Steve\'s Sub Shop is considering investing in toaster ovens for each of its 120

Question

Steve's Sub Shop is considering investing in toaster ovens for each of its 120 stores located in the southwestern United States. The high-capacity conveyor toaster ovens, manufactured by Lincoln, will require an initial investment of $15,000 per store plus $500 in installation costs, for a total investment of $1,860,000. The new capital (including the costs for installation) will be depreciated over five years using straight-line depreciation toward a zero salvage value. Steve's will also incur additional maintenance expenses totaling $120,000 per year to maintain the ovens. At present, firm revenues for the 120 stores total $9 million, and the company estimates that adding the toaster feature will increase revenues by 10%. Steve's weighted average cost of capital is 9%.

a. If Steve's faces a 30% tax rate, what expected project FCFs for each of the next five years will result from the investment in toaster ovens?

b. What is the project's NPV? Should the project be accepted?

c. What is the project's IRR? Should the project be accepted?

Explanation / Answer

Investment $    18,60,000.00 Incremental Revenue each year($9000000*10%) $      9,00,000.00 Maintenance cost $      1,20,000.00 Year 1-5 a) Revenue($9000000*10%) $      9,00,000.00 Maintenance cost $      1,20,000.00 Depreciation($1860000/5) $      3,72,000.00 Net Income before tax $      4,08,000.00 Tax=($408000*30%) $      1,22,400.00 Net Income after tax $      2,85,600.00 Add: Depreciation $      3,72,000.00 B) Annual free cash flow $      6,57,600.00 B C D E F G H 17 Year 0 1 2 3 4 5 18 Investment $ -18,60,000.00 19 Annual Free cash flow $ 6,57,600.00 $ 6,57,600.00 $ 6,57,600.00 $ 6,57,600.00 $ 6,57,600.00 20 P.V Factor 9% for 5 years 1 0.917 0.842 0.772 0.708 0.65 21 P.V $ -18,60,000.00 $ 6,03,019.20 $ 5,53,699.20 $ 5,07,667.20 $ 4,65,580.80 $ 4,27,440.00 22 NPV SUM(C21:H21) 23 NPV 697406.4 c) 25 Year 0 1 2 3 4 5 26 Annual Free cash flow $ -18,60,000.00 $ 6,57,600.00 $ 6,57,600.00 $ 6,57,600.00 $ 6,57,600.00 $ 6,57,600.00 27 IRR= IRR(C26:H26) 28 IRR= 23% b) NPV is positive so Company should accept the project. c) Irr is greater than the hurdle rate so the Company should accept the project.

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