You have decided that Greenville needs a new lounge to appeal to the older crowd. It will feature live blues musicians, appetizers, and a well-stocked bar. You are trying to decide whether you should invest in this venture. Your first step is to prepare a complete capital budgeting analysis for the seven years the bar will operate before you sell it and retire to the Bahamas.
After talking with local vendors, bar owners, bankers, and builders you collect the following data.
You will need to make tenant improvements to the property. These will include an attractive bar, a stage, seating, and interior décor. The construction is estimated to cost $400,000. An additional $125,000 will be spent on chairs, tables, bar equipment, and decorations. Depreciation will be over 7 years using MACRS. You determine that you will require an average cash balance of $10,000 and inventory of $15,000. Accounts payable should average $12,000. You learn that you can borrow the money to pay for these expenses at a 15% interest rate.
You decide that as part of the decision making process you will have a market study performed by a group of ECU faculty to confirm the accuracy of the projections. This study will be completed to help determine whether the project should be undertaken. The charge for this report will be $15,000.
The site you have selected for the lounge is in a building currently owned by your family. Your parents have said that you can use the retail space in any way you wish for free. After checking on local lease rates you determine this space would lease for $10,000 per month ($120,000/year) plus 3% of annual revenues. Your family also owns another bar downtown. You predict that your new blues lounge will decrease its revenues by $5,000/mo ($60,000/year). Your parents tell you that if you open the new lounge that they will reduce your family stipend by this $5000/ month.
Revenues are estimated to be $400,000 the first year. Revenues are expected to increase by 15% the second year, 10% the third year and to continue increasing at 5% thereafter. Fixed annual operating costs are estimated to be as follows. Employee salaries = $150,000, heat, electric, water, janitorial = $50,000. The liquor bill is expected to be 17% of revenues. Total taxes are estimated to be 40% of net revenues.
Your plan is to run the bar for 7 years, then to sell it to an investor for $300,000.
1. Prepare a capital budgeting analysis that shows the initial cash flow, the annual cash flows and the terminal cash flow.
2. Compute the NPV and IRR, assuming a cost of capital of 14%. Is the project acceptable?
3. Prepare an NPV profile. Locate the IRR and the 14% cost of capital on this graph. (To locate points on the graph use drawing tools – again, if you need help, use the “?” to look for “lines” and “arrows” or “drawing”)
4. Now assume that growth in revenues is 20% the first year, 15% the second year and then levels at 7%. Compute the new NPV and IRR.
5. What final sales price makes this project just acceptable assuming the growth rates provided in the case (i.e. 15%, 10%, and 5%) and 14% cost of capital. (In Excel go to Tools, Goal Seek and input that you want the value of NPV to be zero by changing the final purchase price.)