Question

You have worked in an entertainment company for ten years. The company runs hotels, theme parks, tours, novelty stores and so forth. Part of your job is to pitch new ideas to management. These ideas compete with those of your colleagues, so you have to know your stuff and research your ideas well. You have decided that the time is right to open some vintage 1970s style video game arcades. You are going to call each arcade "That 70s Arcade". You have a 2 hour meeting with your supervisors, investors and bankers. You need to show them that the idea will create value for shareholders under a range of possible economic conditions. Of course, your primary analytical tool is capital budgeting, specifically net present value (NPV) and internal rate of return (IRR). Work out the NPV and IRR using the information that you have collected (see below). This is the 'base case'. Be prepared to answer 'what if' questions concerning changes in expected sales, the discount rate, staffing costs and so forth. The people you are meeting with might also ask about aspects of corporate finance (e.g. Can we use IRR for this project if...? or What costs did you consider to be sunk? etc.).

To open a flagship arcade in Capital City plus another arcade in Regional City, will require a capital investment (year 0) of $25,000,000 and a working capital allocation (year 0) of $15,000,000. This buys you the fit-out for the locations, the arcade machines and so forth. The project has a life of 10 years. The working capital is returned at the end of the project.

• You have undertaken a marketing survey at a cost of $1,150,000. In the second year of the project (year 2), you will take a smaller follow-up survey to check customer satisfaction. This second survey will cost $200,000.

• Every three years, the arcade machines need to be refreshed. These refreshes in year 3, year 6 and year 9 will cost $2,000,000 each time.

• Number of customer visits in the first year (year 1) (flagship): 150,000

• Number of customer visits in the first year (year 1) (regional): 60,000

• Customer visits are expected to grow by 5 percent p.a. (flagship) and 2 percent p.a. (regional).

• Customer spending per visit on playing the machines in the first year (flagship): $45

• Customer spending per visit on playing the machines in the first year (regional): $30

• Customer spending per visit on playing the machines is expected to grow by 2.50 percent p.a. (both locations)

Customer spending per visit on snacks in the first year (all stores): $15

• Customer spending per visit on snacks (all stores) is expected to grow by 3 percent p.a.

• The flagship store will sell retro themed merchandise (e.g. Atari t-shirts) in its gift shop. Sales of this merchandise are expected to be $100,000 in the first year and grow at 10 percent p.a.

• Cost of goods sold (merchandise) is $60,000 in the first year and will grow at the same rate as merchandise sales.

• Wages for the twenty permanent staff plus casuals are expected to be $1,500,000 in the first year, growing at 1.50 percent p.a.

• Repairs and other variable costs are expected to be $1,250,000 in the first year, growing at 5 percent p.a.

• Fixed costs (total for both locations) are $800,000 in the first year, growing at 2 percent p.a.

• Depreciation is straight-line to zero.

• Taxes are 27.50 percent.

• The discount rate is 12 percent.

1. How many customers will visit the flagship store in year 6?

2. What if more working capital is required at, say, year 3?

3. What are fixed costs in year 9?

4. What is the operating cash flow (OCF) in year 2?

5. What is the NPV?

6.What is the IRR ?

7. what if customer spending grows faster/slower than the base case?