You are considering starting a lemon aid stand. Over the next 4 years you expect sales to be $100 per year, operational costs are $50 and depreciation is $25. You initially expect to spend $100 on depreciable assets (the table, cups, etc.) and $20 on net working capital (sugar, lemons, money in the till) that you will recover when you sell the stand in year four for $50. Your tax rate is 50%.
You determined that the project is 20% riskier than the general market and therefore has a beta of 1.2. The return on the market is expected to be 8% and the risk free rate is expected to be 2%. You have invested in similar projects in the past and found that roughly 30% of those projects fail.
Because the project is small only one person is expected to be employed. The individual may slack off, steel or simply underperform because of a lack of accountability.
To fund the project you expect to get ½ of the funding from a bank and half from equity investors. When completing your analysis below you assumed 100% equity, because your funding choice should not impact the analysis (the average interest and payments will be the same if they go to just equity holders or if they are split between various providers of capital).
QUESTIONS RELATED TO MINICASE
Answer the following questions using core financial concepts as the basis for your response. Please include a brief discussion of any work you may have completed. In cases where there may be inadequate information please surmise or provide an intuitive guess regarding the response or information requested.
- Compute what the initial investment will be in the project.
- Compute the operating cash flows associated with the project.
- Compute the terminal cash flows associated with the project.
- Compute the NPV (net present value), IRR, and payback of the investment and discuss the implications of the computation. Is the project a good investment?
Hint: use 9.2% as the cost of capital (discount rate associated with this project).
- How would you quantify the risk level of the project being considered? (For example what is the probability you think the project will succeed)? Hint: Review information given.
- Would you expect your project to have more or less risk than the overall stock market, why? Hint: Review information given.
- What rate of return do you expect from the project? Hint: Review information given and Chapter 8
- Where will the money come from to fund the project? Hint: Review information given.
- Compute one ratio that provides information regarding leverage (debt) and one ratio that provides information about profitability, discuss these ratios. Hint review Chapter 3.
- What are agency problems that may exist within your company? How can these issues be mitigated? Hint: review chapter one.