Working capital and capital budgeting. Farbuck’s Tea Shops is thinking about ope

Question

Working capital and capital budgeting. Farbuck’s Tea Shops is thinking about opening another tea shop. The incremental cash flow for the first five years is as follows: Initial capital cost = $3,500,000 Operating cash flow for each year = $1,000,000 Recovery of capital assets after five years = $250,000 The hurdle rate for this project is 12%. If the initial cost of working capital is $500,000 for items such as teapots, teacups, saucers, and napkins, should Farbuck’s open this new shop if it will be in business for only five years? What is the most it can invest in working capital and still have a positive net present value?

Explanation / Answer

Incremental cash flows by the year = $3,500,000 + $500,000

                                                         = $4,000,000

Cash Flow from year 1 through year 4 = $1,000,000

Cash Flow year 5 = $1,000,000 + $500,000 + $250,000

                            = $1,750,000

NPV at 12% NPV is as follow :

= -$4,000,000 + ($1,000,000 (1 - 1/(1.12)^ 4 ) / 0.12) + ($1,750,000 / (1.12)^ 5 )

NPV = -$4,000,000 + $3,037,349 + $992,997 = $30,346

They should go with the project since it has positive NPV.

The most that Farbuck's Tea Shops could spend on working capital is as follows:

For each additional dollar of current value they get ($1/(1.12)^ 5) in return or a net present cash outflow of $1 - $0.5674 = $0.4326.

If the current NPV is $30,346 they could spend another

$30,346/0.4326 = $70,152 in working capital.

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