Question

You and your business partners are considering applying for a franchise. If approved, you expect startup costs to be $400,000 plus $300,000 in real estate costs. Of this $700,000 in upfront costs, you will be allowed to depreciate $420,000 on a five-year MACRS schedule. The remaining $280,000 is not depreciable but should be included in the book value of the fixed assets associated with the franchise when it is sold. Your plan is to start and operate the business for 5 years at which time you expect to sell the business for $1,000,000. You expect to initially have working capital needs of $30,000, but these needs will grow proportionately with sales. You expect sales in the first year to be $200,000 and that sales will grow by 20% in the second year, 15% in the third year, and then 10% in the fourth and fifth years. You project annual fixed operating expenses of $50,000. Your annual variable operating expenses are expected to be 60% of sales in the first year. With improvements in efficiency and experience, you expect variable operating expenses to be 55% of sales in the second year, 50% of sales in the third, fourth and fifth years. You expect to pay taxes of 20%. Assume your required return is 12%.

4. Consider what happens to cash flows and NPV if Sales are 20% more than expected. What if sales are 20% less than expected? Discuss this analysis in your report.

Answer 1

Net Present Value helps in determing the feasability of the project and whether the company will earn profit from the same. For accurate results, the future cash flows are brought to their present value, so as to arrive at the current value of the project.

NPV = PV of Inflow - Initial Investment + Salvage

Year	Start Up and Real Estate costs	Sales	Variable Operating Costs	Fixed Operating Costs	Working Capital	Depreciation	Salvage	Net Inflow Before Tax	Net Inflow After Tax^^	DCF @ 12%	NPV
0	7,00,000.00	-	-	-	-		-	-7,00,000.00	-5,60,000.00	1.00	-5,60,000.00
1	-	2,00,000.00	1,20,000.00	50,000.00	30,000.00	84,000.00	-	-84,000.00	16,800.00	0.89	15,000.00
2	-	2,40,000.00	1,32,000.00	50,000.00	36,000.00	84,000.00	-	-62,000.00	34,400.00	0.80	27,423.47
3	-	2,76,000.00	1,38,000.00	50,000.00	41,400.00	84,000.00	-	-37,400.00	54,080.00	0.71	38,493.08
4	-	3,03,600.00	1,51,800.00	50,000.00	45,540.00	84,000.00	-	-27,740.00	61,808.00	0.64	39,280.10
5	-	3,33,960.00	1,66,980.00	50,000.00	50,094.00	84,000.00	12,80,000.00	12,62,886.00	10,94,308.80	0.57	6,20,940.20
											1,81,136.85

NPV of the project is positive i.e. $ 1,20,576.61 making it a profitable and feasible project. Company should opt in.

**Salvage includes business value and the non-depreciable part of the investment.

^^ Depreciation is added back after deducting tax, so as to claim tax benefit of the same.

In Case where Sales are 20% more

New Sales in the 1st Year = $ 240,000

Year	Start Up and Real Estate costs	Sales	Variable Operating Costs	Fixed Operating Costs	Working Capital	Depreciation	Salvage	Net Inflow Before Tax	Net Inflow After Tax	DCF @ 12%	NPV
0	7,00,000.00	-	-	-	-		-	-7,00,000.00	-5,60,000.00	1.00	-5,60,000.00
1	-	2,40,000.00	1,44,000.00	50,000.00	30,000.00	84,000.00	-	-68,000.00	29,600.00	0.89	26,428.57
2	-	2,88,000.00	1,58,400.00	50,000.00	36,000.00	84,000.00	-	-40,400.00	51,680.00	0.80	41,198.98
3	-	3,31,200.00	1,65,600.00	50,000.00	41,400.00	84,000.00	-	-9,800.00	76,160.00	0.71	54,209.18
4	-	3,64,320.00	1,82,160.00	50,000.00	45,540.00	84,000.00	-	2,620.00	86,096.00	0.64	54,715.56
5	-	4,00,752.00	2,00,376.00	50,000.00	50,094.00	84,000.00	12,80,000.00	12,96,282.00	11,21,025.60	0.57	6,36,100.03
											2,52,652.33

Old NPV = $ 1,20,576,61

New NPV = $ 2,52,652.33

% Change in NPV = ($ 2,52,652.33 - $ 1,20,576.61) / $ 1,20,576,61

= 109.54 %

20% increase in the Sales lead to a drastic increase in the NPV, signifying that the NPV is highly sensitive to an upward change in the Sales Value.

In Case where Sales are 20% less.

New Sales in the 1st Year = $ 160,000

Year	Start Up and Real Estate costs	Sales	Variable Operating Costs	Fixed Operating Costs	Working Capital	Depreciation	Salvage	Net Inflow Before Tax	Net Inflow After Tax	DCF @ 12%	NPV
0	7,00,000.00	-	-	-	-		-	-7,00,000.00	-5,60,000.00	1.00	-5,60,000.00
1	-	1,60,000.00	96,000.00	50,000.00	30,000.00	84,000.00	-	-1,00,000.00	4,000.00	0.89	3,571.43
2	-	1,92,000.00	1,05,600.00	50,000.00	36,000.00	84,000.00	-	-83,600.00	17,120.00	0.80	13,647.96
3	-	2,20,800.00	1,10,400.00	50,000.00	41,400.00	84,000.00	-	-65,000.00	32,000.00	0.71	22,776.97
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