Question

THE COFFEE CLUB celebrates almost three decades of really good food, great service and excellent coffee. It manages 400 stores throughout 9 countries, with upwards of 40 million dedicated customers. THE COFFEE CLUB has identified Westfield Parramatta and Sunshine Marketplace as two possible locations for a new Wimpy franchise given the considerable growth in the local economy. The cost of the feasibility study amounted to $30 000. Assume that you are the capital budgeting manager of THE COFFEE CLUB and have been assigned to this project. Consider the following information and calculate the relevant cash flows for the two mutually exclusive locations. The coffeehouses will have the same serving capacity, i.e. they are the same size.

• The cost of kitchen and restaurant equipment will amount to $600 000.
• Installation cost will amount to $25 000.
• The change in net working capital is $90 000.
• Although THE COFFEE CLUB operates as a franchise, they still consider operating cash flows

before setting up a new franchise to ensure the maximum profitability.

• Annual sales in Westfield Parramatta is expected to be $1.4 million and $900 000 in Sunshine

Marketplace.

• THE COFFEE CLUB franchisee will rent suitable premises to house the coffeeshop. In Westfield

Parramatta the annual rent will amount to $200 000 whereas the annual rent in Sunshine

Marketplace will be slightly less, namely $170 000.

• Operating expenses (excluding depreciation) will amount to $600 000 p.a. for Westfield Parramatta

and $450 000 p.a. for Sunshine Marketplace.

• Fixed (non-current) assets are expected to have a life span of 5 years and will be depreciated on a straight-line basis.
• Profits are taxed at the normal company tax rate of 28%.
• Assets will be sold after 5 years. Given the fact that sales in Westfield Parramatta are expected to

be higher (and thus assets are exposed to more wear and tear). THE COFFEE CLUB expects to get less for Westfield Parramatta’s assets than those of Sunshine Marketplace. It is thus expected that Westfield Parramatta’s assets could be sold after 5 years for $18 000 whereas Sunshine Marketplace’s could be sold for $20 000.

Therefore, you are required to:

1. (a) Calculate the Initial Investment Outlay (IIO) of the new franchises. Note: it will be the same for Westfield Parramatta and Sunshine Marketplace. Clearly show your calculations. (4)
2. (b) Calculate the Operating Cash Flows (OCFs) for both locations for the first year. Clearly show all calculations. (6)
3. (c) Calculate the terminal Cash Flow (TCF) in the last year for both locations. Clearly show your calculations. Assume that the capital gain tax applies at a rate of 25%. (7)
4. (d) What is the optimal location for the new THE COFFEE CLUB franchise? The required rate of return is 15%. Motivate your answer using the NPV and IRR technique. (11)

Answer 1

(a)

The Initial Investment Outlay
Particulars	Amount
Cost of kitchen and restaurant equipment	600000
Installation cost	25000
Changes in working capital	90000
Initial Investment Outlay	715000

(b)

Operating Cash Flows
Particulars	Westfield Parramatta	Sunshine Marketplace
Sales	1400000	900000
Rent	-200000	-170000
Operating Expense other than depreciation	-600000	-450000
Earnings before Depreciation and Tax	600000	280000
Depreciation	-125000	-125000
Earnings before Tax	475000	155000
Tax @ 28%	-133000	-43400
Earnings after Tax	342000	111600
Depreciation	125000	125000
Operating Cash Flows	467000	236600

(c)

Terminal Cash Flow
Particulars	Westfield Parramatta	Sunshine Marketplace
Initial Investment Outlay	715000	715000
Value after 5 years	0	0
Expected value after 5 years	18000	20000
Capital gain	18000	20000
Tax on Capital gain @ 25%	-4500	-5000
Terminal Cash Flow	13500	15000

(d)

Calculation of NPV for Westfield Parramatta
Years	Cash inflows	Discounting Factor @ 15%	Present Value
1st to 5th Years	467000	3.352	1565384
Reversal of Working Capital	90000	0.497	44745.91
Terminal Cash Inflow	13500	0.497	6711.89
Present Value of Cash Inflow			1616841.8
Initial Investment Outlay			-715000
Net Present Value			901841.8

Calculation of NPV for Sunshine Marketplace
Years	Cash inflows	Discounting Factor @ 15%	Present Value
1st to 5th Years	236600	3.352	793083.2
Reversal of Working Capital	90000	0.497	44745.91
Terminal Cash Inflow	15000	0.497	7457.65
Present Value of Cash Inflow			845286.76
Initial Investment Outlay			-715000
Net Present Value			130286.76

The Coffee Club can open its franchise in both location as both NPV is positive.