A company called “Golden Globe” runs entertainment business and owns movie theaters, a DVD rental store chain, etc. In order to expand its business the company is considering opening a new movie theater in eastern Los Angeles county. For this the company hired a team of consultants to whom it paid $150,000 to do research regarding the potential of this project based on the local market analysis. After a four-month long research, the team of consultants came up with a recommendation to replace one of the company’s existing movie theaters that has been losing money, with a high-tech movie theater that would be showing only three-dimensional movies. They believe that this would be a unique movie theater in the area and that this investment could potentially bring high profit to the company.
The original movie theater is located in an old building that was built 40 years ago which at that time cost the company $60 million. The building has been depreciating since then at a constant rate over its 50-year economic life. It can now be demolished and parts of the structure can be sold for the current market price of $10 million.
In order to build the suggested high-tech 3D movie theater, the company would need to spend $30 million. (Assume that this initial investment will be made at the beginning of this year.) The new building as well as all internal structures and equipment will be depreciating according to the 15-year MACRS depreciation schedule. This new project is expected to be running for 7 years after which it will be shut down and the building with all its equipment would be sold. A used building like this with all its equipment can be sold at any time for $4 million.
It is currently estimated that the new 3D movie theater would be a great addition to the entertainment choices for people of all ages in the eastern Los Angeles county and that it would attract 100,000 visitors in each year. The company decided to set the price for a movie pass for each visitor at $40 per person in the first year. This price will include any four movies at this movie theater within one year. (In other words, each visitor will pay a total of $40 per year.) Once the movie theater becomes popular, this promotional movie pass price will be replaced with a higher one reflecting market demand. And so in the second year the price will be $5 higher than in the first, and it will steadily go up by $5 in each of the following years as well. Children, who will represent on average half of all visitors in each year, can obtain a pass to the movie theater at half price.
Miscellaneous fixed costs each year are expected to equal $3 million. The cost of maintaining the movie theater in good condition will be correlated with the attendance and will cost the company $9 per visitor per year, regardless of whether the visitor is an adult or a child. In order to cover unforeseen expenses, the company will need to immediately set aside a quarter million dollars, and it plans to increase this amount by additional $100,000 in each following year. At the end of the final year of the project the money buffer will no longer be needed and will be fully recovered. (Except for the initial investment, assume that all revenues/costs are collected/paid at year end.)
The corporate income tax rate is 34%.
The required annual rate of return is 12% and it reflects the riskiness of this project.
Based on the information given above, answer the following questions:
1) What will be the Net Capital Spending in year 0 associated with switching to the 3D movie theater project? Calculate and explain.
2) In the form of a table with “year0”, “year1”, “year2”, etc. in the top row, show your calculations of the Total Cash Flow for each year and all of its important components (like we did in class).
3) Based on your calculations in question #2, is the project worth undertaking? What is its Net Present Value? Calculate and explain.
4) One of the company’s top executives is concerned about possible inflation in the future years. He decided to hire another team of consultants whom he asked to measure the percentage change in the estimated Net Present Value if the annual fixed costs increase by 25 percent and the price for the annual passes need to be raised by 20 percent in order to compensate, at least partially, for the higher expenses.
What will the consultants’ calculations show? Calculate and explain.
Explain what will change, and show your calculations for all changes, in the table that you created for question #2.
For questions #5~#7 assume that there is no 25 percent increase in fixed costs or 20 percent increase in the annual pass price described in question #4.
5) When presenting his calculations to the company, one of the consultants pointed out that because of the lack of competitors in this unique movie theater business in the area, there is a chance that the 3D movie theater project will attract a lot more visitors than initially expected. If this is the case, the total number of visitors will be 50,000 higher in year 1 than the current estimate of 100,000; and once the new movie theater becomes well known to the locals, the total number of visitors could be as high as three times larger in years 2 through 7 than currently estimated for those years. (Assume that the movie theater can accommodate this large number of visitors by, for example, adding morning and early afternoon shows.) The consultant’s guess is that the probability of this highly successful scenario is 25 percent. Otherwise, the number of visitors will stay at the current estimate of 100,000 per year.
How will this information affect the expected current NPV of the project (in dollars)? Calculate and explain.
Again, explain what will change, and show your calculations for all changes, in the table that you created for question #2.
6) Continuing question #5, would the expected NPV under the highly successful scenario be different if the company had an option to expand the project? Calculate and explain. This possible expansion can be realized by building ten more identical movie theaters in the area two years from now. All estimated expenses and the annual pass price for the ten additional theaters would be the same as for the original one, and the number of visitors for each year would be the same as that for the highly successful scenario explained earlier. It is also known that starting one year from now the California state government will be subsidizing every new movie theater constructions by giving to the movie companies $5 million in cash per movie theater to cover part of the initial investment; in addition, the subsidy would be $10 million per theater if it is built in 2 years, $15 million if built in 3 years, and so on.
Calculate also the current value of this option to expand (in dollars).
EXTRA CREDIT (optional)
7) Because the subsidy will be increasing each year, the company managers are wondering whether delaying the project expansion by one year under the highly successful scenario may be a smart idea. Calculate the current value (in dollars) of the option to delay the project expansion by one additional year (i.e, expanding it 3 years from now instead of 2 years from now). Would the delay be worth it?