Question

You are the analyst for a Pistol Pete’s Pizza Palace, a restaurant that is thinking of expanding their business to include catering for at least the next three years. To take on this project, the restaurant would need to purchase a van to transport food to customer locations. The price of the van is $42,000, and there would be a customization expense of $10,000 to modify the van for this special use. The vehicle would be depreciated using the 3-year MACRS schedule (33%, 45%, 15%, and 7%) and be sold at the end of 3 years for $5,500. This project would increase sales by $25,000 annually and increase food costs by $5,000. There would also be an increase in net operating working capital of $2,500. The restaurant’s current tax rate is 21%, and their WACC is 10%.

Based on the Capital Budgeting Techniques we’re learning about in class, should the restaurant expand their business to include catering services? Why or why not? Once you have calculated the cash flows for this project, you will also need to calculate the project’s payback period, discounted payback period, NPV, IRR and MIRR.

Now assume the restaurant's WACC falls to 7.5% and calculate the NPV, IRR, MIRR, payback period and discounted payback period. Would this change your recommendation? Why or why not?

Answer 1

All financials below are in $.

Total capital expenditure (depreciable basis) = 42,000 + 10,000 = 52,000

After 3 years, tax basis = undepreciated cost = 52,000 x 7% = 3,640

Sale value after 3 years = 5,500

Gain on sale = 5,500 - 3,640 = 1,860

Tax rate, T = 21%

Tax on gain = T x Gain on sale = 21% x 1,860 = 390.60

Post tax salvage value = Sale value - tax = 5,500 - 390.60 = 5,109.40

Please see the table below. The answers are in yellow colored cell. The adjacent cells in blue color shows the formula used in excel to get the results.

When WACC changes to 7.5%, entire calculations are shown below.

Yes if WACC drops to 7.5%, discounted payback period and NPV do change in values. Since it has now become NPV positive project, our recommendation will change. Earlier it was NPV negative project, hence the firm should not take it. Now, since it's NPV positive, the firm should take this project.