Kelly Clark owns a popular hot dog stand on a trendy section of Melrose Boulevard. Following the success of her first hot dog stand, “Kelly’s,” which has been in operations for three years, she is now considering opening a second hot dog stand in another trendy location, on Ocean Drive in Sunset Key. Kelly has hired a consultant, Mark, for $5,000, whose market research shows that the clientele in both areas is similar. They are young professionals, typically without children, who like the traditional aspect of eating hot dogs, but also relish her gourmet, organic hot dogs and the healthy side dishes her stand also sells.
Kelly’s overall plan is to get the second stand up and running for five years, and then sell both stands off to a new owner and travel around the world. Kelly estimates that the cost of the specialized kitchen equipment for the second hot dog stand is $69,000 and installation costs are $1,000. Kelly forecasts that she will need to invest $50,000 initially in net working capital for the new outlet. As annual sales are predicted to be stable, Kelly anticipates that she will need to maintain $50,000 in net working capital for each year of operating the second hot dog stand. She also estimates that yearly operating costs of the new location would be almost identical to those of her current stand. A more detailed breakdown of revenue and costs of the current stand are reported in the table below:
In addition to contributing profits, Kelly expects that opening a second stand will decrease the cost of producing hot dogs from 60 cents to 50 cents in both locations. This is due to economics of scale, since the new outlet would double output over the current level of demand.
Kelly has so far replied upon word-of-month for advertisement. Mark, the marketing consultant, recommends to her to advertise inside mobile apps. He argues that, given the demographic of her customers, this will be an effective way to further maximize the synergy created by opening the second stand. His research shows that an annual advertising spending of $5,000 should bring additional revenue of $4,000 each year to each stand.
The kitchen equipment falls into the MACRS 7-year class. At the end of the fifth year, the equipment is expected to have a market value of $20,000.
Kelly expects that she will be able to manage both locations herself, avoiding hiring a second manager for the new location. Assume that the marginal tax rate is 35 percent and the required rate of return is 10 percent.
1) What is the initial investment outlay of the second hot dog stand?
2) What is the net salvage value of the kitchen equipment at the end of the fifth year?
3) Forecast the incremental cash flows generated by the second hot dog stand from Year 1 to Year 5
4) What are the NPV, IRR and Profitability Index of second hot dog stand? How long will it take for Kelly to recover her initial investment?
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