Rick has been inspired by his sabbatical in DeKalb Illinois and has decided to open a Pizza Bagel restaurant. He was going to open a pizza shop, but seeing as he cannot find decent pizza in DeKalb he concludes that people in DeKalb do not like good pizza. However there is a decent bagel shop, so he adjusts his idea. Rick anticipates that the upfront costs for his equipment will be $45,000, and the CCA rate will be 20%. While Rick is enjoying DeKalb, he realizes that he is not at all suited to the midwest lifestyle just yet (he misses his lake and ocean), nor will he be for at least 25 more years, and that is how long he hopes that his Pizza Bagel shop will stay in business. At that time, the Salvage Value of the equipment he anticipates will be $20,000.
To help in his decision and his forecasts, Rick has hired a group of Dal CR MBA students which he has already paid $30,000 to for their consulting advice. Their analysis shows that the initial upfront working capital needs for the business will be $15,000 and thereafter will be 20% of total Sales. Rick expects to recover his investment in Net Working Capital when the shop closes up for good.
Rick plans to sell two different products; the Husky Pizza Bagel and the Mutt Pizza Bagel. First year unit sales of the Husky Bagel will be 9000 bagels, and the Mutt will have first year unit sales of 7000. The growth of unit sales is expected to increase 20% until year 5, at which time the unit growth will be 4% thereafter. The initial price of the Husky will be $5.00 and the Mutt will cost $4.50. Variable costs for the Husky are 60% of Sales, while variable costs for the Mutt are 30%. Price inflation is expected to be 3% per year. Fixed costs for the first year are expected to be $35,000 and Fixed Costs will increase with inflation.
The Pizza Shop will go into a building that Rick currently rents out to tenants for $20,000 per year. Rent is expected to increase with the inflation rate. Rick will kick out the current tenants and thus will not be able to have this rental income anymore. The tax rate is 25%, while the Discount Rate is 12%. (Note - a negative tax is counted for capital budgeting purposes as a negative number - this is due to the fact that any losses from the Pizza Bagel business will be used to reduce taxes in Rick's other businesses.)
Should Rick invest in the Pizza Shop? Beside the NPV, be sure to calculate the IRR and the Payback Period. Also you should prepare some scenario analysis as rumour has it that Rick believes in that type of analysis.