A Quaint But Well-Established Coffee Shop: The Hot Ne 464841
A Quaint But Well Established Coffee Shop The Hot New Cafe Wants To
A quaint but well-established coffee shop, the Hot New Cafe, wants to build a new cafe for increased capacity. 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 cafe 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 Cafe 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 cafe. 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 must include the following: A double-spaced, two page Word document 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.
Paper For Above instruction
Introduction
Capital budgeting is a crucial financial planning process that entails evaluating potential investments or projects to determine their profitability and feasibility. For the Hot New Cafe, a proposed expansion through building a new cafe requires a thorough analysis to assess whether the investment aligns with the company’s strategic and financial goals. This paper develops a comprehensive capital budget for this project, calculates key financial metrics such as net cash flows, payback period (P/B), and net present value (NPV), and discusses whether the project should be accepted based on these analyses.
Key Terms in Capital Budgeting
To understand the analysis, it is essential to define several key terms:
- Net Cash Flows: The actual cash generated by the project after accounting for all inflows and outflows, excluding non-cash expenses like depreciation.
- Payback Period (P/B): The time required for the project's cumulative cash flows to recover the initial investment.
- Net Present Value (NPV): The difference between the present value of cash inflows and outflows over the project's lifespan, discounted at the company's cost of capital.
- Cost of Capital: The required return necessary to make a capital budgeting project worthwhile.
- Depreciation: The allocation of the cost of the building over its useful life.
Assumptions and Data Inputs
Based on the project description, the key data points are:
- Sales per year: $800,000
- Direct costs (Labor and materials): 50% of sales = $400,000
- Indirect costs: $100,000 annually
- Building cost: $750,000, depreciated straight-line over 5 years = $150,000 per year
- Tax rate: 37%
- Cost of capital: 12%
- Project duration: 5 years
Financial Calculations
1. Operating Income Before Tax
\[
\text{Sales} - \text{Direct costs} - \text{Indirect costs} - \text{Depreciation}
= \$800,000 - \$400,000 - \$100,000 - \$150,000 = \$150,000
\]
2. Tax Calculation
\[
\text{Tax} = \text{Operating income} \times \text{Tax rate} = \$150,000 \times 0.37 = \$55,500
\]
3. Net Income
\[
\text{Net Income} = \text{Operating income} - \text{Tax} = \$150,000 - \$55,500 = \$94,500
\]
4. Cash Flows
Since depreciation is a non-cash expense, add it back to net income to get net cash flows:
\[
\text{Net Cash Flows} = \text{Net Income} + \text{Depreciation} = \$94,500 + \$150,000 = \$244,500
\]
This cash flow is consistent across all five years, assuming stable sales and costs.
5. Initial Investment
Total initial investment:
\[
\$750,000 \text{ (building cost)}
\]
Assuming no salvage value at the end.
6. Discounted Cash Flows and NPV
Calculating NPV involves discounting each year's cash flow to present value:
\[
NPV = \sum_{t=1}^{n} \frac{\text{Cash flow}_t}{(1 + r)^t} - \text{Initial Investment}
\]
Where \(r=0.12\), and \(n=5\).
Using present value of an annuity:
\[
PV = \text{Cash flow} \times \left( \frac{1 - (1 + r)^{-n}}{r} \right)
\]
\[
PV = \$244,500 \times \left( \frac{1 - (1 + 0.12)^{-5}}{0.12} \right) \approx \$244,500 \times 3.6048 \approx \$881,384
\]
\[
NPV = \$881,384 - \$750,000 \approx \$131,384
\]
7. Payback Period
To calculate payback:
\[
\text{Payback} = \frac{\text{Initial Investment}}{\text{Annual Cash Flows}} = \frac{\$750,000}{\$244,500} \approx 3.07 \text{ years}
\]
The payback period exceeds the company’s policy of 3 years.
Discussion of Results
The calculated NPV of approximately \$131,384 indicates that the project would generate value beyond the cost of capital, supporting the case for acceptance from a profitability standpoint. The payback period of 3.07 years slightly exceeds the company's policy of 3 years, which may lead to a decision against proceeding if strict adherence to the payback policy is maintained. However, the positive NPV suggests that financially, the project is beneficial in the long term.
Should the Project Be Accepted?
Given the positive NPV, the project adds value to the company, and from a purely financial perspective, it should be accepted. However, the marginal payback period exceeding the company's internal policy highlights the importance of considering other strategic factors. These may include growth opportunities, competitive positioning, and customer base expansion that the new cafe could facilitate, which may justify accepting a project that exceeds the payback policy marginally.
Conclusion
The comprehensive analysis indicates that the Hot New Cafe project is financially viable, with a positive NPV and acceptable cash flows. Despite exceeding the company's customary payback period, the project’s profitability and strategic benefits suggest that it could be a prudent investment. Ultimately, decision-makers should weigh financial metrics alongside strategic considerations before proceeding.
References
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