Your friend Jennifer Connolly has operated a family restaurant for several years, and she is considering opening another one using a place she owns already

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Your friend Jennifer Connolly has operated a family restaurant for several years, and she is considering opening another one using a place she owns already. Jennifer asks you to help her in evaluating the proposed project. You are also provided with the following information:

1. Jennifer plans to operate the restaurant for 10 years.
2. Jennifer will need to spend $200 000 to decorate the restaurant and purchase some equipment. The costs of decoration and equipment will be depreciated on a straight-Line basis to zero over 10 years. At the end, the equipment can be sold at an estimated market price of $50 000.
3. The new restaurant will be in a place that Jennifer owns. Otherwise, the place can be leased out to collect $40 000 in rent per year.
4. The new restaurant will require a $30 000 investment in inventory, and Jennifer expects that her accounts payable will rise by $10 000 as well. At the end, the working capital will have been completely recovered.
5. Jennifer estimates that 15 000 customers will visit her new restaurant each year and on average each customer will spend $20 which is almost identical to those of her current restaurant.
6. The fixed operating costs, excluding depreciation, are expected to be $100 000 each year, and the variable operating costs, excluding depreciation, are expected to be 25% of the sale each year.
7. Jennifer had paid $5000 to a consultant to collect information for her.
8. Jennifer is negotiating with the bank to borrow half of the decoration expenses, and the commercial lending rate of the bank is 7.2% p.a.
9. Jennifer also assumes that the new restaurant will decrease sales of her current restaurant by $20 000 per year.
10. The tax rate is 30%, and the project’s required rate of return is 12%.

After getting this information, you evaluate the proposed project by addressing the following questions.

 

1. Why should cash flow instead of accounting profit be used in capital budgeting?
2. What kinds of cash flow should be included in capital budgeting analysis? Use the project to demonstrate.