Reference no: EM133010434

Your friend has asked you to evaluate some business options for a property they bought. Two years ago, they paid $1,000,000 for the property, an old gas station. Last year, they also spent $750,000 removing old tanks and taking care of preparing the building for a new business.

They are evaluating turning the property into a restaurant to be called "The Station". If they open this up as a restaurant, they will have to invest another $500,000 in restaurant equipment and fixtures, which will be depreciated over 20 years on a straight-line basis. The friend expects for the restaurant to be open for 20 years and then to shut down. At that time (20 years from now), your friend thinks they can sell the equipment for $120,000 and will have to spend $140,000 to restore the location back into a non-restaurant space (which can be deducted for tax purposes in that year). Finally, your friend will need to spend $50,000 in working capital at the time of initial equipment and fixture investment and will be able to recover this when the restaurant closes.

Each year the restaurant is open, your friend expects to bring in revenue of $450,000, for food costs to be 1/3 of revenues and for other operating costs to be $125,000 per year. Your friend's tax rate is 25%.

Problem 1: What are the appropriate project level cash flows related to this project? Show all of your work.

Problem 2: If your friend believes he should earn a 15% after-tax rate of return, is this a good investment? Be specific about your answer in terms of financial calculations and explanation

Problem 3: What pre-tax annual rent would your friend need to receive each year for 20 years in order for them to be indifferent to starting the restaurant vs. renting the building to someone else from a strictly financial point of view? You may assume that both of these alternatives have the same risk and that the friend wants to earn the same return whether they build the restaurant vs. rent the building to someone else.