Question

You are considering taking a 3-year hiatus from school to open a cupcake business. You estimate the upfront capital expenditure will be $40,000 for equipment, which at the end of the 3-year project life will have a salvage value of $16,000. (Ignore terminal tax effects.) The CCA rate is 20%. You also estimate that you will need upfront Net Working Capital of $6,000 and that Net Working Capital needs thereafter will be 20% of Sales. (Assume recovery of NWC at conclusion of project.) In the first year of business, you expect to sell 15,000 cupcakes, and unit growth you expect to be 7%. You will price the cupcakes at $4.00 each and will keep this price constant over all three years despite inflation. Initially the cost to make each cupcake will be $1.50. Initial Fixed Costs are expected to be $10,000. Fixed Costs as well as Variable Costs will increase with inflation which is expected to be 3%. The Tax Rate is 25%, and your Cost of Capital is 9%. Financially, should you go ahead with your cupcake project and is the payback period within 3 years?

Answer 1

NPV Calculation of the cupcake project
Annual CCA deduction calculation
Year	WDV	CCA @20%
1	40,000	8,000
2	32,000	6,400
3	25,600	5,120
No Tax implication on salvage value being considered

Sales Related details
All Amt in $	Year 0	Year 1	Year 2	Year 3
Units of sales (with 7% growth)		15,000	16,050	17,174
Units sales Price		4	4	4
Sales Revenue Annual		60,000	64,200	68,694
Less variable cost/unit with 3% annual inflation		1.50	1.55	1.59
Annual Variable cost		22,500	24,797	27,329
Annual Fixed cost with 3% inflation		10,000	10,300	10,609
Depreciation /Year		8,000	6,400	5,120
EBT		19,500	22,703	25,636
Net working Capital per year	6000	12,000.0	12,840.0	13,738.8
Incremental NWC	6000	6,000.0	840.0	898.8

	NPV calculation	Year 0	Year 1	Year 2	Year 3
	Initial Investment
	Capital Expenditure	(40,000)
	Investment in NWC	(6,000)	(6,000)	(840)	(899)
a	Initial Cash flow +NWC	(46,000)	(6,000)	(840)	(899)
	Operating Cash flow
	EBT		19,500	22,703	25,636
	Less Tax 25%		4,875	5,676	6,409
	PAT		14,625	17,027	19,227
	Add back depreciation		8,000	6,400	5,120
b	Total operating Cash flow		22,625	23,427	24,347

	Terminal Cash flow
	Return of NWC				13,739
	Salvage value				16,000
c	Total Terminal Cash flow				29,739
d	Total Cash flow =a+b+c	(46,000)	16,625	22,587	53,187
e	PV discount factor @9%=1/1.09^n	1	0.9174	0.8417	0.7722
f	Discounted cash flow =d*e=	(46,000)	15,252	19,012	41,071
	NPV =Sum of discounted cash flows=	29,334

Payback period is 2.13 years
So NPV is positive and payback period is 2.13 years (less than 3 years), therefore the project is acceptable.