Question

John Smith is looking to open an ice-cream parlor place in the neighborhood where he resides. He has been thinking about this project for a while. He has completed the technical, legal, and economic feasibility studies in order to decide properly. The economic study presented him with the following financial forecasts:

• The project will last 5 years.

• The price of an average creamery ice-cream cone should be $6 per unit. Under the current conditions, it is not expected that the price will change over the life of the project.

• The store is expected to sell 20,000 units the first year, with an annual growth of 5% in the units sold.

• The main variable costs are waffle cones, ice-cream, toppings, whipped cream, chocolate fudge, disposable cups, napkins and plastic spoons. The economic study has also found that the variable costs should be 40% of the sales revenues.

• The main fixed costs are rent ($10,000/year), utilities ($5,000/year), and gross salaries for two part-time employees ($10,000/year). In summary, it is expected that the fixed costs will be $25,000 per year. It is not expected that those fixed costs will change considerably over the life of the project.

• The initial investment has to finance the purchase of the refrigerators, freezers, furniture for customers (tables and chairs), the cash register, and some long-term kitchen tools. It is expected that the capital expenditures should cost $200,000.

• The project has to purchase its first batch of inventory (waffle cones, ice-cream, napkins, etc.) in order to begin selling ice-cream units as soon as the business starts to operate. At the moment of the inventory purchase (t=0), the creamery has not generated any income, because it is not in operation yet, but still it has to pay to its providers in the short-term. The required initial investment in inventory (change net operating working capital) is expected to be $20,000 and it will be fully financed with cash.

• The IRS has stated that the refrigerator and freezer and other long-term assets should be depreciated linearly in 5 years, that is, 20% each year.

• The corporate income tax rate is 40% of profits.

• The residual inventory at the year of closing the project should be sold at the same price of its purchase. Therefore, it does not generate taxable capital gains.

• The salvage value of the capital expenditures at the closing year is $100,000. That is, the market price at which the business can expect to receive for selling the refrigerator, the freezer and the furniture, at the moment of closing the project.

• The weighted average cost of capital (WACC) is 8%.

With this information, answer in the order given:

1. Carefully construct the stream of Free Cash Flows—the Free Cash Flow Table for the project. (40% of your grade).
2. Compute NPV and IRR of the project. Would you approve this project? Explain. (15% of your grade).
3. If you want a return of 12%, would you approve this project? Justify. (10% of your grade).
4. If you ask a bank for a loan (with interest) of $220,000 in order to pay for your initial investments, does it change the NPV and IRR of the project? Do be careful, this is a conceptual question. It does not require any computations. (10% of your grade).
5. If you own the facility where the creamery will be located, and you have the possibility to rent it for $25,000 a year instead of doing the business project. Would you still approve this project? Explain. (15% of your grade).
6. Let’s consider the stand-alone risk of the project (10% of your grade). Assume that you have three possible scenarios for sales. The worst scenario is that you have long recession and the units sold per year are 30% less than predicted. The best scenario is that to have a long economic boom and the units sold per year are 30% more than predicted. Finally, there is a base scenario in which the units sold are as predicted. The probability of having a recession is 25%. The probability of having an economic boom is 25% and the probability of having normal times (base scenario) is 50%.
   1. Compute the expected value of NPV, the standard deviation of NPV and the coefficient of variation of NPV.
   2. If you assume a 4% risk adjustment over the cost of capital (8%), do you still approve the project? Explain.

Answer 1