Question

Italian Valley Restaurant

Having assessed the changing dietary needs of your town, you are considering investing in a new Italian

restaurant which you plan to name Italian Valley. The restaurant will feature live musicians, appetizers,

and a stocked bar. You are trying to assess the likely profitability of this business venture. As a new

graduate of the UWI your first step is to prepare a complete capital budgeting analysis for the 5 years you

plan to operate the restaurant before you sell it.

Having spoken with local vendors, other restaurant owners, bankers, and builders you collected the

following data and information about the proposal.

You plan to use a building currently owned by your family, however there will be need for some renovation

and improvements to the property. Your parents have said that you can use the retail space in any way

you wish for free. After checking on local lease rates you determine this space would lease for $75,500

per year. Your family also owns another restaurant downtown. You predict that your new one will

decrease its revenues by $15,000 per year. Your parents tell you that this sum will be taken from your

annual family stipend.

Some of the major improvements to the property include the purchase of cooking equipment, building a

stage, seating, and interior décor. The construction is estimated to cost $1.75 million. An additional

$375,000 will be spent on chairs, tables, bar equipment, and decorations. Depreciation will be over 7

years using MACRS*. You determine that you will require an average cash balance of $15,000 and

inventory of $20,000. Accounts payable should average $10,000. Your local bank has agreed to loan you

monies to pay for these expenses at a 15% interest rate.

You plan to hire a research consultant to conduct a market study, since you believe your chances of

success will increase with greater information about the restaurant market. The charge for this report

will be $200,000.

Revenues are estimated to be $600,000 the first year. Revenues are expected to increase by 20% the

second year, 15% the third year, and continue increasing at 8% thereafter. Fixed annual operating costs

are estimated to be as follows.

Employee salaries = $110,000;

Heat, electricity, water, and janitorial services =$75,000.

The food and liquor bill is expected to be 15% of revenues. Total taxes are estimated to be 40% of net

revenues.

Your plan is to run the bar for 5 years, then to sell it to an investor for $2,000,000.

Required:

1. Prepare a cash flow analysis which includes:

a. the initial investment, ( 5 points)

b. the annual net cash flows, and (46 points)

c. the terminal cash flow. (7 points)

2. What is the Net Present Value (NPV) and Internal Rate of Return (IRR) of this venture? (5 points)

3. Should you invest in this venture and why? (2 points)

(TOTAL 65 POINTS)

Clearly SHOW ALL WORKING in a table format in either Microsoft Excel or Word. Ensure that your table

shows all relevant cash flows such as initial investment flows, Revenue, Expenditure, Depreciation,

Taxes, terminal year cash flows from year 0 to end of project life.

*MACRS Depreciation Table

MACRS Depreciation Table

year	3yr	5yr	7yr	10yr
1	33.0	20.0	14.0	10.0
2	45.0	32.0	25.0	18.0
3	15.0	19.0	17.0	14.0
4	7.0	12.0	13.0	12.0
5		12.0	9.0	9.0
6		5.0	9.0	7.0
7			9.0	7.0
8			4.0	7.0
9				7.0
10				6.0
11				3.0

Individual Assignment Rubric

1. Prepare a cash flow analysis which includes:

a. the initial investment, (includes purchase price 2 points; NWC 2 points; total costs 1

point) ( 5 points)

b. the annual net cash flows, (includes Revenues 5 points; Breakdown of all expenses 6

points; total operating expenses 5 points; depreciation 5 points; Earnings Before Taxes 5

points; Taxes 5 points; Earnings After Taxes 5 points; Depreciation Add back 5 points)

(46 points)

c. the terminal cash flows (include taxes on sale 5 points, NWC 1 point, Terminal Sale 1

point) (7 points)

2. Correct Calculation of Net Present Value (NPV) (3 points) ; Correct Calculation of Internal Rate of

Return (IRR) (2 points) (5 points)

3. Correct decision to invest in this venture and why?

Answer 1

Particulars	Amt.
Initial Investment
Construction Cost	17,50,000
Additional Equipments	3,75,000

Charge for market study is a sunk cost with no significance to the capital budgeting.
Since, expected return of the investor is not mentioned then it is assumed that 15% is the expected return of the investor.

Cash Flow Analysis

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Revenue	6,00,000	7,20,000	8,28,000	8,94,240	9,65,779
Less: Fixed Operating Expenses
Employee Cost	1,10,000	1,10,000	1,10,000	1,10,000	1,10,000
Heat, Electricity , Water	75000	75000	75000	75000	75000
Food & Liquor@ 15%	90,000	1,08,000	1,24,200	1,34,136	1,44,867
Opportunity Cost of Own building	75500	75500	75500	75500	75500
Decrease in revenue	15000	15000	15000	15000	15000
Profit Before Interest and Depreciation	2,34,500	3,36,500	4,28,300	4,84,604	5,45,412
Less: Depeciation	297500	456875	283581.3	239384.4	169705.4
Less: Interest on Loan ( 45000*15%)	6750	6750	6750	6750	6750
Net Revenue	(69,750)	(1,27,125)	1,37,969	2,38,470	3,68,957
Less: Tax @ 40%	27,900	50,850	(55,188)	(95,388)	(1,47,583)
Set Off Deferred Tax Liability Paid before against loss	-	-	55,188	23,562	-
Profit After Tax	(41,850)	(76,275)	-	3,57,419	2,21,374
Add: Depreciation	297500	456875	283581.25	239384.4375	169705.4006
Cash Flow Attributable to Equity Holders	2,55,650	3,80,600	2,83,581	5,96,804	3,91,080
PVF @15%	0.8696	0.7561	0.6575	0.5718	0.4972
PV of Cash Flows	2,22,304	2,87,788	1,86,459	3,41,225	1,94,436
Sum of PV of 5 years					12,32,212
PV of 20,00,000 expected 5 years later					9,94,353
Terminal Cash Flow					22,26,566

Depreciation Schedule

		14%	25%	17%	13%	9%
Particulars	Cost	Year 1	Year 2	Year 3	Year 4	Year 5
Construction Cost	17,50,000	245000	376250	233537.50	197140.13	139757.39
Additional Equipments	3,75,000	52500	80625	50043.75	42244.31	29948.01

It is an investable Project.