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.
2. Estimate the total cash flows for this opportunity. Explain your estimates in your report.
3. Estimate the opportunity’s NPV. Explain how you arrived at your NPV estimates in the report.
4. Consider what happens to cash flows and NPV if Sales are 20% more than expected. What if sales are 20% less than expected? Discuss this analysis in your report.
5. What is your recommendation? Should you and your partners pursue this opportunity? Explain your recommendation and provide your rationale.

Answer 1

Data as mentioned in Question

Start Up Costs : - $400000

Real Estate Costs :- $300000

Total UpFront Costs :- $700000

Depreciation :- $420000

Estimated Sales in Ist Year :- $ 200000

Estimated Sales in IInd Year :- $240000

Estimated Sales in IIIrd Year :- $230000

Estimated Sales in IVth Year :- $220000

Estimated Sales in Vth Year :- $220000

Annual Fixed Operating Expenses :- $50000

Annual Variable Operating Expenses :- $120000 in Ist Year ( 60% of Sales in Ist Year )

:- $132000 in IInd Year ( 55% of Sales in IInd Year)

:- $115000 in IIIrd Year ( 50% of Sales in IIIrd Year )

:- $110000 in IVth Year (50% of Sales in IVth Year )

:- $110000 in Vth Year ( 50% of Sales in Vth Year )

Ist Year

Estimated Sales : - 200000

Less:- Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (120000)

Net Income :- 30000

Less : Taxes (20%) :- (6000)

Income After Taxes :- 24000

Rate of Return :- 12% , Net Amount :- $26880

IInd Year

Estimated Sales :- 240000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (132000)

Net Income :- 58000

Less : Taxes (20%) :- (11600)

Income after Taxes :- 46400

Rate of Return - 12% , Net Amount :- $51968

IIIrd Year

Estimated Sales :- 230000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (115000)

Net Income : 65000

Less : Taxes (20%) (13000)

Income after Taxes 52000

Rate of Return -12% , Net Amount :- $58240

IVth Year

Estimated Sales :- $220000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (110000)

Net Income :- 60000

Less : Taxes (20%) (12000)

Income After Taxes 48000

Rate of Return -12% , Net Amount - $53760

Vth Year

Estimated Sales :- $ 220000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (110000)

Net Income :- $60000

Less Taxes (20%)- (12000)

Income After Taxes $48000

Rate of Return -12% , Net Amount -$ 53760

If Sales are 20% more than expected :-

Ist Year :- Estimated Sales :- 240000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (120000)

Net Income :- 70000

Less : Taxes (20%) - (14000)

Income After Taxes :- 56000

Rate of Return :- 12% , Net Amount :- $62720

IInd Year

Estimated Sales :- $288000

Less : Fixed Operating Expenses :- $50000

Variable Operating Expenses -(132000)

Net Income :- $106000

Less (Tax ) 20% :- 21200

Income After Taxes : $84800

Rate of Return -12% , Net Amount :- $94976

IIIrd Year

Estimated Sales :-276000

Less :- Fixed Operating Costs :- (50000)

Variable Operating Costs :-(115000)

Net Income :- 111000

Less : Tax rate (20%) = 22200

Income After Taxes :- 88800  

Rate of return :-12% , Net Income :- $99456

IVth Year

Estimated Sales : 264000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (110000)

Net Income : - 104000

Less : Taxes (20%) - 20800

Income After Taxes :- 83200

Rate of Return 12% - Net Amount :- $93184

Vth Year

Estimated Sales :- 264000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (110000)

Net Income :- 104000

Less : Taxes (20%) :- 20800

Income After Taxes :- 83200

Rate of Return -12% , Net Amount - $93184

If Sales are 20% Less than expected :-

Ist Year

Estimated Sales :- 160000

Less:- Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (120000)

Net Income :- (10000)

Less:- Taxes 20% = (2000)

Income After Taxes = (12000) , Return nil as loss is there

IInd Year

Estimated Sales :- 192000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (132000)

Net Income :-10000

Less: Taxes (20%) - (2000)

Income After Tax Rate :- 8000

Required Rate of Return (12%) , Net Income - $8960

IIIrd Year

Estimated Sales :- 184000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (115000)

Net Income :- $19000

Less : Taxes (20%) - 3800

Income After taxes :- $15200

Rate of Return :- 12% , Net Income :- $17024

IVth Year

Estimated Sales :- 176000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (110000)

Net Income :- 16000

Less : Taxes (20%) (3200)

Income After Taxes :- 12800

Rate Of return - 12% , Net Amount -$14336

Vth Year

Estimated Sales :- 176000

Less : Fixed Operating Expenses :- (50000)

Variable Operating Expenses :- (110000)

Net Income :- 16000

Less Taxes (20%) - (3200)

Income After Taxes :- 12800

Rate Of Return -12% , $14336

After reviewing above calculation , it would be difficult for me and my Partner to Pursue this opportunity as because in Fourth and Fifth Year , Sales figures are not showing improvement in comparison to Year Ist , IInd , IIIrd .