A large travel agent is thinking of setting up a subsidiary called Wharton Social Trek (WST) to arrange pleasure treks all around the world for Wharton students, faculty, staff and their friends for the next three years. The trip to Rio for Carnival in February is expected to be particularly popular. One professor has already put down a deposit. The current date is 12/31/X1. The office equipment for WST costs $800,000. It is expected to last for three years. At the end of its life the salvage value will be $200,000. The average price of each trip is currently (i.e. on 12/31/X1) $1,450 and is expected to increase at 3 percent per year. The average cost of providing each trip is currently (i.e. on 12/31/X1) $1030 and is expected to increase at 3 percent per year.

They expect to be able to sell 1,000 trips each year for the next three years. The total labor costs to run the project are currently (i.e. on 12/31/X1) $120,000 per year and these are expected to increase at 3 percent per year. The space needed for the travel agency is expected to cost a constant $20,000 per year for each of the three years. The rent is paid at the beginning of each year. The firm has a corporate tax rate of 35 percent and uses straight-line depreciation. The nominal opportunity cost of capital for this type of project if it is all-equity financed is 12 percent. The firm’s nominal debt rate is 6 percent. All costs and expenses are tax deductible. All figures are given in nominal terms. Assume all cash flows occur at year’s end except where otherwise stated and that the firm has other profitable ongoing operations.

(a) Give a table of cash flows with one column for each year’s end.

(b) Calculate the project’s base-case NPV at 12/31/X1 assuming it is all-equity financed.

(c) Calculate the project’s APV at 12/31/X1 assuming that in every year the optimal debt capacity of the firm is increased by 30 percent of the project’s base-case PV and this is the only financing side effect.