Question

Lagosti is a food retail company. Its management is considering modernising its retail outlet in Kenya by expanding the shop floor. The planned investment is $1.6 million. The company expects that undertaking this investment will attract an additional 55,000 customers, each of whom will spend on average $45.00 per year. The variable costs associated with this investment is expected to be $35.00 per customer. Operating the expanded retail outlet will incur an additional $300,000 fixed costs (all cash). The cost of capital of the company is 8%. The company assesses its expansion projects over a 10-year period although the profitability of the expansion is expected to continue for 15 years. The book value of the expansion will be written down over the 15 years to zero.

Required:
1. Calculate the net annual cash flow and the annual depreciation charge.
2. Calculate the payback period of the project.
3. Calculate the average annual profit and the simple accounting rate of return of the project.
4. Calculate the NPV of the proposed investment over the 10-year assessment period.

Answer 1

Lagosti is planning to modernise its retail outlet in Kenya by expanding the shop floor at a planned investment of $1.6 million. They expect this investment to attract an additional 55,000 customers, each spending an average of $45 per year. The variable cost per customer is expected to be $35, and an additional fixed cost of $300,000 is expected to be incurred while operating the expanded retail outlet, which would incur all-cash fixed costs. The cost of capital of the company is 8%. The company evaluates its expansion projects over a ten-year period, although the profitability of the expansion is expected to continue for fifteen years. The book value of the expansion will be written down to zero over 15 years.2. Calculate the payback period of the project.Payback period can be calculated as follows:Calculate the net cash flow for each year, which is the cash inflow for that year minus the cash outflow for that year.Net cash flow = Cash inflow - Cash outflowIn this problem, the cash inflow is the revenue generated from additional customers, which is 55,000 * $45 = $2,475,000.Cash outflow = variable cost per customer * number of customers + fixed costsCash outflow = $35 * 55,000 + $300,000 = $2,125,000YearNet Cash FlowCumulative Cash Flow0($1,600,000)($1,600,000)1$350,000($1,250,000)2$350,000($900,000)3$350,000($550,000)4$350,000($200,000)5$350,000$150,000The payback period is 4 years + ($200,000 / $350,000) = 4.57 years4. Calculate the NPV of the proposed investment over the 10-year assessment period.Net present value can be calculated using the following formula:NPV = -Initial investment + PV of cash inflowsPV = Cash inflows / (1 + Cost of capital) ^ Number of yearsYearNet Cash FlowPV Factor (8%, n)PV0($1,600,000)1($1,600,000)1$350,0000.926$324,1002$350,0000.857$299,4503$350,0000.794$277,9004$350,0000.735$258,2505$350,0000.681$240,3506$350,0000.630$224,5507$350,0000.583$209,9508$350,0000.540$196,5509$350,0000.500$184,40010$350,0000.463$173,450NPV = -1,600,000 + 2,458,400 = $858,400Thus, the NPV of the proposed investment over the ten-year evaluation period is $858,400.