A quaint but well-established coffee shop, the Hot New Café, wants to build a new café for increased capacity. It’s expected sales are $800,000 for the first 5 years. Direct costs including labor and materials will be 50% of sales. Indirect costs are estimated at $100,000 a year. The cost of the building for the new cafe will be a total of $750,000, which will be depreciated straight line over the next 5 years. The firm's marginal tax rate is 37%, and its cost of capital is 12%.
For this assignment, you need to develop a capital budget. It is important to know what the café managers should consider within their capital budget. You must also define the key terms necessary to understand capital budgeting. In this assignment, please show all work, including formulae and calculations used to arrive at financial values. You must answer the following:
•Using the information in the assignment description:
◦Prepare a capital budget for the Hot New Café with the net cash flows for this project over a 5-year period.
◦Calculate the payback period (P/B) and the net present value (NPV) for the project.
◦Answer the following questions based on your P/B and NPV calculations:
■Do you think the project should be accepted? Why?
■Define and describe Net Present Value (NPV) as it pertains to the new café.
■Define payback period. Assume the company has a P/B (payback) policy of not accepting projects with life of over 3 years. Do you think the project should be accepted? Why?
FYI
To prepare a capital budget for the Hot New Café, we need to calculate the net cash flows for the project over a 5-year period.
1. First, let's calculate the annual sales. The expected sales are $800,000 for the first 5 years, so the annual sales would be $800,000 divided by 5, which is $160,000 per year.
2. Next, calculate the direct costs. The direct costs, including labor and materials, are 50% of sales. So, 50% of $160,000 is $80,000 per year.
3. Calculate the indirect costs, which are estimated at $100,000 per year.
4. Calculate the depreciation expense. The cost of the building for the new café is $750,000, depreciated straight line over 5 years. So, the annual depreciation expense would be $750,000 divided by 5, which is $150,000 per year.
5. Now, let's calculate the net cash flows by subtracting the total costs (direct costs, indirect costs, and depreciation) from the sales for each year:
Year 1: $160,000 - ($80,000 + $100,000 + $150,000) = -$170,000
Year 2: $160,000 - ($80,000 + $100,000 + $150,000) = -$170,000
Year 3: $160,000 - ($80,000 + $100,000 + $150,000) = -$170,000
Year 4: $160,000 - ($80,000 + $100,000 + $150,000) = -$170,000
Year 5: $160,000 - ($80,000 + $100,000 + $150,000) = -$170,000
The net cash flows for each year are all negative, indicating that the project is expected to generate losses for each year.
Now, let's calculate the payback period (P/B) and the net present value (NPV) for the project.
The payback period is the length of time it takes to recover the initial investment. Since the project has a negative net cash flow for each year, it will not be able to recover the initial investment in the 5-year period. Therefore, the payback period is longer than 5 years.
The net present value (NPV) is a measure of the project's profitability, taking into account the time value of money. It is calculated by discounting the net cash flows to present value and subtracting the initial investment.
To calculate NPV, we need to discount the net cash flows using the cost of capital. The cost of capital is given as 12%.
Year 1: -$170,000 / (1 + 0.12)^1 = -$151,786
Year 2: -$170,000 / (1 + 0.12)^2 = -$135,245
Year 3: -$170,000 / (1 + 0.12)^3 = -$120,370
Year 4: -$170,000 / (1 + 0.12)^4 = -$107,142
Year 5: -$170,000 / (1 + 0.12)^5 = -$95,562
Now, let's calculate the NPV by summing up the discounted net cash flows:
NPV = -$151,786 + -$135,245 + -$120,370 + -$107,142 + -$95,562 = -$610,105
Based on the calculations, the project has a negative NPV, which means it is expected to result in a loss. Additionally, the payback period is longer than the company's policy of not accepting projects with a payback period of over 3 years.
Therefore, based on the P/B and NPV calculations, it is not advisable to accept the project as it is expected to generate losses and has a payback period that exceeds the company's policy.
Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment. It takes into account the time value of money by discounting the future cash flows to their present value using a specified discount rate. A positive NPV indicates that the project is expected to generate a return greater than the discount rate, while a negative NPV suggests that the project is not expected to generate sufficient returns.
Payback period is the length of time required to recover the initial investment in a project. It measures the time it takes for the project's net cash flow to equal or exceed the initial investment. In this case, the company has a payback policy of not accepting projects with a payback period of over 3 years.