You are graduating in September and would like to start your own business making wine coolers. You collect the following information on the initial costs:
Cost of Plant & Equipment = $500,000
Licensing & Legal Costs = $50,000
You also have been left a tidy inheritance that will cover the initial cost, and is currently invested in a bank account earning 10%. You estimate that you can sell one million bottles a year at $1/bottle. You estimate your costs as follows:
Variable costs/bottle = 50 cents
Fixed Costs/ year = $ 200,000
Adding up state and local taxes, you note that you will be in the 50% tax bracket. To be conservative, you assume that you will terminate the business in five years and that you will get nothing from the plant and equipment as salvage (you also use straight line depreciation.). Should you take on the project? (show all the calculation)
To determine whether you should take on the project, let's calculate the expected cash flows for each year and then calculate the net present value (NPV) of the project. The formula for NPV is:
NPV = Σ [CFt / (1 + r)^t]
Where:
CFt = Cash flow in year t
r = discount rate
t = year
Given the information provided, let's calculate the yearly cash flows:
Year 0:
Initial investment = Cost of Plant & Equipment + Licensing & Legal Costs = $500,000 + $50,000 = $550,000 (outflow)
Year 1-5:
Revenue = Number of bottles sold * Selling price per bottle = 1,000,000 * $1 = $1,000,000 (inflow)
Variable costs = Number of bottles sold * Variable costs per bottle = 1,000,000 * $0.50 = $500,000 (outflow)
Fixed costs = $200,000 (outflow)
Profit before tax = Revenue - Variable costs - Fixed costs = $1,000,000 - $500,000 - $200,000 = $300,000
Tax = Profit before tax * Tax rate = $300,000 * 50% = $150,000 (outflow)
Profit after tax = Profit before tax - Tax = $300,000 - $150,000 = $150,000 (inflow)
Year 5:
Salvage value of Plant & Equipment = $0 (outflow)
Now, let's calculate the NPV of the project. For simplicity, let's assume a discount rate of 10% (as mentioned, the inheritance is currently earning 10% in a bank account).
NPV = Year 0 cash flow + Σ [Year t cash flow / (1 + r)^t]
= -$550,000 + ($150,000 / 1.10^1) + ($150,000 / 1.10^2) + ($150,000 / 1.10^3) + ($150,000 / 1.10^4) + ($150,000 / 1.10^5)
= -$550,000 + $136,363 + $124,057 + $112,779 + $102,526 + $93,296
= -$81,979
The calculated NPV is negative (-$81,979). This signifies that the project's expected cash flows (after considering the time value of money) do not cover the initial investment cost. Therefore, based on the provided information, it is not advisable to take on the project.