Question

Erma’s Beauty Supply is considering expanding the existing store. Erma wants to lease the office space next door to her business. Erma must spend, $120,000 on equipment to expand. The equipment is expected to have a zero-salvage value and will be retired in 8 years. Erma expects to increase networking capital by $8,000 right now if she goes through with the expansion. Erma spent $12,000 last month on a survey of the area surrounding the shop to see if there was sufficient demand for a larger store. Erma estimates she will increase revenues by $110,000 per year in the new store for eight years. The direct expenses incurred to make those sales are $78,000, including rent. The lease she is considering signing is for 8 years. She will liquidate the $8,000 networking capital when the lease is complete in 8 years. Erma’s Beauty Supply pays 40.0% in taxes and has a cost of capital of 9.0%.

38. How much does Erma need to expand her business at T=0?

39. Based on this information, the project’s operating cash flow in each of the first seven years is $_______?

40. Based on this information, the project’s terminal year (year 8) total cash flow is $_______?

41. What is Erma’s NPV if she decides to expand the business?

Answer 1

$12,000 spent on survey is a sunk cost and will not be considered in NPV calculation. This survey cost will never be recovered irrespective of whether we accept the project or not.

Depreciation = (cost of equipment - salvage value)/life of equipment = ($120,000 - $0)/8 = $120,000/8 = $15,000

Net working capital will be cash outflow $8,000 in year 0 and will be recovered in year 8 when it will be liquidated.

Erma need to expand $128,000 at T=0.

project’s operating cash flow in each of the first seven years is $25,200*7 = $176,400.

the project’s terminal year (year 8) total cash flow is $33,200.

Erma’s NPV if she decides to expand the business is $15,492.37.

Calculations