A Quaint But Well-Established Coffee Shop The Hot New Café
A Quaint But Well Established Coffee Shop The Hot New Café Wants To
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 café 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? Your submitted assignment (125 points) must include the following: A double-spaced Word document of 1–2 pages that contains answers to the word questions.
You must include a Microsoft Excel spreadsheet for your calculations. Either the Word document or the Excel spreadsheet must have all of your calculation values, your complete calculations, any formulae that you used, the sources you wish to cite, and your answers to the questions listed in the assignment guidelines. This assignment will also be assessed using additional criteria provided here:
Paper For Above instruction
The project proposed by the Hot New Café involves constructing a new facility to capitalize on increasing demand, which necessitates a thorough financial analysis through capital budgeting methods. This essay develops a detailed capital budget encapsulating net cash flows over five years, calculates the payback period, and evaluates the project's financial desirability using Net Present Value (NPV). Furthermore, it discusses essential concepts of capital budgeting, including the definitions of NPV and payback period, and assesses whether the project aligns with the company's investment policies.
Introduction to Capital Budgeting
Capital budgeting is the process of evaluating and selecting long-term investments that are in line with the strategic objectives of a business. It involves analyzing potential projects or investments to determine their profitability and risk before committing financial resources. This process is critical because it helps firms prioritize projects that maximize value while avoiding those that could impair financial stability. Key terms in capital budgeting include Net Present Value (NPV), internal rate of return (IRR), payback period, and profitability index. NPV, in particular, measures the difference between the present value of cash inflows and outflows, serving as a primary indicator of a project’s profitability. The payback period quantifies the time required to recover the initial investment from cash inflows generated by the project.
Financial Assumptions and Data
- Forecasted sales per year: $800,000
- Direct costs: 50% of sales = $400,000 annually
- Indirect costs: $100,000 annually
- Initial investment (building cost): $750,000
- Depreciation: straight-line over 5 years = $150,000 per year
- Tax rate: 37%
- Cost of capital: 12%
Calculating Net Cash Flows
To compute the net cash flows, we first determine the Earnings Before Tax (EBT). Revenue minus costs (direct + indirect + depreciation) yields EBIT, which, after tax, results in net income. Adding back depreciation, a non-cash expense, gives us net cash flow.
Annual sales = $800,000
Direct costs = 50% of sales = $400,000
Indirect costs = $100,000
Depreciation = $150,000
EBIT (Earnings Before Interest and Taxes) = Sales - Direct costs - Indirect costs - Depreciation = $800,000 - $400,000 - $100,000 - $150,000 = $150,000
Tax on EBIT = $150,000 * 37% = $55,500
Net income = EBIT - tax = $150,000 - $55,500 = $94,500
Adding back depreciation to net income yields net cash flow:
Net cash flow = Net income + Depreciation = $94,500 + $150,000 = $244,500
Constructing the Capital Budget
The initial investment includes the building cost of $750,000, which is the initial cash outflow at Year 0. The annual net cash flows for Years 1 through 5 are $244,500, as calculated above. The depreciation expense is used to evaluate taxable income, but it does not affect cash flows directly after the initial investment.
Therefore, the cash flow timeline is:
- Year 0: -$750,000 (initial investment)
- Years 1 to 5: $244,500 annually
Calculating Net Present Value (NPV)
NPV measures the present value of all cash inflows and outflows discounted at the firm's cost of capital (12%).
NPV = \[ \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t} \] - Initial Investment
Where CF_t = cash flow in year t, r = discount rate (12%), n = number of years (5).
Using the formula and plugging in the values:
NPV = \[ \frac{244,500}{(1.12)^1} + \frac{244,500}{(1.12)^2} + \frac{244,500}{(1.12)^3} + \frac{244,500}{(1.12)^4} + \frac{244,500}{(1.12)^5} \] - 750,000
Calculations yields an NPV value of approximately $201,320, indicating a positive net value from the project.
Calculating Payback Period
The payback period is the time it takes to recover the initial investment from cumulative cash flows.
Cumulative cash flow after Year 1 = $244,500
After Year 2 = $244,500 * 2 = $489,000
After Year 3 = $244,500 * 3 = $733,500
As the initial investment of $750,000 is recovered between Year 3 and Year 4, we estimate the exact point within Year 4:
Remaining amount after Year 3 = $750,000 - $733,500 = $16,500
Time in Year 4 to recover remaining amount = $16,500 / $244,500 ≈ 0.068 years
Total payback period ≈ 3 + 0.068 ≈ 3.07 years
Analysis and Recommendations
The calculated payback period of approximately 3.07 years exceeds the company’s policy of not accepting projects with a lifespan over 3 years. Consequently, based solely on the payback policy, the project would not be approved. However, the NPV is positive ($201,320), indicating that this investment adds value to the company and should be considered financially viable from a long-term profitability perspective.
Deciding whether to proceed depends on weighing short-term payback constraints against longer-term value creation. While the project surpasses the company’s payback threshold, the positive NPV suggests it could benefit the firm if the policy criteria are flexible or if strategic considerations favor expansion.
In conclusion, the project's financial analysis presents a mixed decision: the NPV advocates for acceptance, while the payback period policy suggests rejection. If the company prioritizes long-term value over short-term payback, the project merits approval, especially given its substantial NPV. Conversely, strict adherence to the payback policy would lead to rejection.
References
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