Question

Capital budgeting

The Calpine firm is evaluating the purchase of a Theatre, the Dome. The Theatre would cost Calpine $1 mil­lion and would be depreciated for tax purposes using straight-line over 20 years (that is, $50,000 per year). It is expected that the Theatre will increase Calpine revenues by $400,000 per year, but would also increase expenses by $200,000 per year. Calpine would be expected to increase its working capital by $20,000 to accommodate the increased investment in ticket accounts receivable. Calpine firm intends to sell the Theatre to the city after ten years for $600,000. The marginal tax rate for Calpine is 35%. For purposes of identifying the tim­ing of cash flows, consider the purchase to be made at the end of 2010, the first year of operations the year 2011, and the last year of operations the year 2020.

1. What are the cash flows related to the acquisition of the Theatre?
2. What are the cash flows related to the disposition of the Theatre?
3. Calculate the net cash flows for each year, 2010 through 2020.
4. If the cost of capital for this project is 10%, should Calpine invest in the new Theatre?
5. Draw an investment profile of the project. Over what range of cost of capital would this project be attractive? Over what range of cost of capital would this project be unattractive?

Answer 1

1) cash flows related to acquisition $10,20,000 outflow

initial year $1000,000 is spent towards acquiring the theatre

$ 20,000 is spent towards additional working capital required.

so total acquisition cost is $10,20,000

2)   cash flow related to disposal   $ 565,000 inflow

depreciation per annum is $ 50,000- already given ( since depreciated SLM for 20 years = 1000,000 / 20)

Book value at year end is arrived, which is 500,000. Salvage value is 600,000. giving a profit of 100,000. This will suffer tax at 35% = 35,000. Salvage value Net of tax = 600,000 -35,000   = $ 565,000

3) Revenue =400,000 and cost =200,000. operating profit =200,000. depreciation of 50,000 is reduced. tax at 35% is reduced to arrive at net income.   to this net income Depreciation is added to arrive at operating cash flows( since depreciation is a non cash item) . This gives a yearly cash flow of 147,500 for each year 2011 to 2020 as shown below. in 2010 in addition to this cash flow there will be salvage value net off tax which is an inflow as mentioned above.

4) for the above cash flows, NPV is computed at 10% discount rate, and IRR is computed

since the NPV is positive the theatre can be acquired.

Also IRR of 11.91% is above the cost of capital of 10%- heatre can be acquired.

excel formulas

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