Question

Delizzia, a family owned business, produces and delivers potato chips to supermarkets and mom & pop stores. Located in Buenos Aires, Argentina, Delizzia is planning to expand its operations to cover other major Argentinian cities such as Cordoba and Rosario. This expansion will require Delizzia to set up a new distribution center and acquire new vehicles for last-mile distribution. Due to budget constraints, the company will only be able to expand to one city at a time. Therefore, Delizzia needs to decide if investing in Cordoba or Rosario makes more economic sense. The company is considering a time horizon of five years to make the decision. Assume the tax rate is 40% and the discount rate for Delizzia is 15%. Ignore inflation.

The table below shows the projections (incremental sales, COGS, operating expenses and depreciation) anticipated for expanding Delizzia's operations to Cordoba in millions of Argentine pesos.

Cordoba's Incremental Income Statement (in millions of Argentine pesos)

	Year 1	Year 2	Year 3	Year 4	Year 5
Sales	56	80	140	156	130
COGS	30	34	64	67	52
Gross Income	26	46	76	89	78
Operating Expenses	11	22	40	46	39
Operating Income (EBITDA)	15	24	36	43	39
Depreciation	6	6	6	6	6
Operating Income (EBIT)	9	18	30	37	33
Income Tax	3.6	7.2	12.0	14.8	13.2
Net Operating Profit After Taxes (NOPAT)	5.4	10.8	18	22.2	19.8

Expanding to Cordoba will require an investment of 30,000,000 Argentine pesos (to be paid in Year 0) to remodel the rented space for the distribution center and purchase the vehicles. Similarly, additional working capital will be required, but it comes in the second half of Year 1 after the remodeling is finished. That is why there is no working capital in Year 0. See table below:

Cordoba's Incremental Adjustments (in millions of Argentine pesos)

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Depreciation	-	6	6	6	6	6
Net Capital Expenditures	-30	-	-	-	-	-
Net Working Capital Investment	-	-19	-29	-16	-7	47
Free Cash Flows	-30	-7.6	-12.2	8	21.2

Note.- A negative number for the capital expenditure and working capital represents a cash outflow. The positive working capital cash flow in the final period may not equal the sum of the previous investments due to accounting assumptions, such as not collecting all receivables.

The company uses straight-line depreciation over 5 years. The terminal value is zero.

What are the projected Free Cash Flows for year 5 associated with expanding to Cordoba?

What is the NPV for expanding Delizzia's operations to Cordoba?

Answer 1

Estimation of NPV for expanding to Cardoba and Free Cash Flows for year 5 associated with expanding to Cardoba

Step 1: Identifying Free cash flows for year 5  

Free cash flows at the end of year 5 shall comprise of two components:

Component 1: Operating cash flows

Component 2: Non operating cash flows (terminal year)

Let us first calculate component 1 for year 5 (All calculations are in Million Peso)

Operating Cash Flows (OCF)= EBIT (1-Tax Rate) + Depreciation

OCF Year 5= 33*(1-40%) + 6

OCF Year 5= 33*(0.6) + 6 = 19.8+6=25.8

Now let us calculate Component 2 for year 5

TNOCF Year 5 = Salvage Value + Net Working Capital changes (Terminal year) - Tax Rate (Salvage Value - Book Value)

As given in the information, Salvage Value is zero. Also, the entire asset/investment of Peso 30 Mn has been depreciated completely in 5 years. Accordingly book value of the asset at the end of 5th year is also zero.

Hence, TNOCF Year 5 = 0 + 47 - 40%*(0-0) = 47 - 40% * (0) = 47

Free Cash Flows in Year 5 = OCF year 5 + TNOCF Year 5 = 25.8+47=72.8 Mn Peso

Let us now compute the NPV for expansion decision to Cardoba

FCF1=-7.6

FCF2= -12.2

FCF3= 8

FCF4=21.2

FCF5=72.8

The free cash flows need to be discounted by discount rate of 15% to arrive at PV of FCFs at the end of Year zero

PV FCF1= -(7.6)/(1.15) =-6.61

PV FCF2 = -12.2/(1.15)^2= -9.22

PV FCF3 = 8/(1.15)^3 = 5.26

PV FCF4 = 21.2/(1.15)^4=12.12

PV FCF5=72.8/(1.15)^5=36.19

NPV= -(Initial Investment) + PV FCF1 + PV FCF2 + PV FCF3 + PV FCF4 + PV FCF5

= -(30) - 6.61 - 9.22 +5.26 + 12.12 + 36.19

= 7.74 Mn Peso

Hence, Delizzia's decision of expanding to Cardoba should result in a net positive NPV of 7.74 Mn Peso