2)Your firm (a shampoo maker) has decided to enter a new industry: Doughnuts. Bu

Question

2)Your firm (a shampoo maker) has decided to enter a new industry: Doughnuts. Bubbles Doughnuts will compete with Dunkin Donuts and Krispy Kreme. You will try to exploit your current customer base, women who like to pamper themselves and secretly eat a lot of doughnuts. There will be 25 locations. The combined land and construction cost for all 25 sites will be $20million. Construction will be completed in one year. The land is approximately one quarter of the cost and cannot be depreciated. The remaining fixed costs will be depreciated 20 year straight line. After twenty years of operation, you will exit the business. You anticipate the doughnut shops to have no salvage value but the land can be sold for $7m (net, so after all relevant taxes have been paid) When you open for business after construction is complete, each shop is expected to average sales of $2m/yr. and have operating costs of $1.8m/yr. over its twenty-year life (both of these are end of year figures). The entire operation will require $1m in working capital upon the completion of construction and an additional $0.1m in each of the first five years of operation. That working capital will be recouped in equal increments in the final two years of operation as inventories are eliminated Your firm's CEO's worthless brother-in-law, who has a longstanding, lifetime contract with the company for $500,000/yr., has been assigned as the head of operations at the corporate office He has hired new staff to do the actual work at corporate headquarters at a cost of $250,000/yr beginning in the first year of operations. There are no other new corporate expenses. You firm's WACC is 10%. A freestanding doughnut chain with a Debt/Equity-4 (the same as your firm) has a cost of debt equal to 9% and a cost of equity equal to 16%. The corporate tax rate for both companies is 33%. What is this project's NPV?

Explanation / Answer

while calculating NPV, discount rate to be used need to approximate the risk of the project, hence required return of the similar company in that business is:

Given debt/equity= 4 that means 80% debt and 20% equity financed company

WACC= after tax cost of debt*weight of debt + cost of equity*weight of equity

= 80%*9%*(1-33%) +20%*16%= 8.024%

brother in law salary not considered as if is irrelavent for decision making, as it will not change because of the new investment decision

Cash flows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15 Year 16 Year 17 Year 18 Year 19 Year 20 Investment -20000000 Revenue 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 2000000 Less: operating costs -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 -1800000 Less: salaries -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 -250000 Less: Depreciation(15M/20) -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 -75000 Profit before taxes -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 -125000 Tax benefit -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 -41250 Profit after taxes -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 -83750 Add: Depreciation 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 75000 Cash flow after depreciation -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 Working capital outflow -100000 -100000 -100000 -100000 -100000 Land salvage value 700000 Working capital recovery 250000 250000 Total cash flow -20000000 -108750 -108750 -108750 -108750 -108750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 -8750 241250 941250 Discount factor@8.024% 1 0.92572021 0.8569579 0.7933033 0.7343769 0.6798275 0.62933 0.582584 0.539309 0.49925 0.462165 0.427836 0.396056 0.366637 0.339404 0.314193 0.290855 0.26925 0.24925 0.230736 0.2135969 Discounted cash flows -20,000,000.00 -100,672.07 -93,194.17 -86,271.73 -79,863.48 -73,931.24 -5,506.64 -5,097.61 -4,718.96 -4,368.43 -4,043.95 -3,743.56 -3,465.49 -3,208.08 -2,969.78 -2,749.19 -2,544.98 -2,355.94 -2,180.94 55,665.03 201,048.06 NPV -20,224,173.14

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