Capital Budget

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Capital Budget

A quaint but well-established coffee shop, the Hot New Cafe, wants to build a new cafe for increased capacity. Expected sales are $800,000 for the first 5 years. Direct costs including labor and materials will be 50% of sales. Indirect costs are estimated at $100,000 a year. The cost of the building for the new cafe will be a total of $750,000, which will be depreciated straight line over the next 5 years. The firm’s marginal tax rate is 37%, and its cost of capital is 12%.

Using the information in the assignment description:

Prepare a capital budget for the Hot New Cafe with the net cash flows for this project over a 5-year period.

CapitalBudget

Capital income | Amount in $ |

Expected sales |
800,000 |

Capital expenses | Amount in $ |

New café | 750,000 |

Cost of capital 12% of 750,000 | 90,000 |

Total |
840,000 |

Net cash flow

Duration in years | 1 | 2 | 3 | 4 | 5 | Total |

Expected sales cash flow | 160,000 | 160,000 | 160,000 | 160,000 | 160,000 | 800,000 |

Direct labour and materials | 80,000 | 80,000 | 80,000 | 80,000 | 80,000 | 400,000 |

Indirect cost | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | 100,000 |

Net Cash flow | 60,000 | 60,000 | 60,000 | 60,000 | 60,000 | 300,,000 |

Calculate the payback period (P/B) and the net present value (NPV) for the project.

Payback Period =Initial Investment Cash/ Inflow per Period is

Initial payment= 750,000+90,000=840,000

Inflow per period=160,000

Payback period= 840,000/160,000= 5.25 years

Therefore the payback period will take five and quarter years for the project to payback.

Net Present Value

Duration in years | 1 | 2 | 3 | 4 | 5 | Total |

Revenues | 160,000 | 160,000 | 160,000 | 160,000 | 160,000 | 800,000 |

Direct labour costs | 80,000 | 80,000 | 80,000 | 80,000 | 80,000 | 400,000 |

Indirect cost | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 | 100,000 |

Marginal tax 37% | 59,200 | 59,200 | 59,200 | 59,200 | 59,200 | 296,000 |

Net present value | 800 | 800 | 800 | 800 | 800 | 4,000 |

Answer the following questions based on your P/B and NPV calculations:

The project is acceptable to be implemented since the current value of the project is positive and the time taken by the project to recover the initial outlay is just five years. The project will yield 4000 dollars after the projects have paid back the actual originalcost value. From the calculation above, the cost of installing the project is less than the expectedvalue, and thus the project will be viable.

Do you think the project should be accepted? Why?

The project should be accepted because the expected payback period is within the time range of the managers. The payback period is reasonable, and the cash flow of the project is also positive such that at the end of the project, the company will be able to generate its initial outlay and more revenues.

Define and describe Net Present Value (NPV) as it pertains to the new cafe.

Net present value is the actual value of the project when the tax and future adjustments are included during calculations. Theexpectednet presentvalue is the future value of the project when other factors such as inflation and the depreciation rate are included.

Define payback period. Assume the company has a P/B (payback) policy of not accepting projects with alife of over three years. Do you think the project should be accepted? Why?

Payback period is the time it takes the project to yield the initial outlay of the initialcostinvestedin the project. The time taken for the project to generate the initial cost is very crucial in thedetermination of the projects. As per the café policy,it’s not possible for the business to makeinitial outlay by the end of the year three. From the calculation of the time three years the project will have togenerate 480,000 dollars, yet the outlay is 750,000 dollars thus will not be possible.

References

Shrieves, R. E., & Wachowicz Jr, J. M. (2001). FREE CASH FLOW (FCF), ECONOMIC VALUE ADDED (EVA™), AND NET PRESENT VALUE (NPV):. A RECONCILIATION OF VARIATIONS OF DISCOUNTED-CASH-FLOW (DCF) VALUATION. *The engineering economist*, *46*(1), 33-52.

Ryan, P. A., & Ryan, G. P. (2002). Capital budgeting practices of the Fortune 1000: how have things changed?. *Journal of business and Management*, *8*(4), 355.