Advanced Capital Budgeting

1. You and a partner are considering the purchase of a convenience store. The store has weekly sales of $90,000 and is paying weekly payroll of $5,000. The cost of goods sold every week is $78,500. The firm has miscellaneous expenses (taxes, insurance, garbage, electricity, natural gas, security, maintenance, property taxes, training, advertising, accounting fees, bank charges, etc.) of roughly $3,000-per week. The store would require an investment of $150,000 immediately in working capital (inventory). The investment in working capital would not change until the building is sold in year 10. The working capital would decrease to zero when the building is sold.

The store is currently on the market for $510,000. You will be able to depreciate the building straight line for 29.5 years. You can apply $400,000 of the purchase price to the value of the building. The remaining $110,000 can be applied to the land (the amount applied to the land cannot be depreciated). Your plan is to operate the store for 10 years and then sell the land. You believe that in 10 years you will be able to sell the land and store for $150,000.

You and your partner are currently in the 35% tax bracket. Assuming that the discount rate appropriate for a project of this amount of risk is 12%, what are the NPV, IRR, MIRR and payback for the investment? Should you take on the project? Create a spreadsheet that outlines the initial cash flow, operating cash flows and terminal cash flow.

2. What is the NPV of this investment if the interest rate is 0, 5, 10, 15, 20, 25, and 30%? Draw an NPV profile for the investment.

3. If you are considering using debt should the projected cash flows be revised to show projected interest charges (your answer should come from chapter 12)? Explain.

4. Suppose the purchase and renovation of the convenience store will take business away from other convenience stores the company owns. Should this fact be reflected in your analysis? If so, how (explain in words only)?

5. If the project were a replacement rather than an expansion project, how would the analysis have changed? Think about the changes that would have to occur in the cash flow table (explain in words only - use the chapter 12 in the book as your source).

6. Assume that inflation is expected to increase at the rate of 2% over the next 10 years and that this expectation is reflected in the WACC; and that inflation will increase variable costs and revenues by the same percentage, 2%. Does it appear that inflation was dealt with properly? If not what should be done? Modify your numbers in a new cash flow table to quantify your results. Should you take the project?

7. (1) What is sensitivity analysis?

(2) Perform a sensitivity analysis with sales and cost of goods sold (they move together) being +/- 10% from the base case amounts. Calculate NPV, IRR, MIRR and payback for each case.

(3) Assuming your expectations are that 60% of the time sales will be 10% greater than the base case and 40% of the time sales will be 10% less than your base case, what would be your expected NPV? Should you take on the project?

(4) What is the primary weakness and advantage of sensitivity analysis?

8. How would you describe what cash flows are "relevant" to a project? What does the change in operating working capital represent? How are sunk costs, opportunity costs and externalities different?