QUESTION 8

1. MAIN PROJECT

Iqra University is considering investing in an online book ordering and information service, which will be managed by 2 employees. The following estimates relate to the costs of starting the service and the subsequent revenues from it.

1. The initial investment needed to start the service, including the installation of additional phone lines and computer equipment, will be $1,000,000. These investments are expected to have a life of 4 years with 0 salvage value.
2. The investments will be depreciated straight line over the four-year life.
3. The revenues in the first year are expected to be $1500,000, growing 20% in year 2, and 10% in the two years following.
4. The salaries and other benefits for the employees are estimated to be $150,000 in year 1, and grow 10% a year for the following three years.
5. The cost of the books is assumed to be 0.60 of the revenues in each of the four years.
6. The non-cash working capital, which includes the inventory of books needed for the service and the accounts receivable (associated with selling books on credit), is expected to amount to 10% of the revenues; the investments in working capital have to be made at the beginning of each year.
7. At the end of year four, the entire working capital is salvaged at book value.
8. The tax rate on income is expected to be 40%.

For above project prepare the following :

Assume that the company would be funded using the same market debt-to-equity ratio as the book/publishing industry. Staying consistent, we will use the market debt-to-capital ratio of the sector to compute the cost of capital for the firm.

Cost of Equity : 7.46%

Pre-tax cost of debt : 4.05%

After tax cost of debt : 2.43%

Debt to equity ratio : 17.63%.

The ten-year U.S. Treasury bond rate was 2.75%.

Tax rate for the firm is 40%. We computed a cost of capital based on that assumption.

For this project we will use total beta of 1.6783 to measure the additional risk that the owner of business is exposed to because of his lack of diversification.

EXTENSION PROJECT

Assume that Online book store is considering adding a cafe to its bookstore. The cafe, it is hoped, will make the bookstore a more attractive destination for would-be shoppers. The following information relates to the proposed cafe:

The initial cost of re-modelling a portion of the store to make it a cafe is expected to be $150,000. This investment is expected to have a life of five years, during which period it will be depreciated using straight-line depreciation. None of the cost is expected to be recoverable at the end of the five years.

The revenues from the cafe in the first year are expected to be $60,000, growing at 10% a year for the next four years.

There will be one employee, and the total cost for this employee in the first year is expected to be $30,000, growing at 5% a year for the next four years.

The cost of the material (food, drinks, etc.) needed to run the cafe is expected to be 40% of

revenues in each of the five years.

An inventory amounting to 5% of the revenues has to be maintained; investments in the inventory are made at the beginning of each year.

The tax rate as a business is 40%.

Find payback period for Main project.