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Accounting Report
Student
Institution
Course
Instructor
Date
2
Question 1: Incremental Cash Flows
A) Calculations:
1.1. Initial Investment
This is gotten by summing the costs as follows: Initial Investment=Cost of Bicycles
+Cost of Metal Shelves + Design and Printing
Substitute the values:
(2×€1,500) + €4,000 + €15,000 + €3,200
Collect the like terms together:
= €25,200
1.2. Annual Cash Flows
Sales Revenue−Cost of Goods Sold (COGS)−Delivery Guys’ Salaries−Net Working Capital Inv
estment
Year 1
(750× €20 × (1−0.75)) − (750 × €20 × 0.75) − €16,000 − (0.12 × Year 1 Sales)
= €5,350
Year 2
(1,000× €20 × (1−0.75)) −(1,000 × €20 × 0.75) − €16,000 − (0.12 × Year 2 Sales)
= €8,900
Year 3
(1,200× €20× (1−0.75)) − (1,200× €20×0.75) − €16,000− (0.12×Year 3 Sales)
= €12,450
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1.3. Salvage Value
Gotten by:
=Salvage value of Bicycles + Salvage value of Metal Shelves
Substitute the values:
= (2 × €400) + 0
=€800
1.4. Net Cash Flow:
Annual Cash Flows + Salvage Value
Year 1
€5,350 −€25,200 + €800
=−€19,050
Year 2
€8,900 − €16,000 + €800
=−€6,300
Year 3
€12,450 − €16,000 + €800
= −€2,750
B) Paragraph of Justification:
All cash flows identified are incremental to the project. The initial investment and annual cash
flows are directly associated with the implementation and operation of the delivery service. The
salvage value represents the recovery of some initial investment at the end of the project. Each
cash flow is crucial in assessing the project’s financial viability.
Question 2: NPV, IRR, and Payback Period
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A) Calculations:
2.1. NPV:
NPV = ∑ (Net Cash Flow (1 + Cost of Capital)
NPV = −€19,050/ (1+Cost of Capital) + (−€6,300/ (1+Cost of Capital)2 + (−€2,750/
(1+Cost of Capital) ^3 + €800/ (1+Cost of Capital) ^3
2.2. IRR:
IRR=Rate
where NPV equals zero
2.3. Payback Period:
Cumulative Cash Flow1=−€19,050
Cumulative Cash Flow2=Cumulative Cash Flow1+(−€6,300)
=−€25,350
Cumulative Cash Flow3 = Cumulative Cash Flow2 +(−€2,750 + €800)
= −€27,300
Now, let’s determine the Payback Period:
Payback Period=Number of years before cumulative cash inflows cover the initial investment
The initial investment is covered sometime during Year 2. To find the exact Payback Period:
Payback Period = 1+(Remaining InvestmentCash Flow at the Start of Year 3)
Remaining Investment =−(Cumulative Cash Flow2)
Payback Period=1+ (−(−€25,350) −€2,750)
Payback Period≈1+9.21818
Payback Period≈10.22
B) Paragraph of Justification/Thought Process:
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The NPV is a key indicator of the project’s profitability, with a positive value indicating a viable
investment. A higher IRR signifies a better return on investment, and a shorter payback period
implies quicker recovery of the initial investment. In this case, Manuel should consider the NPV,
IRR, and payback period collectively to make an informed decision.
Question 3: Cost of Capital
A) Calculation:
3.1. Weighted Average Cost of Capital (WACC):
WACC = (Cost of Debt × Weight of Debt) + (Cost of Equity × Weight of Equity)
Cost of Debt = 7%
Weight of Debt=0.35
Cost of Equity = Risk-Free Rate + (Beta × Market Risk Premium)
Risk-Free Rate = 2.746% (3-year bonos yield)
Market Risk Premium=5.8%
Beta= 1.3
Cost of Equity = 2.746% + (1.3 × 5.8%)
=10.526%
WACC = (Cost of Debt × Weight of Debt) + (Cost of Equity × Weight of Equity)
WACC= (0.07× 0.35) + (0.10526 × 0.65)
WACC= 0.0245 +0.0682
WACC=0.0927
B) Justification
The WACC represents the overall cost of capital, considering both debt and equity. By using the
current market yields for debt and incorporating the risk premium and beta for equity, the
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WACC provides an accurate estimate of the cost of capital for the project. Manuel can use this
WACC as a reliable benchmark for evaluating the project’s financial feasibility.
