The manager of the College Town Restaurant is considering placing a hot dog cart
ID: 2673902 • Letter: T
Question
The manager of the College Town Restaurant is considering placing a hot dog cart in front of his restaurant over the lunch hour. After some careful analysis, he estimates that the cart will generate the following cash flows after expenses over its 7-year life:year 0: $0
year 1: +$1,000
year 2: +$1,000
year 3: +$1,000
year 4: +$1,000
year 5: $0
year 6: +$1,000
year 7: +$1,000
The manager estimates that the project has a risk of beta = 1.0, that the K^m =16% and that the R^f = 8%.
1.) Calculate the appropriate required rate of return on the project.
2.) Calculate the present value of the project's cash flows.
3.) If the cost of the cart is $4,000 (to be paid today), should College Town's manager proceed with the project? Why or why not?
Explanation / Answer
1) required rate of return = R^f +beta*(K^m -R^f)
=8% + 1*(16% - 8%)
= 16%
2) given cash flow = $1000. required rate = 16% =0 .16
present value of the project's cash flows
= 1000/1.16 + 1000/1.16^2 + 1000/1.16^3 + 1000/1.16^4 + 0 +1000/1.16^6 +1000/1.16^7
notice here that as in year 5 cash flow is zero. so calculating this we get present value
3) given if cost is $4000 . see if present value calculated in 2nd question exceeds $4000 . if it exceeds then accept project or if it is otherwise reject it
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