Question Three: Capital Budgeting

You are considering starting a small coffee shop in Auckland. After some market research and analysis, you have come up with two potential locations, one in the Central City (to be named as City Caf) and the other one in Ellerslie (to be called Ellerslie Caf). The setup costs are estimated to be $50,000 for City Caf and $45,000 for Ellerslie Caf. Given your budget constraint, you can only choose one of these options.

You have learned that small businesses would generally struggle during the first few years of operations. You took an optimistic forecasting approach and estimated that the first year after-tax net cash flows would be $8,000 and $6,800 for City Caf and Ellerslie Caf, respectively. The annual growth in net cash flows is estimated to be 3% for City Caf and 2% for Ellerslie Caf for the first 5 years (years 2 to 5) and then based on the end of year 5 cash flows, the growth in cash flows will increase to 6% for City Caf and 5% for Ellerslie Caf from years 6 to 10 as you improve your customer service and gain more loyal customers.

You are optimistic that you will be running the business for at least 10 years. At the end of the 10^th year, if you were to end the business, you estimated the salvage values (after depreciation) to be $10,000 for City Caf and $7000 for EllerslieCaf. Your estimated cost of capital is 9.5%.

a) Using the above information, conduct an NPV analysis for each option. (6 marks)

NPV for City Caf: Central Cafe :

NPV for Ellerslie Caf:

a) Based on your NPV results, which option shall you adopt to start your small business?

Option to be adopted: City cafe

Explanation:

b) Before you make your final decision, what financial analysis can be performed for a more in-depth or comprehensive capital budgeting analysis? Why would that be useful? Use an example to clearly illustrate your point.

[Word limit: 80 words; answers beyond the word limit will not be marked.] (4 marks)

i. Further financial analysis to perform: [Type here]

ii. Explanation using an example: [Type here]