Assignment - Case Study: America Coffee House
Purpose - For this case approach, you will demonstrate your ability to develop costing methods and a set of forecasts of future cash Qows for two proposed investment projects. You will also be required to identify the cost of Tnancing through the issuance of bonds.
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Q1. Calculate the bond yield to utilize as your required return.
Calculation of the Bond's Current Yield
Face value = $1,000
Coupon Rate = 12%
N=10 years
Current Market Price = $1,100
Coupon payment = semi-annual
The bonds current yield is calculated as follows:
Current Yield = Interest / bond Price = $120/$1190 = .1008 = 10.08%.
2. Prepare a summary narrative (i.e., a detailed description) of each proposal with detailed elements on the initial investment, as well as the costs/revenues over the life of each of the projects. Identify which revenues and costs are relevant to your analysis, and which costs are irrelevant. Identify the time horizon for each investment.
Description of the Project Proposal
The two proposals for increasing the growth and profitability is estimated to cost an initial investment of $1,000,000. Both the investment proposal would have a life term of 5 years. The other details of the proposals are as follows:
|
Proposal 1 (buy the New Roaster)
|
Proposal 2 (remodeling of the Company Stores)
|
|
Initial investment
|
1,000,000
|
1,000,000
|
|
Scrap
|
10%
|
nil
|
|
Life
|
5 years
|
5 years
|
|
Increase in revenue /saving of costs
|
400,000 each year on account of saving in costs of import.
|
1.200,000
2.300,000
3.500,000
4.650,000
5.700,000
|
|
Initial working capital needed
|
100,000
|
0
|
|
Corporate tax rates
|
30%
|
30%
|
|
Rate of discounting
|
10%
|
10%
|
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Q3. Calculate the after-tax cash Qows during the life of each of the projects. Be sure to identify the total costs of ownership and deduct those costs from the beneTts to arrive at the net cash inQow per year.
Calculation of after-tax cash flows for the projects
Based on the above projections the cash flows relevant for the 2 projects are estimated as follows:
Cash flows for Project proposal 1:
|
Proposal 1
|
|
|
|
|
|
|
|
0
|
1
|
2
|
3
|
4
|
5
|
|
initial investment
|
-1,000,000
|
|
|
|
|
|
|
Working capital
|
-200,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Saving of costs
|
|
400,000
|
400,000
|
400,000
|
400,000
|
400,000
|
|
less:
|
|
|
|
|
|
|
|
Depreciation
|
|
180000
|
180000
|
180000
|
180000
|
180000
|
|
Profit before taxes
|
|
220,000
|
220,000
|
220,000
|
220,000
|
220,000
|
|
less:
|
|
|
|
|
|
|
|
tax @ 30%
|
|
66000
|
66000
|
66000
|
66000
|
66000
|
|
PAT
|
|
154,000
|
154,000
|
154,000
|
154,000
|
154,000
|
|
add: Depreciation
|
|
180000
|
180000
|
180000
|
180000
|
180000
|
|
Scrap value
|
|
0
|
0
|
0
|
0
|
100,000
|
|
working capital realized
|
|
0
|
0
|
0
|
0
|
200,000
|
|
Cash flows after taxes
|
-1,200,000
|
334,000
|
334,000
|
334,000
|
334,000
|
634,000
|
Cash flows for Project proposal 2:
|
Proposal 2
|
|
|
|
|
|
|
|
0
|
1
|
2
|
3
|
4
|
5
|
|
initial investment
|
-1,000,000
|
|
|
|
|
|
|
Working capital
|
0
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Increase In revenue
|
|
200,000
|
300,000
|
500,000
|
650,000
|
700,000
|
|
less:
|
|
|
|
|
|
|
|
Depreciation
|
|
200000
|
200000
|
200000
|
200000
|
200000
|
|
Profit before taxes
|
|
0
|
100,000
|
300,000
|
450,000
|
500,000
|
|
less:
|
|
|
|
|
|
|
|
tax @ 30%
|
|
0
|
30000
|
90000
|
135000
|
150000
|
|
PAT
|
|
0
|
70,000
|
210,000
|
315,000
|
350,000
|
|
add: Depreciation
|
|
200000
|
200000
|
200000
|
200000
|
200000
|
|
Scrap value
|
|
0
|
0
|
0
|
0
|
0
|
|
working capital realized
|
|
0
|
0
|
0
|
0
|
0
|
|
Cash flows after taxes
|
-1,000,000
|
200,000
|
270,000
|
410,000
|
515,000
|
550,000
|
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Q4. Utilizing the after-tax cash Qows from part 4, evaluate each investment proposal utilizing the following criteria (unless directed otherwise):
a. Payback;
b. Discounted payback;
c. NPV;
d. IRR; and
e. Profitability index.
