833.33 |
230,833.33 |
230,833.33 |
193,333.33 |
193,333.33 |
193,333.33 |
|
(-) tax @40% |
230,833.33 * 0.40 = (92,333.33) |
230,833.33 * 0.40 = (92,333.33) |
230,833.33 * 0.40 = (92,333.33) |
193,333.33 * 0.40 = (77,333.33) |
193,333.33 * 0.40 = (77,333.33) |
193,333.33 * 0.40 = (77,333.33) |
|
PAT |
138,500 |
138,500 |
138,500 |
116,000 |
116,000 |
116,000 |
|
(+) Depreciation |
131666.67 |
131666.67 |
131666.67 |
131666.67 |
131666.67 |
131666.67 |
|
Cash flows after tax |
270,166.67 |
270,166.67 |
270,166.67 |
247,666.67 |
247,666.67 |
247,666.67 |
|
(-) working capital requirement (working note b) |
(150,000) |
- |
- |
- |
- |
- |
|
(+) salvage value |
- |
- |
- |
- |
- |
160,000 |
|
Net cash flows |
120,166.67 |
270,166.67 |
270,166.67 |
247,666.67 |
247,666.67 |
407,666.67 |
|
PVIF (10%, n) = 1 / (1 + 0.10)n |
0.9091 |
0.8264 |
0.7513 |
0.6830 |
0.6209 |
0.5645 |
|
Present value of cash flows (net cash flows * PVIF10%, n) |
109,243.52 |
223,265.74 |
202,976.22 |
169,156.33 |
153,776.23 |
230,127.83 |
(PVIF refers to present value interest factor)
Therefore,
NPV of the project = Present values of all future cash inflows – present value of cash outflows
NPV of the project = (109,243.52 + 223,265.74 + 202,976.22 + 169,156.33 + 153,776.23 + 230,127.83) – 950,000
NPV of the project = 1,088,545.87 – 950,000
NPV of the project = $138,545.87
So, this project is making an addition of a positive $138,545.87 in shareholder’s value. So, Sovrano Café should accept this project.
Working notes –
(a) Calculation of depreciation –
Straight line method is followed.
Lifespan of project = 6 years
Purchase price of equipment = $800,000
Installation and transportation cost = $150,000
Total initial cost = Purchase price + Installation and transportation cost = 800,000 + 150,000 = $950,000.
Depreciation (annual) = (Initial cost – salvage value) / lifespan = (950,000 – 160,000) / 6 = $ 131666.67
(b) Working capital requirement –
Account receivable to increase by = $200,000
(+) Inventory to increase by = $350,000
(-) account payable to increase by = $400,000
Total working capital requirement = $ 150,000
(c) Marketing expenses are ignored because in calculation of cash flows, we only consider operating cost and incomes. That’s why depreciation is added back after deducting tax.
