Question

Last year, you and two friends from college purchased a food truck for $70,000 hoping to make

it big selling breakfast tacos. Your tacos were a big hit, and an investor made an offer to buy

your business (truck, name, and all equipment) for $100,000 today (2020). Over the next 5 years,

you project annual revenue to be $50,000 with operating costs of $10,000. Escalation of revenue

and operating costs are expected to be a washout. The MACRS depreciation class of the truck is

5-year property. Perform a DCFROR analysis assuming that the food truck cost is both a) sunk

and b) not sunk. The tax rate is 21%, and the after-tax hurdle rate is 15%. Should you and your

friends sell or develop your business?

Answer 1

The DCFROR is given below:

	Truck
a	Initial cost	70000
b	Tax rate	21%
c	After-tax hurdle rate	15%
	CASE 1: Truck is not sunk cost
	Year	2020	2021	2022	2023	2024	2025
d	Revenue		50000
e	Op costs		-10000
f	Operating Profit (d-e)		40000	40000	40000	40000	40000
g	Depreciation rate (MACRS)	20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
h	Depreciation amount (g*a)	-14000	-22400	-13440	-8064	-8064	-4032
i	Earnings before tax (f-g)		17600	26560	31936	31936	35968
j	Tax @21% (b*i)		3696	5577.6	6706.56	6706.56	7553.28
k	Profit after tax (i-j)		13904	20982	25229	25229	28415
l	Present value of CF (k/((1+c)^(year -2020))		12090	15866	16589	14425	14127
	Total present value	73097
	CASE 2: Truck is sunk cost
	Year	2020	2021	2022	2023	2024	2025
d	Revenue		50000
e	Op costs		-10000
f	Operating Profit (d-e)		40000	40000	40000	40000	40000
h	Depreciation amount (g*a)	0	0	0	0	0	0
i	Earnings before tax (f-g)		40000	40000	40000	40000	40000
j	Tax @21% (b*i)		8400	8400	8400	8400	8400
k	Profit after tax (i-j)		31600	31600	31600	31600	31600
l	Present value of CF (k/((1+c)^(year -2020))		27478	23894	20778	18067	15711
	Total present value	105928

Explanations:

1. since Escalation of revenue and operating costs are expected to be a washout, the net operating profit will remain the same.

2. The depreciation rate schedule for a 5-year MACRS property is given under case 1. Note that it takes 6 years for 100% depreciation.

3. Under case 2, there is no depreciation expense as initial cost of truck is assumed to be a sunk cost.

Conclusion:

a. sunk: as per the DCFROR analysis in case 2, the total present value is more than 100,000. So the friends should not sell the truck and instead develop it.

b. not sunk: as per the DCFROR analysis in case 1, the total present value is much less than 100,000. So the friends should sell the truck and pocket the difference as profit (100,000 - 73097 = 26093).