Question

Hi! I am in an intro level Finance course and I am stuck on this problem. Any help would be greatly appreciated.

I am deciding on opening a restaurant. I was able to scrape together some capital from friends and family, but I must pay them back in 4 years at 12% per annum. I figure that it will cost me $165,000 to start up with rent, deposits, equipment, salaries, chicken, basil, rice, etc. for the first year, but I expect to make gross revenue of $63,120, $70,800, and $91,080 in the following 3 years and net income of $13,620, $3,300 and $29,100 in those 3 years. Should I do it?

The bank says it can give me a loan for up to $165,000 at an interest rate of 12% as long as I pay it back at in 4 years. Should I do it? How much should I borrow, or should I not borrow at all?

This is all part of one question, but if this counts as more than one question I would love it if I can get help with at least the first part of the question. Thank you!

Answer 1

The question has very limited information. Therefore, some assumptions have been made as follows:

1) Annual net income is taken as annual cash flow for each year. The total value of $165,000 is taken as the cash outflow for for first year. Cash outflow will be reported with a minus sign.

2) Interest rate is taken as the discount rate.

3) The final decision has been taken with the use of NPV method.

4) The answer may differ on the basis of assumptions used.

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NPV (Net Present Value) if the difference between the present value of cash inflows and cash outflows. NPV can be calculated with the use of following formula:

NPV = Cash Flow Year 1/(1+Interest Rate)^1 + Cash Flow Year 2/(1+Interest Rate)^2 + Cash Flow Year 3/(1+Interest Rate)^3 + Cash Flow Year 4/(1+Interest Rate)^4

Substituting values in the above formula:

NPV = -165,000/(1+12%)^1 + 13,620/(1+12%)^2 + 3,300/(1+12%)^3 + 29,100/(1+12%)^4 = -$115,621.20

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Decision:

As, the NPV is negative, you shouldn't undertake the project (open the restaurant) at all. Therefore, the question of borrowing will not arise in the given case. In other words, the restaurant will not be a profitable venture as it results in cash inflows which when discounted at the given interest rate are not sufficient to cover the amout of loan borrowed. You will not be able to pay for the loan with the amount of cash inflows generated by the restaurant after a period of 4 years.