Question

Italian Valley Restaurant Having assessed the changing dietary needs of your town, you are considering investing in a new Italian restaurant which you plan to name Italian Valley. The restaurant will feature live musicians, appetizers, and a stocked bar. You are trying to assess the likely profitability of this business venture. As a new graduate of the UWI your first step is to prepare a complete capital budgeting analysis for the 5 years you plan to operate the restaurant before you sell it. Having spoken with local vendors, other restaurant owners, bankers, and builders you collected the following data and information about the proposal. You plan to use a building currently owned by your family, however there will be need for some renovation and improvements to the property. Your parents have said that you can use the retail space in any way you wish for free. After checking on local lease rates you determine this space would lease for $75,500 per year. Your family also owns another restaurant downtown. You predict that your new one will decrease its revenues by $15,000 per year. Your parents tell you that this sum will be taken from your annual family stipend. Some of the major improvements to the property include the purchase of cooking equipment, building a stage, seating, and interior décor. The construction is estimated to cost $1.75 million. An additional $375,000 will be spent on chairs, tables, bar equipment, and decorations. Depreciation will be over 7 years using MACRS*. You determine that you will require an average cash balance of $15,000 and inventory of $20,000. Accounts payable should average $10,000. Your local bank has agreed to loan you monies to pay for these expenses at a 15% interest rate. You plan to hire a research consultant to conduct a market study, since you believe your chances of success will increase with greater information about the restaurant market. The charge for this report will be $200,000. Revenues are estimated to be $600,000 the first year. Revenues are expected to increase by 20% the second year, 15% the third year, and continue increasing at 8% thereafter. Fixed annual operating costs are estimated to be as follows. Employee salaries = $110,000; Heat, electricity, water, and janitorial services =$75,000. The food and liquor bill is expected to be 15% of revenues. Total taxes are estimated to be 40% of net revenues. Your plan is to run the bar for 5 years, then to sell it to an investor for $2,000,000.

Required:

1. Prepare a cash flow analysis which includes:

a. the initial investment, ( 5 points)

b. the annual net cash flows, and (46 points)

c. the terminal cash flow. (7 points)

2. What is the Net Present Value (NPV) and Internal Rate of Return (IRR) of this venture? (5 points)

3. Should you invest in this venture and why? (2 points)

*MACRS Depreciation Table MACRS Depreciation Table

Year	3-yr	5-yr	7-yr	10-yr
1	33.0	20.0	14.0	10.0
2	45.0	32.0	25.0	18.0
3	15.0	19.0	17.0	14.0
4	7.0	12.0	13.0	12.0
5		12.0	9.0	9.0
6		5.0	9.0	7.0
7			9.0	7.0
8			4.0	7.0
9				7.0
10				6.0
11				3.0

Answer 1

CASH FLOWS

(A) INITIAL INVESTMENT

Particulars	$
Capital Expenditure
Construction cost	1,750,000
Cost of Furniture and Equipment	375,000
Add: Working capital requirements
(15,000 + 20,000 - 10,000)	25,000
Initial investments	2,150,000

B. ANNUAL NET CASH FLOWS

Year	Revenue	Operating Expenses (W.N.1)	Depreciation (W.N.2)	Profit before tax	Tax @ 40%	Profit after tax	Cash Profit after tax
1	600,000	688,000	297,500	(385,500) (600,000 - 985,500)	NIL	(385,500)	(88,000)
2	720,000 (600,000*1.2)	706,000	531,250	(517,250) (720,000 - 1,237,250)	NIL	(517,250)	14,000
3	828,000 (720,000*1.15)	722,200	361,250	(255,450) (828,000 - 1,083,450)	NIL	(255,450)	105,800
4	894,240 (828,000*1.08)	732,136	276,250	(114,146) (894,240 - 1,008,386)	NIL	(114,146)	162,104
5	965,779.20 (894,240*1.08)	742,867	191,250	31,662,20 (965,779.20 - 934,117)	12,664.88	18,997.32	210,247.32
							404,151.32

W..N.1 OPERATING EXPENSES

YEAR	EMPLOYEE COST	OTHER COSTS	RENT	OPPORTUNITY COST(*)	FOOD & LIQUOR (15% of Revenue)	INTEREST @15% (2,150,000 *15%)	TOTAL
1	110,000	75,000	75,500	15,000	90,000	322,500	688,000
2	110,000	75,000	75,500	15,000	108,000	322,500	706,000
3	110,000	75,000	75,500	15,000	124,200	322,500	722,200
4	110,000	75,000	75,500	15,000	134,136	322,500	732,136
5	110,000	75,000	75,500	15,000	144,867	322,500	742,867

* The restaurant results in decrease of revenue of $15,000 of the downtown restaurant. Hence, $15,000 is the opportunity cost of the revenue lost. Hence, it is relevant for decision making.

# The market survey cost of $200,000 is sunk cost. Hence, it is irrelevant for decision making.

W.N.2 DEPRECIATION

YEAR		$
1	21,25,000*14%	297,500
2	21,25,000*25%	531,250
3	21,25,000*17%	361,250
4	21,25,000*13%	276,250
5	21,25,000*9%	191,250

W.N.3 It is assumed that loss on business income cannot be carried forward for tax purpose.

C. TERMINAL CASH FLOWS

PARTICULARS	$
Sale proceeds of restaurants after 5 years	2,000,000
Add: Working capital requirements	25,000
Terminal Cash flow	2,025,000

2.

Net Present Value

Particulars	$
Initial Investments	2,150,000
Annual Operating cash flow	404,151.32
Terminal Cash flow	2,025,000
Net cash flow	279,151.32

Internal Rate of Return

Internal rate of return is a rate at which initial outflow of the project is equal to the total cash inflow.

Particulars	Rate of Return@2%	Rate of Return@3%
Present value of terminal cash flow	1,834,105	1,746,782
Present value of annual cash inflow	367,066	349,970
	2,201,171	2,096,752
Less: Initial cash investments	2,150,000	2,150,000
Net Present value	51,171

IRR = 2% + 51,171/(2,201,171 - 2,096,752) = 2.49% or 2.50%