Question

You and your business partners are considering applying for a franchise. If approved, you expect startup costs to be $400,000 plus $300,000 in real estate costs. Of this $700,000 in upfront costs, you will be allowed to depreciate $420,000 on a five-year MACRS schedule. The remaining $280,000 is not depreciable but should be included in the book value of the fixed assets associated with the franchise when it is sold. Your plan is to start and operate the business for 5 years at which time you expect to sell the business for $1,000,000. You expect to initially have working capital needs of $30,000, but these needs will grow proportionately with sales. You expect sales in the first year to be $200,000 and that sales will grow by 20% in the second year, 15% in the third year, and then 10% in the fourth and fifth years. You project annual fixed operating expenses of $50,000. Your annual variable operating expenses are expected to be 60% of sales in the first year. With improvements in efficiency and experience, you expect variable operating expenses to be 55% of sales in the second year, 50% of sales in the third, fourth and fifth years. You expect to pay taxes of 20%. Assume your required return is 12%. Should you apply for a Guthrie’s Franchise? Prepare a report responding to the following prompts:

1. Estimate the total cash flows for this opportunity. Explain your estimates in your report.

Answer 1

Operating cash flow (FCF) each year = income after tax + depreciation - change in working capital

In year 5, the entire working capital investment is recovered, and hence the change in working capital is negative

profit on sale of fixed assets at end of year 5 = salvage value - book value

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value - tax on profit on sale of fixed assets

NPV is calculated using NPV function in Excel

NPV is $49,195

Yes, you should apply for the franchise as the NPV is positive