a firm interested in opening up a new retail location. location is rented with a

Question

a firm interested in opening up a new retail location. location is rented with a five year lease. To get started the firm needs to invest $120,000 in fixtures and leasehold improvements. These will be depreciated on a straight line basis over five years. In addition, the new location will require $25,000 in inventory. At the end of the project, the inventory will be sold off. The firm anticipates sales of $40,000 per month. Cost of sales (that is, the cost of goods) and operating expenses run $18,000 per month. The firm faces a 40% tax rate. The firm's WACC is 12%. Calculate a NPV and IRR. Should this firm pursue the project?

Explanation / Answer

cash outflow in year 0 = $120,000

depreciation = 120,000/5 = 24000

inventory = $25,000

sales = 40,000*12 = $480,000

cogs & ope.expenses = $18,000*12 = $216,000

depreciation = 24,000

EBIT = 480,000-216,000- 24,000 = $240,000

PAT = EBIT*(1-t) = 144,000

cash flows = PAT + depreciation - change in working capital

hence cash flow in year 1 = 144,000 + 24000 -25000 = 143,000

cash flow in year 2 = 144,000 + 24000 = 168,000

cash flow in year 3 = 144,000 + 24000 = 168,000

cash flow in year 4 = 144,000 + 24000 = 168,000

cash flow in year 5 = 144,000 + 24000 +25000 = 193,000 (since inventory is sold at the end of year 5 hence we add 25,000 to the cash flows)

therefore NPV = -120,000 + 143,000/1.12 + 168,000/1.12^2 + 168,000/1.12^3 + 168,000/1.12^4 + 193000/1.12^5

= $ 477,466.64

irr=126.46%

since NPV>0,hence firm should pursue the project

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