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Assignment - Case Study: America Coffee House

Purpose - For this case approach, you will demonstrate your ability to develop costing methods and a set of forecasts of future cash Qows for two proposed investment projects. You will also be required to identify the cost of Tnancing through the issuance of bonds.

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Q1. Calculate the bond yield to utilize as your required return.

Calculation of the Bond's Current Yield

Face value = $1,000

Coupon Rate = 12%

N=10 years

Current Market Price = $1,100

Coupon payment = semi-annual

The bonds current yield is calculated as follows:

Current Yield = Interest / bond Price = $120/$1190 = .1008 = 10.08%.

2. Prepare a summary narrative (i.e., a detailed description) of each proposal with detailed elements on the initial investment, as well as the costs/revenues over the life of each of the projects. Identify which revenues and costs are relevant to your analysis, and which costs are irrelevant. Identify the time horizon for each investment.

Description of the Project Proposal

The two proposals for increasing the growth and profitability is estimated to cost an initial investment of $1,000,000. Both the investment proposal would have a life term of 5 years. The other details of the proposals are as follows:


Proposal 1 (buy the New Roaster)

Proposal 2 (remodeling of the Company Stores)

Initial investment

1,000,000

1,000,000

Scrap

10%

nil

Life

5 years

5 years

Increase in revenue /saving of costs

400,000 each year on account of saving in costs of import.

1.200,000

2.300,000

3.500,000

4.650,000

5.700,000

Initial working capital needed

100,000

0

Corporate tax rates

30%

30%

Rate of discounting

10%

10%

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Q3. Calculate the after-tax cash Qows during the life of each of the projects. Be sure to identify the total costs of ownership and deduct those costs from the beneTts to arrive at the net cash inQow per year.

Calculation of after-tax cash flows for the projects

Based on the above projections the cash flows relevant for the 2 projects are estimated as follows:

Cash flows for Project proposal 1:

Proposal 1








0

1

2

3

4

5

initial investment

-1,000,000






Working capital

-200,000













Saving of costs


400,000

400,000

400,000

400,000

400,000

less:







Depreciation


180000

180000

180000

180000

180000

Profit before taxes


220,000

220,000

220,000

220,000

220,000

less:







tax @ 30%


66000

66000

66000

66000

66000

PAT


154,000

154,000

154,000

154,000

154,000

add: Depreciation


180000

180000

180000

180000

180000

Scrap value


0

0

0

0

100,000

working capital realized


0

0

0

0

200,000

Cash flows after taxes

-1,200,000

334,000

334,000

334,000

334,000

634,000

Cash flows for Project proposal 2:

Proposal 2








0

1

2

3

4

5

initial investment

-1,000,000






Working capital

0













Increase In revenue


200,000

300,000

500,000

650,000

700,000

less:







Depreciation


200000

200000

200000

200000

200000

Profit before taxes


0

100,000

300,000

450,000

500,000

less:







tax @ 30%


0

30000

90000

135000

150000

PAT


0

70,000

210,000

315,000

350,000

add: Depreciation


200000

200000

200000

200000

200000

Scrap value


0

0

0

0

0

working capital realized


0

0

0

0

0

Cash flows after taxes

-1,000,000

200,000

270,000

410,000

515,000

550,000

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Q4. Utilizing the after-tax cash Qows from part 4, evaluate each investment proposal utilizing the following criteria (unless directed otherwise):

a. Payback;

b. Discounted payback;

c. NPV;

d. IRR; and

e. Profitability index.

Evaluation of projects using NPV, IRR, PI etc.

a. Payback period

Payback period for both the proposals are estimated as follows:

Payback period






Proposal 1

Proposal 1

Year

CF

Cum CF

CF

Cum CF

0

-1,200,000

-1,200,000

-1,000,000

-1,000,000

1

334,000

-866,000

200,000

-800,000

2

334,000

-532,000

270,000

-530,000

3

334,000

-198,000

410,000

-120,000

4

334,000

136,000

515,000

395,000

5

634,000

770,000

550,000

945,000

Payback period


3.59


3.23

The payback period for the proposal 1 is 3.59 years and proposal 2 is 3.23 years. This means the proposal 1 would take 3.6 years approx. to return the initial investment made but the proposal 2 would need 3.23 years for the same. Proposal 2 is doing better than proposal 1 as it takes lesser time for generating the initial investment back fully (ROSS and Westerfield, 2012).

