2)Your firm (a shampoo maker) has decided to enter a new industry: Doughnuts. Bu

Question

2)Your firm (a shampoo maker) has decided to enter a new industry: Doughnuts. Bubbles Doughnuts will compete with Dunkin Donuts and Krispy Kreme. You will try to exploit your current customer base, women who like to pamper themselves and secretly eat a lot of doughnuts. There will be 25 locations. The combined land and construction cost for all 25 sites will be $20million. Construction will be completed in one year. The land is approximately one quarter of the cost and cannot be depreciated. The remaining fixed costs will be depreciated 20 year straight line. After twenty years of operation, you will exit the business. You anticipate the doughnut shops to have no salvage value but the land can be sold for $7m (net, so after all relevant taxes have been paid) When you open for business after construction is complete, each shop is expected to average sales of $2m/yr. and have operating costs of $1.8m/yr. over its twenty-year life (both of these are end of year figures). The entire operation will require $1m in working capital upon the completion of construction and an additional $0.1m in each of the first five years of operation. That working capital will be recouped in equal increments in the final two years of operation as inventories are eliminated Your firm's CEO's worthless brother-in-law, who has a longstanding, lifetime contract with the company for $500,000/yr., has been assigned as the head of operations at the corporate office He has hired new staff to do the actual work at corporate headquarters at a cost of $250,000/yr beginning in the first year of operations. There are no other new corporate expenses. You firm's WACC is 10%. A freestanding doughnut chain with a Debt/Equity-4 (the same as your firm) has a cost of debt equal to 9% and a cost of equity equal to 16%. The corporate tax rate for both companies is 33%. What is this project's NPV?

Explanation / Answer

Initial Cost 0th 1st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th 11th 12th 13th 14th 15th 16th 17th 18th 19th 20th Remarks Land 5 Land cost (quarter of total initial investment of 20m) P & M 15 Remaining investment WC 1 Initial working capital 21 A Sales 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50 2m per year per shop (25*2) B Operating cost 45 45 45 45 45 45 45 45 45 45 45 45 45 45 45 45 45 45 45 45 1.8m per year per shop (25*1.8) C Depreciation 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 plant and machinery i.e, 15m for 20 years using SLM = 15/20 = .75M D Working capital 0.1 0.1 0.1 0.1 0.1 E Salary 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 salary to Brother in law and hired staff F =(A-B-C-D-E) PBT 3.4 3.4 3.4 3.4 3.4 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 3.5 G = F x 33% Tax @ 33% 1.122 1.122 1.122 1.122 1.122 1.155 1.155 1.155 1.155 1.155 1.155 1.155 1.155 1.155 1.155 1.155 1.155 1.155 1.155 1.155 Tax on PBT H = F-G PAT 2.278 2.278 2.278 2.278 2.278 2.345 2.345 2.345 2.345 2.345 2.345 2.345 2.345 2.345 2.345 2.345 2.345 2.345 2.345 2.345 I = H + C Cashflows (PAT + DEP) 3.028 3.028 3.028 3.028 3.028 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 J Release of WC 0.75 0.75 Total Working capital released from project in 2 equal installments in last 2 years. K Land 7 Net amount received after selling of land. L = I +J + K Final Cash flows 3.028 3.028 3.028 3.028 3.028 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.095 3.845 10.845 WACC 10% PV of cash flows 2.7527 2.5024 2.2749 2.0681 1.8801 1.7470 1.5882 1.4438 1.3129 1.19325 1.08478 0.9862 0.8965 0.8150 0.7410 0.6736 0.6123 0.5567 0.6287 1.6120 27.3701 NPV 6.370116 NPV = pv of cash flows - Initial Investment) (27.37 - 21)

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