Discounted cash flow analysis

Reference no: EM13197515

You have been asked by your 60 year old uncle Karl to help him assess a new venture. It is Friday night, and he needs the work finished by Sunday in preparation for an early Monday morning meeting, so you know that he will not be able to give you any more information than he already has (and you will be unable to contact him over the weekend), and therefore you may need to rely on your own estimates for some of the analysis.

Karl lives in New Jersey and recently took early retirement (from a company he joined 35 years ago), and left the company with a lump sum payment of $300,000. Surprisingly, rather than being depressed by his new state of independence, he is excitedly contemplating a new career as a retailer of fine chocolate. He is confident that he can set up a business to import chocolate from Switzerland and sell it in the USA. His wife, whom he met at business school, is pleased with his passion for this possible new venture, but concerned that it might turn into a financial disaster. She has suggested that he develop a financial plan to evaluate the venture and its viability.

After a couple of hours with Uncle Karl you have assembled the following information from him:

- SwissChoc SA (owned by a college friend) is prepared to give him exclusive rights to sell their products in the USA for a five year period in exchange for an upfront payment;

- The products retail in Europe for an average of CHF 100 per kilogram;

- SwissChoc would sell products to Karl at a 40% discount to their European price (f.o.b.);

- SwissChoc would ship to Karl on receipt of payment for each order;

- Karl has found out that air freight from Switzerland via DHL would cost CHF 10 per kg and that shipment from the factory to him would take three days;

- Karl plans to order from Switzerland every two weeks and intends to maintain a minimum stock of four weeks worth of sales to ensure that he will be able to supply a suitable range of products to customers;

- He will buy a special refrigerator at a cost of $5,000 to be able to keep the chocolate in good condition, and has found a small industrial unit he can rent nearby at a cost of $300 per month;

- Karl intends to sell by internet only, and is planning to spend $1,000 with a website designer;

- He is not sure what price he will be able to achieve for the chocolates, but is confident that it should be somewhere between $120 and $150 per kg;

- All sales would be by credit card, with the credit card company taking 2% per sale and remitting the balance to Karl once every month;

- Karl estimates that he will be able to build sales up slowly in the first year, starting at 20kg a week initially, up to 50kg a week at the end of the year, and continuing at 50kg a week from the beginning of the second year onwards;

- He believes that one person could run the operation and hopes to do so himself, paying a salary of $5,000 per month in the first year, going up to $6,500 per month thereafter;

- Karl's marginal tax rate on investment or earned income is 30%.

Karl believes that he could invest his redundancy lump sum at 5% per annum and therefore suggests that you use 5% as the after tax discount rate for a discounted cash flow analysis.

Karl has asked you to prepare an analysis to help him with his decision, making clear any assumptions that you make; the analysis should not exceed 4,000 words (excluding the content of exhibits, headings, etc) and should include:

- A summary of all assumptions and estimates that you have made for your analysis, including justifications where appropriate;

- Monthly cash flow in the first year of operation;

- Annual cash flow thereafter;

- Any sensitivity analysis that you think would be helpful;

- The amount which Karl could offer SwissChoc SA as an upfront fee for the exclusive rights for the five year period which would leave him no better or worse off than if he did not undertake the venture;

- Conclusions and recommendations.

Karl has explained that he is going to be out of town for a wedding so will be unable to provide any assistance at all, but as he pointed out before leaving "you business school students have it a lot easier than we did in our day, what with computers and the internet to help".

Reference no: EM13197515

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