| Year | Net Cash Flow (€) |
|——|——————–|
|0
| -19,050
|
|1
| 5,350
|
|2
| 8,900
|
|3
| 12,450
|
Bicycle price in €
Quantity
1,500
Items
Bicycles
Metal Shelves
Design
Printing
Total initial costs
Employee salary
Net working capital rate
Bicycle selling price each
Initial investment
Books selling rate
tax rate
interest rate
total cost
2
3,000
Costs (€)
3,000
Year
1
2
3
4,000
15,000
3,200
25,200
Sub-Total
15,000
0.12
400
1,250
0.75
30%
7%
Year
1
2
3
sub-Total
Year
1
2
3
NPV, IRR, and Cash payment period Calculations
Year
Cash flow
cumulative cash flow
0
-1,250
-1,250
1
11,550
10,300
2
18,900
29,200
3
24,780
53,980
IRR
981%
NPV
$47,530.25
Cash payment period
1
monthly Books sold
Delivery system
Annual books sold
Sales price (€)
750
9,000
1000
12,000
1200
14,400
Annual Books sold instore
6,750
9,000
10,800
Instore
sales price (€)
20
20
20
Annual revenue (€)
15
15
15
101,250
135,000
162,000
398,250
Total annual revenue
total annual costs
Net Working Capital Investment
281,250
216,000
33,750
375,000
288,000
45,000
450,000
345,600
54,000
Cost of Capital
Cost of Debt
Weight of Debt
Risk free rate
beta
Market Risk Premium
Cost of Equity
Weight of Equity
WACC
7%
35%
2.746%
1.30
5.8%
10.286%
65%
9.1359%
Annual revenue (€)
Costs of books sold
180,000
135,000
240,000
180,000
288,000
216,000
708,000
531,000
costs
81,000
108,000
129,600
318,600
Expenses
profit
15,000
15,000
15,000
Tax
16,500
27,000
35,400
Net cash flows
4,950
11,550
8,100
18,900
10,620
24,780
Assignment A3.1 – Making a Business Decision
Assignment Description
In this final assignment, you are asked to answer several questions regarding a potential
business idea (described below). Apply all that you have learnt throughout the course to
answer the questions – and good luck!
A small bookstore on Gran Via, one of the main arteries through Madrid and a famous
shopping street, has come up with the idea of delivering books to visitors to Madrid who
stay in local hotels. Given the central location of the bookstore, the books would be
delivered to tourists staying in nearby hotels within less than 30 minutes.
The idea for the delivery service originally came from five MBA students at IE Business
School who conducted a market study into the potential need for such a service. From
person experience, the students knew that it is easy to forget one’s current book at
home while travelling. The five MBA students spent last summer interviewing local
tourists about the desirability of such a service. Manuel Munoz, the bookstore owner,
sponsored this market study with €1,250. The market study also revealed that Amazon
were planning to set up a similar delivery service in central Madrid. Due to various
administrative delays, Amazon would only be able to start its delivery service in exactly 3
years from now. It would then immediately price Manuel’s bookstore out of the market.
The bookstore would need to buy two electrical bicycles for the delivery guys at a price
of €1,500 each. The two bicycles would be fully depreciated in a straight line over the
three years. They could be sold for €400 each at the end of the project. The bookstore
would also need to use an empty room at the back of the store as a storeroom. If the
bookstore were not to go ahead with the delivery service, the empty room could be
rented out at an annual rent of €2,000. The storage room would require heavy-duty
metal shelves at a total cost of €4,000. These metal shelves would have to be fixed to
the walls and would therefore be difficult to remove once fixed. Hence, Manuel assumes
that the shelves will not have a resale value. He also assumes that they will not be
depreciated.
If going ahead, Manuel wants to advertise the new delivery service by distributing
leaflets to nearby hotels. He has been quoted a fee of €15,000 for the design of various
promotional items and another €3,200 for the printing of sufficiently enough leaflets and
other promotional items (such as free keyholders) to last for the next three years.
The two delivery guys needed for the delivery service would be paid €16,000 p.a.
However, Manuel expects to relocate an existing employee who already works for the
bookstore to the delivery service. This employee currently earns €15,000 p.a.
The new delivery service would generate sales of 750 books, 1,000 books and 1,200
books each month during the first year, the second year and the third year, respectively.
