Handout-Week 9-Advanced Cap Bu.. Done Carrie and Julie run a successful catering
ID: 1170464 • Letter: H
Question
Handout-Week 9-Advanced Cap Bu.. Done Carrie and Julie run a successful catering business. They currently rent space in a commercial kitchen for $500 per day and average 10 days each month. The are considering the purchase and remodel of a small building. The cost of the building is $200,000 and the remodel would add another $80,000. The bank is willing to lend the money for half of the project at 6%, and they would need to invest their own money (Owner's Equity) for the balance Return-on. Equity for their business has averaged 18%, Carrie and Jule asked you to help them make a decision. The building has an expected life of 10 years, and could be sold for $200,000 at the end of 10 years. Property tax, insurance, and maintenence would be $1,200 each month on the building. What WACC should they use as the Cost of Capital? What is the monthly cash flow from the investment? What is the payback period of this investment based on monthly cash flows? What is the annual Internal Rate of Return based on monthly cash flows? Using the WACC as the discount rate, what is the Net Present Value based on monthly cash flows? What is the Profitability Index based on monthly cash flows? Should Carrie & Julie invest?Explanation / Answer
Monthly Rent 5000 Property tax and other overheads 1200 cost of the building 200000 Remodelling 80000 Total cost 280000 Life (years) 10 salvage value after 10 years 200000 Equity 50% Debt 50% Interest rate 6% ROE 18% WACC calculation = (E/V)*Re + (D/V)*Rd*(1-Tc) Where: Re = cost of equity or ROE 18% Rd = cost of debt 6% V = E + D = total project cost 280000 E/V = percentage of financing that is equity 50% 140000 D/V = percentage of financing that is debt 50% 140000 Tc = corporate tax rate not given WACC = (0.50*18%)+(0.50*6%*(1-0%)) 12% Monthly cashflow from the investment Property tax and other overheads 1200 Total debt raised 140000 Interest to be paid @ 6%/12 0.5% total number of payments = term * 12 = 10*12 = 120 Loan repayment schedule Principal paid per month = Principal left to be paid- previous months principal paid Interest= Principal left to be paid * monthly i% Monthly home loan payment P+I P Left to be paid months left for payment Month 1 1167 700 1867 1,38,833 120 Monthly cashflow = Property tax and other overheads + Loan repayment 3067 Profit per month = Monthly rent - Monthly cashflow 1933 payback period = total cost of the project / profit per month 145 Months 12.1 years Annual Rate of return can be taken as WACC NPV= sum of Present values of all cashflows - Intial investment initial investment = 280000 sum of Present values of all cashflows = Present value of Annuity of annual payment + Saalvage value of the building PV of the Salvage value of the building = salvage value/(1+WACC)^10 years 64395 cashflow per year 36800 PV factor= 0.25 sum of Present values of all cashflows = Present value of Annuity of 3067 228693 NPV= sum of Present values of all cashflows - Intial investment 13087 Net present value is positive Thus the investment should be accepted
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