Question

Case Problem:

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

Project Evaluation:	All Amts in Euro
Ans 1.
Sunk cost is a cost that is already incurred and is not relevant for decision making .
In this case John'travelling cost to New York is a sunk cost. It has already been incurred
and will not change whether we accept the project or reject it. Therefore it is irrelevant
for decision making and hence a sunk cost.
Ans 3.
Discount rate :
Risk free rate =2% pa
Risk premium for the project =6%
So the effective discount rate is 2%+6%=8%
Therefore, 8% discount rate should be used for the project.

Ans 2+4.
Investment in Fixed asset	200,000		Working capital Reqd in 2020
SL depreciation for 10 years @10% pa			Increase in AR	75,000
Book value after 4 years at 2023 end =200000*60%	120,000		Increase in Inventory	25,000
Salvage value of fixed assets at 2023 end	92,300		Less Increase in AP	(50,000)
Capital loss on sale of assets	27,700		Net Increase in Working Capital	50,000
Tax savings @25% on Capital loss	6,925		Additional working capital due to increased Inventory in 2022	10,000
Effective salvage value with tax saving =	99,225

	Cash flow and Inventory Calculation	Year 2019	Year 2020	Year 2021	Year 2022	Year 2023
	Initial Investment	(200,000)
	Investment in addition WC		(50,000)		(10,000)
a	Total Investment Outflow	(200,000)	(50,000)	-	(10,000)	-
	Cash flow from Operations
	Annual sales with 10% YOY increase		150,000	165,000	181,500	199,650
	Cost of sales(@60% of sales)		90,000	99,000	108,900	119,790
	Depreciation		20,000	20,000	20,000	20,000
	EBT		40,000	46,000	52,600	59,860
	Tax @25%		10,000	11,500	13,150	14,965
	PAT		30,000	34,500	39,450	44,895
	Add back depreciation		20,000	20,000	20,000	20,000
b	Total Cash flow from operations		50,000	54,500	59,450	64,895
	Terminal Cash flow
	Return of Working Capital					60,000
	Salvage value with Tax benefit					99,225
c	Total Terminal cash flow					159,225
d	Total Cash flow =a+b+c	(200,000)	-	54,500	49,450	224,120
e	PV discount factor @85 =1/1.08^n	1	0.9259	0.8573	0.7938	0.7350
f	PV of Cash flow =d*e=	(200,000)	-	46,723	39,253	164,728
	NPV = Sum of PV of cash flows=	50,704

As the NPV of the project is positive , John should accept the project.
Ans 5.
If the project is undertaken ,the project will return net postive cash flows over next 4 years, therefore the value of the company
would increase .