Purpose 1. Develop intuition in cash flow estimation and capital budgeting.
Purpose 2. Calculate a project’s expected cash flows using the free cash flow approach.
Purpose 3. Calculate and use the net present value (NPV) method for evaluating capital intensive opportunities.
Preparation: Study chapter 12 and 13. Be familiar with cash flow estimation
Field Work: Each student is expected to visit one (or more) of the local companies. For example, we can visit a local restaurant. If it’s by a group, be sure to clearly state as a group submission as the title of your post. Also please include the names of all group members.
- Sales estimation. By observing the customer flow during breakfast (for example, *** Donut, Waffle ***, etc.), lunch, and dinner (for example, *** Buffet, *** Steakhouse, etc.) times, we can estimate the daily cash flow for the restaurant. To be a bit precise, we can do this over the entire week so that our estimation is not influenced by the day of week effect, that is, there might be more customers on Friday or Saturday. Then we can estimate the weekly or monthly cash flow for the restaurant.
- Expense estimation. If the restaurant leases the building, we can estimate the lease expense. Of course, if it’s closer to a mall, the monthly lease might be higher. We can also estimate the payroll expense along with the raw material cost, advertising costs, etc. In summary, we can have a rough estimate for the expenses. Alternatively, we can also assume that expense is a percentage of sales, for example, 70% of sales.
- Cash flow estimation. In this section, we need to estimate the depreciation costs for the restaurant equipment. We also need to estimate the taxes. Then we can estimate the free cash flows for the restaurant.
- Cash flow estimation for extended periods. Now, let’s study further the macroeconomic conditions and also the local dining business to see whether our cash flow estimation should be adjusted for next three years. We might not be able to do a very precise job in this regard. But we can assume that there is 3% inflation so we can adjust our sales upward. If we expect the restaurant is doing a better job than its competitors, we can adjust the sales growth rate further by, say, 2%. We might also need to adjust the expenses. In summary, we can have some estimation of the cash flows for the next three years.
- Start your own business. Now let’s start our own restaurant business. Try to project your initial investment (cash outlay), projected sales, expenses, and cash flows for the next five years. We can sell the restaurant after 5 years for X dollars. Essentially, the present value of X should be equal to a similar restaurant in business for 5 years now. We can then draw the cash flows and the terminal value of the restaurant on a timeline. With a cost of capital estimation, for example, 10%, we can find out the NPV of our business. If the NPV is a lucrative number, we might be able to convince potential investors to invest in our upcoming restaurant.Although I used a restaurant as an example, we can certainly change this into a grocery store, a car dealership, a hair salon, a dry cleaning store, a clothes retailer, and so on.
- Discuss the business you chose and why you choose that kind of business.
- Analyze in detail the 5 points mentioned in Field Work section.