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Suppose you own a donut shop that generates $680,000 in after-tax operating income and has revenues of $6 million. You are pondering whether you should

Suppose you own a donut shop that generates $680,000 in after-tax operating income and has revenues of $6 million. You are pondering whether you should start a service that will ship your products to houses in your city. Suppose that you estimate that such a service would generate an additional $1.5 million in revenues. Youve come up with the following additional information:

  • The existing facilities and donut-making equipment will require updating, which will cost you $750,000. You can however depreciate this investment (straight line over 5 years to a salvage value of $250,000). Note here that you dont need to pay a capital gains tax.

  • Additional staff must be hired to process the additional orders. The additional staff will add $300,000 to your costs (salary and related costs).

  • You also need to step up your advertising, which will increase from $60,000 (now) to $90,000 (if you pursue the project).

  • Your realize that your current inventory of $200,000 is not sufficient; it must increase to $250,000 right away. This increase in inventory however is recovered at the end of the project.

  • As far as the cost of your product (donut's) goes, it will be 60% of revenues.

  • The service will run for the next 5 years.

  • Lastly, your marginal tax rate is 35%.

  1. Find the yearly after-tax cash flows from this investment.

  2. If your cost of capital (or discount rate) is 9%, estimate the net present value of this

    investment.

  3. What is the IRR of this project?

  4. Assume that 30% of the revenues from the delivery service end up going to loyal

    customers who would have otherwise come to the donut shop? (The assumption here is that these customers would have spent a similar amount at the donut shop). What is your new NPV?

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