Capital Budgeting Analysis

Of
Yummy Pizza – A startup

Submitted to Submitted by

_______________________________ ______________________________
 Part1: Proposed Capital budgeting project

1.

An already good running restaurant wants to expand its business and therefore, it proposes to

open an exclusive restaurant for Pizza. The pizza would be branded as Yummy Pizza. It is

supposed to be served in restaurant as well as facility of home delivery would also be available.

Tea, coffee etc would also be provided in the restaurant but that are considered here as

complementary items and thus, not considered here for project evaluation. However, few major

players are already in the market like Domino’s and Pizza Hut, the restaurant’s pizza would be

different in two aspects. One, Yummy Pizza would be cheaper but at par of quality and size of

branded Pizza and second, it would have some very unique test. Further, restaurant also

proposes to serve only one type of pizza, although different in sizes – Small, Medium and Large.

Such decision would keep the investment and operating expenses at minimum level and pizza

would build its unique identity in due course that will be helpful to compete the market as well as

for brand building.

2.

The expected initial investment and monthly cash flow for first 3 years including assumptions

are as follows –

Initial Investment
Purchase of Machinery and Equipment $90,000
Working capital requirement $10,000
$100,00
0

It is assumed that Machinery and Equipments include following items –

 Expected
Items price
Refrigeration Equipments $10,000
Dough preparation equipments like
dough sheeters, dough presses and
proofing cabinets $6,000

Pizza oven $8,000

Basic preparation supplies like pizza
cutters, cutting boards, serving utensils
and plates $5,000

Serving supplies like pizza stand, pizza

boxes and pizza delivery bags $3,000
Chairs & Tables $10,000
Desk and Cuttleries $5,000
Air conditioning $10,000
Interior designing of restaurant $28,000
Lightening and Heating facilities $5,000
Total $90,000

Here, it is assumed that machinery and equipments will have useful life of 10 years and
Depreciation is calculated through St. line Method. Other costs are as follows -

Variable cost per unit

Direct material cost per unit 30% of selling price
Direct labor cost per unit 25% of selling price
Commission paid to staff 10% of selling price
Variable overhead cost 20% of Direct material

Fixed cost per month

Water usage $500
Electricity usage $1,500
Rent $1,000
Fixed overhead cost $3,000

Sales and administrative cost $2,000

Indirect labor cost $7,500
Depreciation $625
For restaurant, a carpet area of 200 sq meters is taken on rent of $1,000 per month. Since, Pizza

would also be delivered at customers’ home, four delivery boys and one administrator would be

hired at monthly salary of $1,500 each.

The proposed prices of Pizza and expected monthly sales volume are as follows -

Small Medium Large

Selling price $10 $15 $20
Sales Volume 1,600 1,200 800

The expected monthly and annual profits are as follows –

Monthly and Annual Income Statement

Size of Pizza Total
Particulars
Small Regular Large Monthly Annual
Sales price per unit $10.00 $15.00 $20.00
Sales
No. of units sold 1,600 1,200 800 3,600 43,200
Total sales amount $16,000 $18,000 $16,000 $50,000 $600,000

Direct Material Cost per unit $3.00 $4.50 $6.00

Direct Labor Cost per unit $2.50 $3.75 $5.00
Commission paid to staff $1.00 $1.50 $2.00
Variable
costs Variable overhead costs $ 0.60 $ 0.90 $1.20
Total variable costs per unit $7.10 $10.65 $14.20

Variable cost for the month $11,360 $12,780 $11,360 $35,500 $426,000

Contribution per unit $2.90 $4.35 $5.80

Contribut
ion Contribution Margin $4,640 $ 5,220 $4,640 $14,500 $174,000
Gross profit margin 29.00% 29.00% 29.00%

Fixed overhead costs $3,000 $36,000

Sales and administrative costs $2,000 $24,000
Fixed
costs Indirect labor cost $7,500 $90,000
Depreciation $625 $7,500
Total fixed cost for a month $13,125 $157,500
Net Profit $1,375 $16,500

Further, it is assumed that in 2nd and 3rd year, the sales and variable costs are expected to rise by

10% while all other costs remain same.

