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Question Three: Capital Budgeting You are considering starting a small coffee shop in Auckland. After some...
Question Three: Capital Budgeting
You are considering starting a small coffee shop in Auckland. After some market research and analysis, you have come up with two potential locations, one in the Central City (to be named as City Café) and the other one in Ellerslie (to be called Ellerslie Café). The setup costs are estimated to be $50,000 for City Café and $45,000 for Ellerslie Café. Given your budget constraint, you can only choose one of these options.
You have learned that small businesses would generally struggle during the first few years of operations. You took an optimistic forecasting approach and estimated that the first year after-tax net cash flows would be $8,000 and $6,800 for City Café and Ellerslie Café, respectively. The annual growth in net cash flows is estimated to be 3% for City Café and 2% for Ellerslie Café for the first 5 years (years 2 to 5) and then based on the end of year 5 cash flows, the growth in cash flows will increase to 6% for City Café and 5% for Ellerslie Café from years 6 to 10 as you improve your customer service and gain more loyal customers.
You are optimistic that you will be running the business for at least 10 years. At the end of the 10th year, if you were to end the business, you estimated the salvage values (after depreciation) to be $10,000 for City Café and $7000 for EllerslieCafé. Your estimated cost of capital is 9.5%.
a) Using the above information, conduct an NPV analysis for each option.
NPV for City Café: Central Cafe :
NPV for Ellerslie Café:
a) Based on your NPV results, which option shall you adopt to start your small business?
Option to be adopted: City cafe
Explanation:
b) Before you make your final decision, what financial analysis can be performed for a more in-depth or comprehensive capital budgeting analysis? Why would that be useful? Use an example to clearly illustrate your point.
[Word limit: 80 words; answers beyond the word limit will not be marked.]
i. Further financial analysis to perform: [Type here]
ii. Explanation using an example: [Type here]
Solutions
Expert Solution
a) Find the Net Present Value (NPV) of both the options.
To find out the NPV, Annual Free Cash Flows to be determined. The below table shows the Annual Free cash flow for both the options.
| Cash Flow for City Café | |||||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Cash from Operation after tax - A | $ 8,000 | $ 8,240 | $ 8,487 | $ 8,742 | $ 9,004 | $ 9,544 | $ 10,117 | $ 10,724 | $ 11,367 | $ 12,049 | |
| Investment cost -B | $ (50,000) | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
| Salvage value - C | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | $ 10,000 |
| Free cash flow - A+B+C | $ (50,000) | $ 8,000 | $ 8,240 | $ 8,487 | $ 8,742 | $ 9,004 | $ 9,544 | $ 10,117 | $ 10,724 | $ 11,367 | $ 22,049 |
Note:
i) For Year 2 - 5, cash flow will be Previous year cash flow*1.03 (since 3% YoY Growth) and from Year 5 - 10, it will be previous year cash flow*1.06 (6% YoY growth).
ii) No tax outflow considered for the Salvage value.
| Cash Flow for Ellerslie Café | |||||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Cash from Operation after tax - A | 0 | $ 6,800 | $ 6,936 | $ 7,075 | $ 7,216 | $ 7,361 | $ 7,729 | $ 8,115 | $ 8,521 | $ 8,947 | $ 9,394 |
| Investment cost -B | $ (45,000) | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
| Salvage value - C | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | $ 7,000 |
| Free cash flow - A+B+C | $ (45,000) | $ 6,800 | $ 6,936 | $ 7,075 | $ 7,216 | $ 7,361 | $ 7,729 | $ 8,115 | $ 8,521 | $ 8,947 | $ 16,394 |
Note:
i) For Year 2 - 5, cash flow will be Previous year cash flow*1.02 (since 2% YoY Growth) and from Year 5 - 10, it will be previous year cash flow*1.05 (5% YoY growth).
ii) No tax outflow considered for the Salvage value.
Once, the Free cash flow is determined, NPV can be found out using the Discounting factor. The below table shows the NPV under both the options.
| Net Present Value for City Café | |||
| Year | Cash flow - A | DF @ 9.5% - B | PV - AxB |
| 0 | $ (50,000) | 1 | $ (50,000) |
| 1 | $ 8,000 | 0.913 | $ 7,306 |
| 2 | $ 8,240 | 0.834 | $ 6,872 |
| 3 | $ 8,487 | 0.762 | $ 6,464 |
| 4 | $ 8,742 | 0.696 | $ 6,081 |
| 5 | $ 9,004 | 0.635 | $ 5,720 |
| 6 | $ 9,544 | 0.580 | $ 5,537 |
| 7 | $ 10,117 | 0.530 | $ 5,360 |
| 8 | $ 10,724 | 0.484 | $ 5,189 |
| 9 | $ 11,367 | 0.442 | $ 5,023 |
| 10 | $ 22,049 | 0.404 | $ 8,897 |
| NPV (Sum) | $ 12,448 |
| NPV for Ellerslie Café | |||
| Year | Cash flow - A | DF @ 9.5% - B | PV - AxB |
| 0 | $ (45,000) | 1 | $ (45,000) |
| 1 | $ 6,800 | 0.913 | $ 6,210 |
| 2 | $ 6,936 | 0.834 | $ 5,785 |
| 3 | $ 7,075 | 0.762 | $ 5,388 |
| 4 | $ 7,216 | 0.696 | $ 5,019 |
| 5 | $ 7,361 | 0.635 | $ 4,676 |
| 6 | $ 7,729 | 0.580 | $ 4,483 |
| 7 | $ 8,115 | 0.530 | $ 4,299 |
| 8 | $ 8,521 | 0.484 | $ 4,123 |
| 9 | $ 8,947 | 0.442 | $ 3,953 |
| 10 | $ 16,394 | 0.404 | $ 6,615 |
| NPV (Sum) | $ 5,552 |
| Discounting factor = 1/(1+i)^n |
| i = Discounting rate (in this case 9.5%) |
| n = Period (in thi case 1 to 10). |
Conclusion - Since NPV is grater for City Café, it is advisiable to proceed with City Café.
b) What indepth financial analysis
i) Further indepth Financial analysis to be performed includes finding out the correct Free cash flow available from the project. One of the important element is depreciation. Though it is a non-cash item, the taxation benefit available because of depreciation should be considered. Another missing information is on the working capital. Generally, in any new investment or project or expansion, there is a certain element of Working capital that is also required to be invested and this can be recouped in the last year.
ii) Examples - For examaple, assuming the given cash flow of City Cafe is before tax, after taking the depreciation impact the following would be the cash flow of City Cafe.
| Cash Flow for City Café | |||||||||||
| Year | 0 | 1 | 2 | 3 |
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