Question

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 $900,000 equipment, that require installation cost and transportation cost equal $100,000.

o The sources of fund will be 250,000 loan from bank at interest 8% and the remaining will be from equity.

o The company will pay interest equal to $120,000 each year.

o The project has an economic life of 4 years. o The cost can be depreciated using straight line method.

o At t = 0, the project requires that increase Account receivable by $80,000 and inventory by $120,000 while Account payable will increase by $160,000.

o The project’s salvage value at the end of 4 years is expected to be Zero.

o The company forecasts that the project will generate $725,000 in sales the first 2 years and $650,000 in sales during the last 2 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 bond yield premium in Egypt was 18% at that time

o The company already pays marketing expenses equal 80,000.

o The government treasury bond earn interest equal to 5%

Requirements:

1. Using the Net present value, what do you recommend?

Answer 1

assumptions

1. Identification of discounting factor.- Normaly organisations are disounting cash flows at WACC, BUT in case of risky projects organizations add risk premium also.

Based on this discounting rate will be selected.

here we are selected 18% higher rate for discounting cash flows

2.... in question incresing account receivable and inventory shows additional requirment of working capital and increasing account payables shows decrese in working capital. based on that net working capital requirement is=$80000+$120000-$160000= $40000

WC will treated as out flow in year zero and inflow at the final year.

3....Interest expenses taken only interst expenses for purchasing this asset ($25000*8%=$20000)

solution for the problem

Cash out flow
Cost of asset	9,00,000.00
Installation charge	1,00,000.00
Total	10,00,000.00
Working capital	40000.00	(120000+80000-160000)
Total out flow	$10,40,000.00
calculation of cash in flow
year	1	2	3.	4
sales	725000.00	725000.00	650000.00	650000.00
operating exp	362500.00	362500.00	325000.00	325000.00
operating profit	362500.00	362500.00	325000.00	325000.00
Interest	20000.00	20000.00	20000.00	20000.00
depreciation	250000.00	250000.00	250000.00	250000.00		depreciation =1100000/4=250000
PBT	92500.00	92500.00	55000.00	55000.00
TAX	37000.00	37000.00	22000.00	22000.00
PAT	55500.00	55500.00	33000.00	33000.00
Add Depreciation	250000.00	250000.00	250000.00	250000.00
add working capital			40000.00
net cash flow	305500.00	305500.00	283000.00	323000.00
DISCOUNTING FACTOR AT 18%	0.847	0.718	0.609	0.516
Discounted cash flow	258898.31	219405.34	172242.54	166599.81
Net cash inflow (A)	$8,17,145.99
Out Flow (B)	$10,40,000.00
NPV(A-B)	($2,22,854.01)

from the above solution NPV is Negative so project is rejected.

above solution can also be solved by takig cost of capital as discounting factor.

following are not considerd for solving the solution

1.marketing exp which are alredy incured is not relevent for the decision

2. fixed interest charge of $120000

3.salvge value is nill.