TML Smoothie Company has just completed a $10,000 feasibility study and decided to go with the exercise fad and plans to open an exercise facility in conjunction with its main smoothie and health food store.
TML Smoothie will rent additional space adjacent to its current store. The equipment required for the facility will cost $50,000. In addition, it must pay $5,000 in cash to cover the costs of shipping and installation of the equipment. This equipment will be depreciated on a straight-line basis over its 5 year useful life. The equipment will have an estimated salvage value of $4,000, but do not include the salvage value in the straight-line depreciation calculation. In order to open the exercise facility, TML estimates that it will have to add about $7,000 initially to its new working capital in the form of additional inventories of exercise supplies, cash, and accounts receivable for its exercise customers. Also, TML expects that it will have to add about $5,000 per year to its net working capital in years 1, 2, and 3 and nothing in years 4 and 5. During its first year of operations, TML expects its total revenues (from smoothies and exercise services) to increase by $50,000 above the level that would have prevailed without the exercise facility addition. These incremental revenues are expected to be $60,000 in year 2, $75,000 in year 3, $60,000 in year 4, and $45,000 in year 5. The company’s incremental operating costs associated with the exercise facility, including the rental of the facility, are expected to be $25,000 in year 1, $26,500 in year 2, $28,090 in year 3, $29,775 in year 4, $31,562 in year 5.
The company has a marginal tax rate of 40%. Finally, suppose the cost of capital is 10%.
Should TML Smoothie Company open an exercise facility?