Question
In: Accounting
1) At Bradford Bed and Breakfast, the manager is looking to expand the facility. The following...
1) At Bradford Bed and Breakfast, the manager is looking to expand the facility. The following facts are known:
Cost of the expansion $2,200,000
The Manager is paid $99,000 per year. Compensation will not change due to the expansion
Property taxes will increase by $33,000 annually
The expansion will add 10 rooms and it is expected all 10 will be occupied by paying guests
The addition of the 10 guests each day is expected to add $800,000 of revenue annually
A garden and patio that was built last summer at a cost of $75,000 will be removed to make way for the expansion.
Additional cost of staff based on 10 occupied rooms is $260,000 annually
Additional cost of supplies and food based on 10 occupied rooms $80,000 annually
All expenses are expected to increase 3% annually. Due to competition revenue is expected to increase only 2% annually.
The useful life of the expansion is 8 years. Bradford uses a 8% discount rate.
Based on this information determine the following:
a. After the building is expanded, what is the incremental fixed cost incurred annually as a result of the expansion?
b. What are the incremental variable expense incurred annually due to the expansion?
c. What are the sunk costs of the expansion, if any?
d. Create an 8 year proforma cash flow statement for the expansion project (assume there are no income taxes)
e. Calculate the projects NPV and IRR. Should the project be accepted or rejected?
Solutions
Expert Solution
| (A). Incremental Fixed Costs incurred annually as a result of the expansion | |||||||||||
| $ | |||||||||||
| Property Taxes | 33,000 | ||||||||||
| Total | 33,000 | ||||||||||
| (B). Incremental Variable Costs incurred annually as a result of the expansion | |||||||||||
| $ | |||||||||||
| Additional cost of staff | 2,60,000 | ||||||||||
| Additional cost of supplies and food | 80,000 | ||||||||||
| Total | 3,40,000 | ||||||||||
| (C) Sunk costs of the Expansion | |||||||||||
| $ | |||||||||||
| Garden and patio | 75,000 | ||||||||||
| (D) Proforma Cash Flow Statement | |||||||||||
| Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | Remarks | |
| Particulars | $ | $ | $ | $ | $ | $ | $ | $ | $ | ||
| Cost of the Expansion | -22,00,000 | ||||||||||
| Revenue | 8,16,000 | 8,32,320 | 8,48,966 | 8,65,946 | 8,83,265 | 9,00,930 | 9,18,949 | 9,37,328 | Inflation at 2% from Year 1 | ||
| Expenses | |||||||||||
| Property Taxes | 33,000 | 33,000 | 33,000 | 33,000 | 33,000 | 33,000 | 33,000 | 33,000 | |||
| Additional cost of staff | 2,60,000 | 2,60,000 | 2,60,000 | 2,60,000 | 2,60,000 | 2,60,000 | 2,60,000 | 2,60,000 | |||
| Additional cost of supplies and food | 80,000 | 80,000 | 80,000 | 80,000 | 80,000 | 80,000 | 80,000 | 80,000 | |||
| Total of Expenses | 3,73,000 | 3,73,000 | 3,73,000 | 3,73,000 | 3,73,000 | 3,73,000 | 3,73,000 | 3,73,000 | |||
|
Total of Expenses (including the effect of inflation) |
3,84,190 | 3,95,716 | 4,07,587 | 4,19,815 | 4,32,409 | 4,45,382 | 4,58,743 | 4,72,505 | |||
| Profit | 4,31,810 | 4,36,604 | 4,41,379 | 4,46,131 | 4,50,855 | 4,55,548 | 4,60,206 | 4,64,822 | |||
| Discount Rate at 8% | 1 | 0.93 | 0.86 | 0.79 | 0.74 | 0.68 | 0.63 | 0.58 | 0.54 | ||
| Present value of Cash Flows | -22,00,000 | 3,99,824 | 3,74,318 | 3,50,381 | 3,27,920 | 3,06,845 | 2,87,073 | 2,68,526 | 2,51,129 | ||
| NPV at 8% | 3,66,014 | ||||||||||
| IRR | r1+(NPV1/(NPV1-NPV2))*(r2-r1) | ||||||||||
| where, | |||||||||||
| r1 | =lower discount rate chosen |
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expand the facility. The following facts are known:
Cost of the expansion $2,200,000
The Manager is paid $99,000 per year. Compensation will not
change due to the expansion
Property taxes will increase by $33,000 annually
The expansion will add 10 rooms and it is expected all 10 will
be occupied by paying guests
The addition of the 10 guests each day is expected to add
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