b. Discounted Payback Period

Discounted Payback period for both the proposals are estimated as follows:

Discounted Payback period


Proposal 1


Proposal 1


Year

CF

Cum CF

CF

Cum CF

0

-1,200,000

-1,200,000

-1,000,000

-1,000,000

1

303,636

-896,364

181,818

-818,182

2

276,033

-620,331

223,140

-595,041

3

250,939

-369,391

308,039

-287,002

4

228,126

-141,265

351,752

64,750

5

393,664

252,399

341,507

406,256

Payback period


4.36


3.82

The payback period for the proposal 1 is 4.36 years and proposal 2 is 3.82 years. This means the proposal 1 would take 4.4 years approx. to return the initial investment made but the proposal 2 would need 3.8 years for the same. Proposal 2 is doing better than proposal 1 as it takes lesser time for generating the initial investment back fully after discounting (Eugene Brigham & Michael Ehrhardt, 2010).

c&d. NPV & IRR

NPV and IRR for both the proposals are estimated as follows:

Proposal 1








0

1

2

3

4

5

Cash flows after Taxes

-1,200,000

334,000

334,000

334,000

334,000

634,000

PVF @ 10%

1

0.909091

0.826446

0.751315

0.683013

0.620921

PV

-1200000

303636.4

276033.1

250939.1

228126.5

393664.1

NPV

252399.2






IRR

17.18%













Proposal 2








0

1

2

3

4

5

Cash flows after Taxes

-1,000,000

200,000

270,000

410,000

515,000

550,000

PVF @ 10%

1

0.909091

0.826446

0.751315

0.683013

0.620921

PV

-1000000

181818.2

223140.5

308039.1

351751.9

341506.7

NPV

406256.4






IRR

22.28%






The net present value is the net value generated by a project after considering the present value of both cash inflows and outflows. The projects which generate positive NPV are considered for investment and the project with the highest NPV is accepted. NPV of the proposal 1 I estimated to be $252,400 where as the same for Proposal 2 is $406,256. This means if proposal 2 is accepted then the value of the firm would increase by more than proposal 1 (Damodaran, 2012).

Internal rate of return is the rate of return which must be generated to make sure the NPV is zero. A project is accepted if IRR is greater then the discount rate (r). for proposal 1 the IRR is 17.18% and for Proposal 2 the IRR is 22.28%. as IRR for both is higher both can be accepted but as proposal 2 has a higher IRR the same is recommended (Brealey, Myers, & Allen, 2017).

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e. Profitability index.

Profitability Index for both the proposals are estimated as follows: Profitability Index = PV of Inflows/ PV of outflows


Proposal 1

proposal 2

Present value of Cash inflows

1,970,000

1,945,000

Present value of cash outflows

1,200,000

1,000,000

Profitability Index

1.641667

1.945

The profitability index of the proposal 1 is 1.641 and the same for proposal 2 is 1.945. this means for every $1 of investment the Proposal 1 would generate $1.61 and $1.95 by proposals 2. So proposal 2 is expected to do better (Atrill, 2013).

Analysis and Recommendations

On the basis of the above analysis, Proposal 2 is recommended or investment as it is expected to generate higher cash flows and better value for the company. The basis of recommendation is as follows:

  • Proposal 2 is doing better than proposal 1 as it takes lesser time (lower payback period) for generating the initial investment back fully.
  • Proposal 2 is also better as its discounted payback period is much better than the Proposal 1 as well.
  • Proposal 2 has a NPV of $406,256 which is very high than NPV of $252,400 of proposal 1. Hence the proposal 2 would increase value of the firm better than the other proposal.
  • Proposal 2 has a IRR of 22.28% which is much higher than the 17.18% IRR generated by proposal 1. Hence better return would be expected form Proposal 1.
  • The profitability index of the proposal 1 is 1.641 and the same for proposal 2 is 1.945. this means for every $1 of investment the Proposal 1 would generate $1.61 and $1.95 by proposals 2. So, proposal 2 is expected to do better.

As al the above parameters indicate Proposal (remodeling of the company stores) the same seems to be better and must be implemented without delay.

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