Tax is supposed to be 30%.

At the end of 3rd year, Machinery and Equipments are sold at their book value and working

capital is recovered.

The expected cash flows for 3 years are as follows –

Free Cash Flow Statement

Year 0 Year 1 Year 2 year 3
Initial Investment -$100,000
$600,00
Sales 0 $660,000 $726,000
$426,00
Less: Total Variable cost 0 $468,600 $515,460
$157,50
Less: Fixed cost 0 $157,500 $157,500
Income before tax $16,500 $33,900 $53,040
Income Tax @ 30% $4,950 $10,170 $15,912
Income after tax $11,550 $23,730 $37,128
Add: Depreciation $7,500 $7,500 $7,500
Add: Recovery of working capital $10,000
Add: After tax sales proceed of Equipments $20,250
Free cash flow -$100,000 $19,050 $31,230 $74,878

3.

Not applicable here as the useful life of the project is assumed to be here only 3 years. Since,

there is no assumption of forever existence of project, the terminal value or horizon value of the

cash flow can’t be found.

 Part 2: Value the Equity funded project

To find the equity funded project, first cost of Equity is found using CAPM.

Calculation of Cost of Equity, Ke

Risk free rate 1.65%
Market return 10%
Beta 0.84
According to CAPM model,
Cost of Equity, ke 8.66%

Free Cash Flow Statement

Year 0 Year 1 Year 2 year 3
Initial Investment -$100,000
$600,00 $660,00 $726,00
Sales 0 0 0
$426,00 $468,60 $515,46
Less: Total Variable cost 0 0 0
$157,50 $157,50 $157,50
Less: Fixed cost 0 0 0
Income before tax $16,500 $33,900 $53,040
Income Tax @ 30% $4,950 $10,170 $15,912
Income after tax $11,550 $23,730 $37,128
Add: Depreciation $7,500 $7,500 $7,500
Add: Recovery of working capital $10,000
Add: After tax sales proceed of Equipments $20,250
Free cash flow -$100,000 $19,050 $31,230 $74,878

Cumulative cash flow -$80,950 -$49,720 $25,158

Payback period 2.66

NPV @ 8.66% $2,346.18
IRR 9.72%
 Part 3: Select the Organizational form

There are many forms of organizations – Sole proprietorship, Partnership, Private limited

Company and Public limited Company. Since, the restaurant is opened at small scale with small

investment and cash flows, it would be better to take the organizational form as Sole

proprietorship. This form of organization would be helpful in many ways. Decision making

process would be quick and easy as single person is owner of the business. Second, least

documentations are required to be complied with government authority. Thus, starting of

business becomes hassle free and preliminary costs are also less occurred.

Part 4: Recommended Capital Structure

The recommended capital structure of the firm would be 75% equity and 25% debt. A small

portion of debt in the capital structure would be safer as well as beneficial for the business. Safer

in the sense that company would have lower fixed obligation in the terms of interest and

principal payment. Thus, risk of insolvency would be low. Beneficial in the sense that company

will enjoy the benefit of interest tax shield as interest is tax deductible. Debt is also quick and

easy to raise fund. The cost of debt is lesser than cost of equity. Thus, overall Cost of capital will

be low. Therefore, a small portion of debt in capital is better for starting phase of the business.

With growth and expansion of business in due course, more debt can be considered.
8

Weighted average capital approach

Weight of debt 25%
Weight of Equity 75%
Pre tax cost of debt 6%
Tax rate 30%
Post tax cost of debt 4.20%
Cost of Equity 8.66%

Weighted average cost of capital (WACC) 7.55%

Free Cash Flow Statement

Year 0 Year 1 Year 2 year 3
Initial Investment -$100,000
Sales $600,000 $660,000 $726,000
Less: Total Variable cost $426,000 $468,600 $515,460
Less: Fixed cost $157,500 $157,500 $157,500
Less: Interest expense $1,500 $1,500 $1,500
Income before tax $15,000 $32,400 $51,540
Income Tax @ 30% $4,500 $9,720 $15,462
Income after tax $10,500 $22,680 $36,078
Add: Depreciation $7,500 $7,500 $7,500
Add: Recovery of working capital $10,000
Add: After tax sales proceed of Equipments $20,250
Free cash flow -$100,000 $18,000 $30,180 $73,828

