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. Prepare pro forma income statements and operating cash flow projections. Explain your pro forma statements in your report.

Answer 1

Particulars	t0	Year1	Year2	year3	yrar4	Year5
Initial outflow	(450000)	-	-	-	-	-
Sales		200000	240000	276000	303600	333960
-variable cost		120000 (60%)	132000 (55%)	138000 (50%)	151800 (50%)	166980 (50%)
-fixed cost		50000	50000	50000	50000	50000
-Depreciation		84000	84000	84000	84000	84000
-working capital		30000	36000	41400	45540	50094
Net cash flow before tax		(84000)	(62000)	(37400)	(27740)	(17114)
Tax @ 20%		0	0	0	0	0
Net cash flow after tax		(84000)	(62000)	(37400)	(27740)	(17114)
Cash flow after Depreciation added back+Working cpl		0	24000	46600	56260	(66886+233034) 299920
DF @12	0.0	.893	.797	..712	.636	.567
Discouted cashflow	(450000)	0	19128	33179	35781	170055

NPV = 258143-450000 =(191857)

Conclusion : Since NPv is negative it is better to reject the proposal

Working notes :

1.Depreciation =420000/5yr=84000

2.working capital at the end=30000+30000+36000+41400+45540+50094=233034