Question

You can purchase the right to sell beverages at sporting events for 3 years at a local minor league baseball stadium. The cost of the rights to sell the beverages costs $200,000. The first year you plan on selling 25,000 drinks at $5 each. They will cost you $3 each. The second and third years, you will sell 50,000 drinks at $5, but now your cost is only $2.50 each. You need to spend $5,000 each year no matter what for electricity (ie. this is a fixed cost of the project). You already paid $10,000 to get your food license. You can depreciate the cost of the rights over the three years (straight line) and your tax rate is 25%. With a require rate of return of 10%, should you buy the rights? (NOTE: If EBIT is less than zero, use zero for the amount of taxes. Ignore any loss carry-forward.)

Answer 1

We need to calculate net present value (NPV) of the project to determine whether we should buy the rights or not. If NPV is positive then we can buy the rights. if it's negative then we can't buy the rights as it will be a loss making project.

NPV is difference between the present value of cash flows and initial investment.

NPV = year 1 cash flow/(1+required rate of return) + year 2 cash flow/(1+required rate of return)² + year 3 cash flow/(1+required rate of return)³ - initial investment

Initial investment will be sum of cost of rights and Food licence cost.

	Years	0	1	2	3
	Cost of the rights	-$200,000
	Food license	-$10,000
	No. of drinks to be sold	0	25,000	50,000	50,000
	Sales	$0	$125,000	$250,000	$250,000
Less:	Cost of drink	$0	$75,000	$125,000	$125,000
Less:	Electricity cost	$0	$5,000	$5,000	$5,000
Less:	Depreciation	$0	$66,667	$66,667	$66,667
	EBT	$0	-$21,667	$53,333	$53,333
Less:	Tax @ 25%	$0	$0	$13,333	$13,333
	EAT	$0	-$21,667	$40,000	$40,000
Add Back:	Depreciation	$0	$66,667	$66,667	$66,667
	Cash flows	-$210,000	$45,000	$106,667	$106,667
	NPV	-$796.39

As we can see in the above table that NPV is -$796.39, so we should not buy the rights. This project will generate a loss of $796.39.

Formula and Calculations

Less: Years Cost of the rights -200000 Food license -10000 No. of drinks to be sold o Sales Cost of drink Electricity cost Depreciation EBT Tax @ 25% EAT Depreciation Cash flows =C3+C4 NPV =NPV(10%,D14:F14)+C14 25000 =D5*5 =D5*3 5000 =-($C$3/3) =D6-07-D8-D9 Less: Less: 50000 =E5*5 =E5*2.5 5000 --($C$3/3) =E6-E7-E8-E9 =E10*25% =E10-E11 =E9 =E12+E13 50000 =F5*5 =F5*2.5 5000 --($C$3/3) =F6-F7-F8-F9 =F10*25% =F10-F11 Less: 13 Add Back: =D10-D11 =D9 =D12+D13 =F9 14 =F12+F13