Question

Question #7 You are the owner of a small business. An opportunity to expand into a new market niche arose. It requires an initial equipment investment of $300,000. You will finance the entire amount with a 5-year loan at 3.2% interest rate (annual payments). Depreciation will follow MACRS-3 Sales projections look very promising as shown below: • $200,000 in first year's projected sales • Sales growth is expected to increase by 40% over the previous year's sales with a high level of confidence) • COGS is expected to remain at 25% of each years' sales Operating Expenses are $40,000 the first year and increase by 20% over the previous year's Operating Expense. Business ordinary tax rate is 29% A. Develop the following for years 1 thru 5: 1. Loan amortization table (2 points) 2. Depreciation table (2 points) 3. Income Statement (2 points) 4. Cash Flow Statement (2 points) B. Based on the information provided in the above statements, would you pursue the opportunity? In -50 words, explain why or why not. 2 points) Note: your assessment must be rational & reasonable and your explanation should be supported by facts within the statements to earn full credit) Note: In your Income Statement if Net Earnings (AKA EBT) is negative, no taxis charged/assessed

Answer 1

A.

1.

Loan Amortization Table
Year	Interest	Principle	Payment	Balance
				$300,000
1	$9,600	$56,281	$65,881	$243,719
2	$7,799	$58,082	$65,881	$185,637
3	$5,940	$59,941	$65,881	$125,697
4	$4,022	$61,859	$65,881	$63,838
5	$2,043	$63,838	$65,881	$0

2.

Depreciation Schedule
Year	Rate	Depreciation	Balance
			$300,000
1	33.33%	$99,990	$200,010
2	44.45%	$133,350	$66,660
3	14.81%	$44,430	$22,230
4	7.41%	$22,230	$0
5	0%	$0	$0

3.

Income Statement
Year	1	2	3	4	5
Sales	$200,000	$280,000	$392,000	$548,800	$768,320
COGS	$50,000	$70,000	$98,000	$137,200	$192,080
Gross Profit	$150,000	$210,000	$294,000	$411,600	$576,240
Operating Expenses	$40,000	$48,000	$57,600	$69,120	$82,944
EBITDA	$110,000	$162,000	$236,400	$342,480	$493,296
EBITDA Margin	55%	58%	60%	62%	64%
Depreciation	$99,990	$133,350	$44,430	$22,230	$0
EBIT	$10,010	$28,650	$191,970	$320,250	$493,296
EBIT Margin	5%	10%	49%	58%	64%
Interest	$9,600	$7,799	$5,940	$4,022	$2,043
EBT	$410	$20,851	$186,030	$316,228	$491,253
EBT Margin	0%	7%	47%	58%	64%
Tax	$119	$6,047	$53,949	$91,706	$142,463
Net Income	$291	$14,804	$132,081	$224,522	$348,790
Net Margin	0%	5%	34%	41%	45%

4.

Cash Flow Statement
Year	1	2	3	4	5
Cash Flow from Operations
Net Income	$291	$14,804	$132,081	$224,522	$348,790
Interest	$9,600	$7,799	$5,940	$4,022	$2,043
Depreciation	$99,990	$133,350	$44,430	$22,230	$0
Cash Flow from Operations	$109,881	$155,953	$182,451	$250,774	$350,833
Cash Flow from Investing
Capital Expenditure	-$300,000	$0	$0	$0	$0
Cash Flow from Investing	-$300,000	$0	$0	$0	$0
Cash Flow from Financing
Debt Raised	$300,000
Interest	-$9,600	-$7,799	-$5,940	-$4,022	-$2,043
Debt Repayment	-$56,281	-$58,082	-$59,941	-$61,859	-$63,838
Cash Flow from Financing	$234,119	-$65,881	-$65,881	-$65,881	-$65,881
Net Cash Flow	$44,000	$90,072	$116,571	$184,893	$284,952
Opening Cash and Bank Balance	$0	$44,000	$134,073	$250,643	$435,536
Closing Cash and Bank Balance	$44,000	$134,073	$250,643	$435,536	$720,488

B. As reflected in the income statement, Net Margin is projected to expand from 0% during Year 1 to 45% by Year 5. This margin expansion is driven by 3 factors -

i) Operating leverage: Owing to fixed costs, EBITDA margins increase at a faster pace than increase in sales. E.g. during Year 2, EBITDA margins increased by 47% while sales increased by 40%.  

ii) Accelerated Depreciation: The Business is getting the benefit of Modified Accelerated Cost Recovery Systems (MACRS) based depreciation policy. The accelerated depreciation rates during the first 3 years help minimize the taxes as MACRS is required by IRS for tax reporting.

iii) Financial Leverage: The entire capital expenditure of $300,000 is funded through long term debt without use of any equity. The interest cost on debt is tax deductible giving the benefit of tax shields.

However, leverage has certain disadvantages. Operating leverage extends the break-even point of the business and high financial leverage poses the risk of bankruptcy. If the projected sales growth is not achieved, the earnings might not be sufficient for debt repayment and such low earnings may trigger restrictive covenants. However in this case,

i) the EBIT earnings are cosmetically low owing to accelerated depreciation policy. Hence lower reported earnings may not necessarily jeopardize ability to repay debt

ii) the sales projections are realistic as reflected in high degree of confidence. Hence the required even if actual sales for the first year are 75% of the projections i.e. $150,000, business can still repay the debt obligation of $65,881 (including interest)

iii) since I am already in the small business, this business is assumed to have sufficient net worth to wither the strain caused by missing sales projections.

Owing to these reasons, I would pursue this opportunity

Happy Learning!