Question

A local bike shop is considering opening a new coffee shop and to operate the shop over the next ten years. The coffee shop will occupy space next door in the same building. That space is currently being rented out to a tenant for $30,000 per year (paid at the end of each year). If you open the coffee shop, you will not be able to rent out the space and you will forgo the $30,000 rental income per year starting in one year. The project will require an upfront capital investment of $200,000 today in order to pay for remodeling the space and the new equipment. This capital investment can be expensed for tax purposes. At the end of the ten years, the store believes it can sell the equipment for $20,000. The store expects the new coffee shop to generate sales revenue from the project of $200,000 one year from today. The sales revenues are expected to grow annually at a rate of 5% over the next 10 years. The costs of goods sold amount to 30% of sales. Selling, general, and administrative (SG&A) costs are expected to amount to 40% of sales. The project will require an investment in net working capital of 10% of sales, to be in place at the beginning of each year (i.e., working capital in year 0 is based on the sales in year 1). The bike shop expects to remain very profitable in the future and to incur a marginal corporate tax rate of 20%. You plan to finance the project 40% with equity and 60% with debt. The bank offers you a loan with a fixed interest rate of 5%. The probability that you will default in any year on this loan is 1% and if you default creditors expect to recover 50% of the loan principal. You estimate the equity beta of the project to be 1.5, the Treasury bill rate to be 2%, and the market risk premium to be 8%.a) Compute the NPV of the project.b) The assumptions above state that the SG&A costs amount to 40% of sales. However, you are not completely sure about this assumption. What is the breakeven SG&A proportion relative to sales?

Answer 1

Answer

The answer and procedures of the exercise are attached in the following archives.

Explanation  

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