Question

Michael is planning to set up a new “buy now pay later” business given its popularity in Australia. The aim of the business is to provide credit-line and easy repayments to its customers when purchasing goods and services. Michael had carried out his own research which cost him $12,000 and managed to finalize the following information.

· The total set-up cost is $150,000 which includes the $120,000 purchase of several powerful computers. The remaining amount goes to pay for special software and subscriptions.

· For tax purposes, all the computers are required to be fully depreciated straight-line over the next five years.

· Michael intends to exit the business at the end of year 4. At that time, Michael expect to sell the computers for $25,000.

· Rent, electricity, advertising, wages, and other expenses are $33,000 a year.

· A working capital investment of $15,000 is required immediately to undertake the business. The working capital will be recovered at the end of the business.

· Also, Michael will have to give up his current job as a junior analyst at Macquarie, which pays $75,000 per year.

· The revenue will come from charging retailers that opt for the services. Michael estimates that the annual number of retailers will be constant at 500 for the next four years with the average monthly gross profit of $30 per retailer.

· The business is in the 30% tax bracket, and has a cost of capital of 13% per annum.

A. What are the annual Free Cash Flows for the business?

B. What is the NPV of this project? Should Michael give up his job and invest in this business?

Answer 1

ANSWER

Assuming Computers will be depreciated to zero in 5

years and Softwares and Subscriptions will be

amortized over 4 years on SL basis

Depreciation a/amortization details	Computers	Software & Subscription	Total
Acquisition Cost	120,000	30,000
Useful life for Depreciation	5	4
Annual Depreciation /Amortization	24,000	7,500	31,500
Tax Rate =30%
Annual Depreciation /Amortization Tax Savings =31500*30%=			9,450

Book Value of Computers after year 4=(120000-24000*4)=	24,000
Resale value of Computers after year 4	25,000
Capital Gain on sale	1,000
Tax on Capital Gain @30%	300
After Tax Resale Value=25000-300=	24,700
Annual Gross profit per retailer =12*30=	360
Annual no of Retailers	500
Total Annual Gross profit =500*360=	180,000
Rent,Electricty, Advertising, Wages per year	33,000
Net Operating Income before Tax(w/o depreciation)	147,000
After Tax Operating Income (w/o depreciation )=147000*(1-30%)	102,900
Discount rate for project =	13%

	Cash Flow and NPV Calculation:
	Year	Year 0	Year 1	Year 2	Year 3	Year 4
	Initial Investment:
	Capital Investment (Computers , softwares, Subscription)	(150,000)
	Additional Working Capital Investment	(15,000)
a	Net Initial Investment	(165,000)
	Operating Cash flow :
	Net Annual Operating Income After Tax(w/o depreciation)		102,900	102,900	102,900	102,900
	Add: Depreciation Tax savings		9,450	9,450	9,450	9,450
	Opportunity cost of giving up current job		(75,000)	(75,000)	(75,000)	(75,000)
b	Total Operating Cash flow		37,350	37,350	37,350	37,350
	Terminal Cash flow
	After Tax Resale value of computer					24,700
	Return of Net Working Capital					15,000
c	Total Terminal Cash flow					39,700
d	Total Free Cash flow from Project =a+b+c	(165,000)	37,350	37,350	37,350	77,050	Ans A.
e	PV Factor @13% =1/1.13^n=	1	0.8850	0.7831	0.6931	0.6133
f	PV of FCF =d*e=	(165,000)	33,053	29,251	25,885	47,256
g	NPV =Sum of PV of Free Cash Flows=	(29,554.74)	Ans B.
	As the NPV of the project is negative, Michael should not give up his job and
	invest in this business.

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