W Café, Inc. is a large restaurant chain with roughly 3000 locations nationwide.
ID: 2797769 • Letter: W
Question
W Café, Inc. is a large restaurant chain with roughly 3000 locations nationwide. JW has decided to sell a new line of desserts called Flavor Burst Ice Cream Cones. The cones will sell for $3 each and have a variable direct materials cost of $1.45 each. The company has spent $20,000 for a marketing study that determined that each store will sell 500 cones per store during the first year. It was also estimated that those sales will double each year for 2 years but level off at a 4% growth rate thereafter. The marketing study also determined that 50% of the Flavor Burst Cones sold will actually cannibalize sales of its regular ice cream cones. These regular cones sell at $2 and have variable direct materials costs of 55 cents. The company will also increase food sales as a result of the new dessert. It is estimated that 20% of the Flavor Burst Cones cause an additional meal to be sold. The average meal sells for $10 and has variable direct materials costs of $3.50 per meal. The company has also spent $10,400 on research and development for the new cones will cost $11,000 and weight approximately approximately 1 kWh per hour. The national average cost for electricity is 12 cents per kWh. Each store cones. The machine required to produce these new 400 lbs. The electricity usage of a single machine is will need its own machine. This project will also require an increase in inventory corresponding to the increase in direct materials. Assume that the Days' Sales in Inventory will remain at 10 days. The taxable income for the company is expected to be in excess of $25 million before any incremental taxable income from the initiation of this product. Suppose your company has been hired as a financial consultant to JW Café, Inc. After researching IRS Pub. 946 (among other resources), it has been determine that elther straight-line to a zero book value or 7-year MACRS depreciation methods can be used. The expected useful life of the machine is twelve years. After this time, the machine will be essentially worthless except for 45 cents/lb. in scrap metal that you can get for the stainless steel. Also, assume any working capital investment is made at the beginning of the year in which it is needed and that it is fully recoverable at the end of the machine's life. As part of your research, you have discovered that current market data suggests a market risk premium of 8% with 90-day T-Bills yielding 6%. JW has 231,000, 9.4% coupon bonds with 25 years to maturity selling in the open market at 109% of the $1000 face value and paying semiannual coupons. JW also has 8.9 million shares of common stock trading at $71.10 with a beta of 1.2, and 451,000 shares of $100 Management feels like this venture is equally as risky as a par, 9% preferred stock selling for S77.50. typical project within the company. Café, Inc. uses G Wee Zee as its lead underwriter. G. wee Zee charges JW spreads of 9% on new common stock issues, 7% on new preferred stock issues, and 5% on new debt issues. Assume that any NWC requirements will be financed internally, and therefore does not require flotation costs At this point, it is uncertain as to whether JW will have the capital available to finance this project. It is likely that the financing from this project will need to be raised externally, and if so the capital structure of the company must remain unchanged. Help management determine if this is a worthwhile venture, and if ernal versus external financing makes any difference in the decision to invest. Suppose you feel that the quantity changes (new product in year 1, % changes of existing products, % growth ofnew productExplanation / Answer
Base Case Year 0 Year 1 Year 2 Yr 3(2000*1.04)/0.04 Sales volume 500 1000 2000 52000 Contribution $(3-1.45)*Sales volume----------------------a 775 1550 3100 80600 Cannibalised sales volume(50%*above sales) 250 500 1000 26000 Contribution loss $(2-0.55)*Sales volume----------b -362.5 -725 -1450 -37700 No.of addl.meal volume(20%*new sales) 100 200 400 10400 Addl. Contribution $(10-3.5)*Sales volume-----------c 650 1300 2600 67600 Electricity costs 3000*0.12----d -360 -360 -360 -360 Cash flows before depreciation---------------1= a+b+c+d 702.5 1765 3890 110140 Cost of machine -11000 Incremental Investment reqd. -26 -25 -52 -2568 Recovery of inv.in inventory 2671 Salvage 180 CAPEX & NWC cash flows----2 -11000 -26 -25 -52 283 Net annual cash flows-----1+2 -11000 676.5 1740 3838 110423 PV F at 12.28% 1 0.89063 0.79322 0.70647 0.70647 PV at 12.28% WACC -11000 602.51 1380.21 2711.61 78010.18 NPV 71705 Investment in Inventory Year 0 Year 1 Year 2 Year 3 Sales volume 500 1000 2000 52000 New cone 1.45*sales volume----1 725 1450 2900 75400 Less: Cannibalised slaes volume 250 500 1000 26000 D/M 0.55*volume-----------------2 -137.5 -275 -550 -14300 Add:Addl.meal volume 100 200 400 10400 D/M3.5*Volume--------------------3 350 700 1400 36400 Total direct materials-------1+2+3 937.5 1875 3750 97500 Investment in inventory 10 days(Total Dir.mat./365*10) -26 -51 -103 -2671 Incremental Investment reqd. -26 -25 -52 -2568 Recovery of inv.in inventory 2671 Cost of equity RFR+(Beta*Risk Premum) 6%+(1.2*8%) 15.6% Cost of preferred stock (9%*100)/((1-7%)*77.50) 12.49% Cost of bond (109%*1000)=(47*(1-(1+r)^-50)/r)+(1000/(1+r)^50) r=4.26% Type of capital No.of stock/Bond Price Value Weight to total Cost Wt.*Cost Common shares 8900000 64.70 575838900 0.677464 15.60% 0.105684 Preferred stock 451000 77.5 34952500 0.041121 12.49% 0.005136 Debt 231000 1035.5 239200500 0.281415 4.26% 0.011988 Total 849991900 0.122809 WACC 12.28% Price per share=71.1*(1-9%)= 64.70 Price per bond=1000*109%*(1-5%) 1035.5
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