Ideal Company owns a department store selling furniture and home furnishing. It is studying the feasibility of opening a new store.
Ideal plans to run the store for only 3 years.
The details relating to the project are as follows:
• Additional working capital of $100,000 is required. This level is expected to remain the same until the end of the project.
• Sales of the new store for the 3 years are $500,000, $550,000 and $600,000, respectively.
• Lost sales of in main store due to opening of new store is $50,000 a year. • Rent and other expenses for the new store amount to $150,000 each year. • Cost of goods are 50% of sales.
• Cost of market research done 1 year ago is $50,000.
Ideal plans to borrow $500,000 to finance this project. The bank will charge the same loan rate as the existing bank loan that the company has of $2 million. The bank charges the company a loan rate which consists of the risk-free rate and a risk premium of 2%.
Ideal has 1,000,000 common shares with a market price of $2 each. The stock has a beta of 1. Currently, the market risk premium is 5% while the risk-free rate is 3%.
Ideal pays a 20% tax rate.
- Compute the operating cash flows related to the project.
- Compute cash flows from assets for the project.
- Compute the NPV of the project using a discount rate of 10 %. Appraise whether the firm should go ahead with the project.