Evaluation of projects using NPV, IRR, PI etc.
a. Payback period
Payback period for both the proposals are estimated as follows:
|
Payback period
|
|
|
|
|
|
Proposal 1
|
Proposal 1
|
|
Year
|
CF
|
Cum CF
|
CF
|
Cum CF
|
|
0
|
-1,200,000
|
-1,200,000
|
-1,000,000
|
-1,000,000
|
|
1
|
334,000
|
-866,000
|
200,000
|
-800,000
|
|
2
|
334,000
|
-532,000
|
270,000
|
-530,000
|
|
3
|
334,000
|
-198,000
|
410,000
|
-120,000
|
|
4
|
334,000
|
136,000
|
515,000
|
395,000
|
|
5
|
634,000
|
770,000
|
550,000
|
945,000
|
|
Payback period
|
|
3.59
|
|
3.23
|
The payback period for the proposal 1 is 3.59 years and proposal 2 is 3.23 years. This means the proposal 1 would take 3.6 years approx. to return the initial investment made but the proposal 2 would need 3.23 years for the same. Proposal 2 is doing better than proposal 1 as it takes lesser time for generating the initial investment back fully (ROSS and Westerfield, 2012).
b. Discounted Payback Period
Discounted Payback period for both the proposals are estimated as follows:
|
Discounted Payback period
|
|
Proposal 1
|
|
Proposal 1
|
|
|
Year
|
CF
|
Cum CF
|
CF
|
Cum CF
|
|
0
|
-1,200,000
|
-1,200,000
|
-1,000,000
|
-1,000,000
|
|
1
|
303,636
|
-896,364
|
181,818
|
-818,182
|
|
2
|
276,033
|
-620,331
|
223,140
|
-595,041
|
|
3
|
250,939
|
-369,391
|
308,039
|
-287,002
|
|
4
|
228,126
|
-141,265
|
351,752
|
64,750
|
|
5
|
393,664
|
252,399
|
341,507
|
406,256
|
|
Payback period
|
|
4.36
|
|
3.82
|
The payback period for the proposal 1 is 4.36 years and proposal 2 is 3.82 years. This means the proposal 1 would take 4.4 years approx. to return the initial investment made but the proposal 2 would need 3.8 years for the same. Proposal 2 is doing better than proposal 1 as it takes lesser time for generating the initial investment back fully after discounting (Eugene Brigham & Michael Ehrhardt, 2010).
c&d. NPV & IRR
NPV and IRR for both the proposals are estimated as follows:
|
Proposal 1
|
|
|
|
|
|
|
|
0
|
1
|
2
|
3
|
4
|
5
|
|
Cash flows after Taxes
|
-1,200,000
|
334,000
|
334,000
|
334,000
|
334,000
|
634,000
|
|
PVF @ 10%
|
1
|
0.909091
|
0.826446
|
0.751315
|
0.683013
|
0.620921
|
|
PV
|
-1200000
|
303636.4
|
276033.1
|
250939.1
|
228126.5
|
393664.1
|
|
NPV
|
252399.2
|
|
|
|
|
|
|
IRR
|
17.18%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Proposal 2
|
|
|
|
|
|
|
|
0
|
1
|
2
|
3
|
4
|
5
|
|
Cash flows after Taxes
|
-1,000,000
|
200,000
|
270,000
|
410,000
|
515,000
|
550,000
|
|
PVF @ 10%
|
1
|
0.909091
|
0.826446
|
0.751315
|
0.683013
|
0.620921
|
|
PV
|
-1000000
|
181818.2
|
223140.5
|
308039.1
|
351751.9
|
341506.7
|
|
NPV
|
406256.4
|
|
|
|
|
|
|
IRR
|
22.28%
|
|
|
|
|
|
The net present value is the net value generated by a project after considering the present value of both cash inflows and outflows. The projects which generate positive NPV are considered for investment and the project with the highest NPV is accepted. NPV of the proposal 1 I estimated to be $252,400 where as the same for Proposal 2 is $406,256. This means if proposal 2 is accepted then the value of the firm would increase by more than proposal 1 (Damodaran, 2012).
Internal rate of return is the rate of return which must be generated to make sure the NPV is zero. A project is accepted if IRR is greater then the discount rate (r). for proposal 1 the IRR is 17.18% and for Proposal 2 the IRR is 22.28%. as IRR for both is higher both can be accepted but as proposal 2 has a higher IRR the same is recommended (Brealey, Myers, & Allen, 2017).
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e. Profitability index.
Profitability Index for both the proposals are estimated as follows: Profitability Index = PV of Inflows/ PV of outflows
|
Proposal 1
|
proposal 2
|
|
Present value of Cash inflows
|
1,970,000
|
1,945,000
|
|
Present value of cash outflows
|
1,200,000
|
1,000,000
|
|
Profitability Index
|
1.641667
|
1.945
|
The profitability index of the proposal 1 is 1.641 and the same for proposal 2 is 1.945. this means for every $1 of investment the Proposal 1 would generate $1.61 and $1.95 by proposals 2. So proposal 2 is expected to do better (Atrill, 2013).
Analysis and Recommendations
On the basis of the above analysis, Proposal 2 is recommended or investment as it is expected to generate higher cash flows and better value for the company. The basis of recommendation is as follows:
- Proposal 2 is doing better than proposal 1 as it takes lesser time (lower payback period) for generating the initial investment back fully.
- Proposal 2 is also better as its discounted payback period is much better than the Proposal 1 as well.
- Proposal 2 has a NPV of $406,256 which is very high than NPV of $252,400 of proposal 1. Hence the proposal 2 would increase value of the firm better than the other proposal.
- Proposal 2 has a IRR of 22.28% which is much higher than the 17.18% IRR generated by proposal 1. Hence better return would be expected form Proposal 1.
- The profitability index of the proposal 1 is 1.641 and the same for proposal 2 is 1.945. this means for every $1 of investment the Proposal 1 would generate $1.61 and $1.95 by proposals 2. So, proposal 2 is expected to do better.
As al the above parameters indicate Proposal (remodeling of the company stores) the same seems to be better and must be implemented without delay.
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