Question

You are considering starting a small coffee shop in australia. 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 East (to be called East Café). The setup costs are estimated to be $50,000 for City Café and $45,000 for East 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 east Café, respectively. The annual growth in net cash flows is estimated to be 3% for City Café and 2% for east 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 East 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 10^th 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 East cafe. Your estimated cost of capital is 9.5%.

  Using the above information, conduct an NPV analysis for each option.

NPV for City Café:

NPV for East Café:

Answer 1

Calculation of dep. Of the Cafe :- (Cafe cost - Salvage value)/no. Of year)

Central Cafe : ($50000-$10000)/10years

. : $4000 p.a.

East Cafe. : ($45000-$7000)/10 years

. : $3800 p.a.

Calculation of net cash inflow after tax and depreciation of Central cafe

Particular	Y1	Y2	Y3	Y4	Y5	Y6	Y7	Y8	Y9	Y10
Cash flow after tax	$8000	$8240	$8487	$8742	$9004	$9544	$10117	$10724	$11367	$12050
Depreciation	$4000	$4000	$4000	$4000	$4000	$4000	$4000	$4000	$4000	$4000
Salvage value										$10000
Cash flow after tax & dep.	$12000	$12240	$12487	$12742	$13004	$13544	$14117	$14724	$15367	$26050

Calculation of net cash inflow after tax and depreciation of East cafe

Particular	Y1	Y2	Y3	Y4	Y5	Y6	Y7	Y8	Y9	Y10
Cash flow after tax	$6800	$6936	$7075	$7216	$7360	$7728	$8115	$8521	$8947	$9394
Depreciation	$3800	$3800	$3800	$3800	$3800	$3800	$3800	$3800	$3800	$3800
Salvage										$7000
Cash flow after tax & dep	$10600	$10736	$10875	$11016	$11160	$11528	$11915	$12321	$12747	$20194

Calculation of net present value of central and east cafe

Years	Cash inflow (central) ($)	Cash inflow (east) ($)	D.f. @9.5%	P.V. of cash inflow (central) ($)	P.V. of cash inflow (East) ($)
1	12000	10600	0.913	10956	9678
2	12240	10736	0.834	10208	8954
3	12487	10875	0.762	9515	8287
4	12742	11016	0.695	8856	7656
5	13004	11160	0.635	8258	7086
6	13544	11528	0.580	7855	6686
7	14117	11915	0.530	7482	6315
8	14724	12321	0.484	7126	5963
9	15367	12747	0.442	6792	5634
10	26050	20194	0.403	10498	8138
TOTAL				87546	74397
Initial investment				(50000)	(45000)
NPV				37546	29397

Conclusion: According to the NPV approach Investor should invest in central cafe I.e. City Cafe...