Reference no: EM132194298

Question - The City of Empty Pockets has (another) serious budget shortfall and the mayor is proponent of selling city assets under the guise of privatizing. His office has called for bids on the exclusive right to rent bicycles, in-line skates and skate boards in the city's extensive park system. The successful bidder can also sell or ancillary items such as helmets, protective guards and sundry non-alcoholic refreshments.

The agreement will terminate after five years and the successful bidder will not have any renewal rights. You have commissioned a marketing survey and feasibility study (at a total cost of $750,000) that suggest the following forecasts of expected financial results.

The immediate startup investment will be $5,500,000. You have already paid the mayor's brother-in-law a $800,000 consulting fee. The salvage value of the property plant and equipment and working capital at the end of the project will be sufficient only to remove all traces of commercial development from the otherwise pristine parks and cannot be recaptured by the successful bidder. Annual capital expenditure is expected to be 20.0% of the gross balance of PP&E at the beginning of the year and depreciation (both book and tax) is expected to be 19.0% of the gross balance of PP&E at the beginning of the year. Net working capital should run at 2.0% of revenues.

Total revenues in the first year are expected to be $7,000,000, growing at 4.00% in nominal terms. The gross profit margin should be 65.0% of revenues and SG&A should account for a further 22.0% of revenues. Depreciation is included in cost of goods sold.

The income tax rate is 40.0% and taxable income is equal to book income Assume the cost of capital is 10.0% per year.

Questions -

a. What value would you place on this opportunity?

b. Suppose you could make additional capital expenditures equal to 1.0% of gross PP&E and increase the gross profit margin to 68.0%. Would you do so?

c. One of the consultants suggests a marketing plan that should increase the sales growth rate. The plan would cost $200,000 per year for the each of the first four years of operations. What increase in revenue growth is necessary to justify such a plan?

d. Suppose you could recapture 25.0% of the book value of the PP&E and all of the book value of the NWC at the end of year 5. How much extra value would this add, assuming the recovery is not taxable?

e. Briefly discuss two features of the contract proposed by the city that are likely to lower the bids.