You are considering introducing a new Tex-MexThai fusion restaurant. The initial

Question

You are considering introducing a new Tex-MexThai fusion restaurant. The initial outlay on this new restaurant is $6.9 million and the present value of the free cash flows (excluding the initial outlay) is $4.9 million, such that the project has a negative expected NPV of $2.0 million. Looking closer, you find that there is a 50 percent chance that this new restaurant will be well received and will produce annual cash flows of $818,000 per year forever (a perpetuity), whereas there is a 50 percent chance of it producing a cash flow of only $191,000 per year forever (a perpetuity) if it isnt received well. The required rate of return you use to discount the project cash flows is 10.2 percent. However, if the new restaurant is successful, you will be able to build 10 more of them and they will have costs and cash flows similar to the successful restaurants costs and cash flows.

a. In spite of the fact that the first restaurant has a negative NPV, should you build it anyway? Why or why not?

b. What is the expected NPV for this project if only one restaurant is built but isnt well received? What is the expected NPV for this project if 10 more are built after one year and are well received? (ignore the fact that there would be a time delay in building additional restaurants.)

Explanation / Answer

The restaurant should not be built as it has a negative NPV over its useful life, Moreover, even if the present value is not considered, then the restaurant is not yielding a good rate of return i.e., it will be below 10.2% which cannot be accepted.

Expected NPV of the project if one restaurant is built = 0.5 x 818000 + 0.5 x 191000 = $504500 per year

The expected NPV for 10 more will be the same as the initial outlay and cash flows remain the same.

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