1. Five Gals is currently considering opening its first restaurant, and it plans
ID: 2486473 • Letter: 1
Question
1. Five Gals is currently considering opening its first restaurant, and it plans to open it in Center City. They must decide whether or not to open the restaurant now (i.e., year 0), and cash flows would begin in year 1. If the restaurant does well, expected cash flows are $200,000 per year forever, starting next year (year 1). If it does not do well, expected cash flows are expected to be -$220,000 per year forever, starting next year. There is a 50% probability that the restaurant will be successful and a 50% probability that it will be a failure. The discount rate is 10% and the risk-free rate is 3%. What is the NPV of this project (i.e., of opening this restaurant)?
2. Suppose that if the first restaurant is a success, the owners will open a second Five Gals restaurant in University City. They must decide whether or not to open the restaurant in year 2, and cash flows would begin in year 3. Cash flows from the second restaurant are expected to be $150,000 per year forever, starting in year 3. What is the NPV of opening the first restaurant, including the option to open the second restaurant? The discount rate is 10% and the risk-free rate is 3%.
PLEASE SHOW ALL WORKS AND PROCESSES ,THANKS!
Explanation / Answer
Risky cash flow generated at year end.so the perpetual cash flow discounted at 10%
= {[(200000*0.50)+(-220000*0.50)]/0.10}/1.10
= {-10000/0.10}/1.10
= -$90909.09
Five Gals should not open the restaurant as the NPV of the project is negative.
The perpetual cash flow generated at different year, hence it’s discounted at 10% as the cash flow is also risky one. So,the NPV would be:
= 1818181.81+ 1126972.20
= $ 2945154.01
Five Gals should open the second restaurant as the NPV of the project is positive.
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