Question

John invents The Night Truck, a mobile night-shop with home delivery service between 8

pm and 6 am.

We are end December 2019 and John needs your help to evaluate this project. The project could generate annual sales of 150.000 € in 2020. The sales could then increase by 10% a year. John anticipates that a new regulation as from 2024 would prevent the sales of

alcohol during the night, meaning that sales would stop on the 31st of December 2023. Cost of sales amounts to 60% of sales.

The project requires a new warehouse as well as two trucks. The initial total investment (in 2019) is estimated at 200.000 € (which can be depreciated linearly over 10 years from 2020 onwards). At the end of 2023, the initial investment could be sold for 92,300 €.

John recently travelled to New York, where the concept already exists, to study the feasibility of the project. This trip cost 5.000 € and will be paid in 2020. In 2020, accounts receivable would increase by 75,000 €, inventories by 25.000 € and accounts payable by 50.000 €. Those accounts will stay stable until 2022, with the exception of inventories which John expects to further increase by 10.000 € in 2022 to meet the increasing demand. At the end of the project, all these amounts would be recovered.

The company is subject to a tax rate of 25%. Assume that all cash flows occur at the end of the year, that the inflation rate is 0% and that the annual risk-free rate is 2% (annually compounded). The risk premium for similar projects is 6% (annually compounded).

Questions:

1) What is a sunk cost? Do you identify such cost for the project?

2) Calculate the incremental net incomes and free cash flows of the project.

3) Which discount rate should you choose to evaluate the project? How do you interpret your answer? What is the main information included in this number?

4) Calculate the NPV of this project? What would you advise to John? Why?

5) What would be the impact of this project on the company’s value (if the project is undertaken...)?

Answer 1

Q - 1

Sunk cost is a cost that is irrelevant in decision making. It's a cost item, that's not going to alter the decision making. It's incurred, irreversible and can't be recovered.

There is indeed on esunk cost in the porject. John recently travelled to New York, where the concept already exists, to study the feasibility of the project. This trip cost 5.000 € is the sunk cost.

Q - 2

Please see the table below. Yellow colored cells contain your answers. All financials are in €. The second column titled "Linkage"explains the mathematics. Blue colored cells contain the excel formula used in the adjacent cell to get the answer.

Year wise incremental net incomes and free cash flows of the project appear in the table above.

Part (3)

Discount rate = 8% (See table above)

The intepretation is that the riskiness of the project cash flows is measured by the discount rate. The opportunity coist of the capital in this project is 8%. Another interpretation is 8% is an adequate rate of return for the investors of this project.

Part (4)

NPV = € 47,011.16

As NPV is positive, the project is recommended / accepted / selected.

Part (5)

If the project is undertaken, the value of the firm should increase by NPV i.e. € 47,011.16