The average sales price of the books would be €20. The cost of the books sold is 75% of
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their sales price to the customers. Manuel expects that the number of books sold instore
would drop by 25% of the number of books sold via the delivery service. The average
sales price per book for the eroded sales is €15 and the cost of the books sold is 80%.
The bookstore pays 30% of tax on its profits.
Manuel is somewhat confused about his cost of capital. He knows that he should not
rely on the bookstore’s historic cost of debt. He therefore phoned up his bank manager
who quoted him an interest rate of 7% if he were to take out a loan today. Following
some extensive research on the internet, he is pretty sure that the equity beta of his
bookstore is roughly 1.3. He asked one of his regular customers, a finance professor at
IE, what risk premium he should use for the market premium. The professor suggested to
use a market risk premium of 5.8% p.a.
However, Manuel does not know what rate to use for the risk-free rate. He looked up
the yields on various debt securities issued by the Spanish government and he found the
following:
Debt security
Current yield
3-month bills
1.820%
1-year bills
2.655%
3-year bonos
2.746%
5-year bonos
2.952%
10-year bonos
3.384%
Note: The Spanish word for bond is “bono”.
The bookstore is currently financed by 35% of debt and 65% of equity. The new project
is expected to require the same capital structure or mix of debt and equity as the entire
bookstore.
Net working capital of 12% of the annual sales revenue would need to be in place at the
start of each year. The net working capital would be fully recovered at the end of the
project.
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Manuel does not feel very confident about estimating his cost of capital. Would you be
able to help him? What value would you suggest for the cost of capital? Please answer
each of the following questions:
1. Determine the incremental cash flows for this project. Clearly explain why a given
cash flow is incremental or not.
2. Compute the NPV, IRR and payback period for the project. Should Manuel go ahead
with this project?
3. Manuel does not feel very confident about his estimated cost of capital. Would you
be able to reassure him? If yes, how?
Assignment Structure
Your assignment will be an Excel spreadsheet cleary showing your answers to the
questions below (three main questions, with each question subdivided into parts).
For Question 1 (25% of your grade):
A. Determine the incremental cash flows for this project – calculate each.
B. Clearly explain why a given cash flow is incremental or not – write your thought
process/justification in another cell (to the right of your calculations for each selected
cash flow).
For Question 2 (50% of your grade):
A. Compute the NPV, IRR and payback period for the project – calculate each.
B. Should Manuel go ahead with this project? Write your recommendation (paragraph,
using a cell in the Excel sheet and clearly label it as your answer to Question 2B) with
your explanation for what your suggestion is for Manuel as far as going ahead with
the project.
For Question 3 (25% of your grade):
A. Manuel does not feel very confident about his estimated cost of capital – calculate
the cost of capital (show your calculation).
B. Would you be able to help him? What would be your suggested cost of capital? Write
your recommendation (paragraph, using a cell in the Excel sheet and clearly label it as
your answer to Question 3B) explaining your thought process.
Assignment Format
Your assignment should be handed in as an Excel sheet containing your calculations and
answers to the questions (as listed above):
•
•
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Question 1: A) calculations; B) paragraph of justification for each cash flow selected.
Question 2: A) calculation of NPV, IRR and payback period for the project; B)
paragraph of justification/thought process.
•
Question 3: A) calculation of cost of capital; B) paragraph of justification/thought
process.
Grading
Your assignment will be graded as follows:
INCREMENTAL CASH FLOWS
Correct identification of each
incremental cash flow and providing
a thorough explanation for each on
why it is or is not an incremental
cash flow
25 possible points
COMPUTING NPV, IRR, AND
PAYBACK PERIOD
Correctly computing each value and
providing an appropriate
recommendation for Manuel on
whether to accept the project or not
50 possible points
COST OF CAPITAL
Correctly calculating the cost of
capital and providing a thorough
explanation of why the cost of capital
is appropriate for the project.
25 possible points
Considerations for Completing this Assignment
•
•
•
•
•
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This is individual work.
Your assignment should be submitted in Excel format. Please make sure you include
both your calculations and the text explanation within the Excel sheet, clearly labeling
your text explanations as “Question 1 Response,” “Question 2b Response,” etc. (where
applicable).
This assessment will be graded by your Learning Facilitator and will count as 60% of
your grade.
Use the rubric in the Grading section (above) as a guide to understand how you will be
assessed.
Please label your assignment with the following format: as CXXFinanceAXXLastNameFirstName.
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