NPV@7.55% $2,173.65

Adjusted present value approach

Cost of debt 6%
$25,00
Debt financing 0
Annual Interest on debt $1,500
Tax rate 30%
Interest tax shield per year $450
PV of Interest rate shield $1,203
 Unlevered NPV of project $2,346
Adjusted present value (APV) of the project $3,549

Part 5: Additional Project Analysis

Three different tools – Discounted Payback period, Modified Internal Rate of Return (MIRR)

and Accounting Rate of Return (ARR) is used to find the Breakeven.

The Calculated Breakeven points are as follows –

 Discounting Payback period = 2.92 years

 Modified Internal rate of Return (MIRR) = 9.28%

 Accounting Rate of Return (ARR) = 12.35%

Discounting Payback period is less than 3 years, MIRR is more than Cost of Capital (7.55%) and

Accounting Rate of return is positive. Therefore, it is concluded that project should be accepted.

10

Scenario Analysis

Scenario Analysis helps the business to evaluate the project in different favorable and

unfavorable scenarios. Future is uncertain and therefore, any good or bad situation may arise.

Therefore, by considering major macro and micro level possible changes in market and

economy, the consequent changes in different cost and revenue items of the project are

considered and then project is evaluated for its financial feasibility.

Here two possible scenarios are taken into consideration – “Best case Scenario” and “Worst Case

Scenario”.

The assumptions for both the scenarios are as follows –

Best Case Scenario: Worst Case Scenario:

Sales increases by 15% in 2nd and 3rd year Sales decreases by 10% in 2nd and 3rd year
Variable costs increases by 12% in 2nd and 3rd year Variable costs reduces by 5% in 2nd and 3rd year
Tax reduces to 25% Tax increases to 33%

The NPV under both the scenario are calculated as follows –

Free Cash Flow Statement (Best case)

Year 0 Year 1 Year 2 year 3
Initial Investment -$100,000
$600,00 $690,00 $793,50
Sales 0 0 0
$426,00 $477,12 $534,37
Less: Total Variable cost 0 0 4
$157,50 $157,50 $157,50
Less: Fixed cost 0 0 0
Less: Interest expense $1,500 $1,500 $1,500
$100,12
Income before tax $15,000 $53,880 6
Income Tax @ 25% $3,750 $13,470 $25,031
Income after tax $11,250 $40,410 $75,094
Add: Depreciation $7,500 $7,500 $7,500
Add: Recovery of working capital $10,000
Add: After tax sales proceed of
Equipments $20,250
$112,84
Free cash flow -$100,000 $18,750 $47,910 4

$49,561.8
NPV@7.55% 0
\
Free Cash Flow Statement (Worst Case)
Year 0 Year 1 Year 2 year 3
Initial Investment -$100,000
Sales $600,000 $540,000 $486,000
 Less: Total Variable cost $426,000 $404,700 $384,465
Less: Fixed cost $157,500 $157,500 $157,500
Less: Interest expense $1,500 $1,500 $1,500
Income before tax $15,000 -$23,700 -$57,465
Income Tax @ 33% $4,950 -$7,821 -$18,963
Income after tax $10,050 -$15,879 -$38,502
Add: Depreciation $7,500 $7,500 $7,500
Add: Recovery of working capital $10,000
Add: After tax sales proceed of Equipments $20,250
Free cash flow -$100,000 $17,550 -$8,379 -$752

NPV@7.55% -$91,530.02
Since, Under “Best Case Scenario”, NPV comes positive, project should be accepted but under

“Worst case Scenario”, NPV comes negative, project shouldn’t be accepted.

11.

Sensitivity Analysis

Sensitivity Analysis is a financial technique that is used to determine the effect of different

independent variables on a particular dependent variable under a given set of assumptions.

Simply, we can say that it is the method that is used to look at the variation pattern of the

dependent variable due to the influence of different independent variables under the given

condition. Here, Dependent variable is taken as NPV while Independent variables are Initial

Investment, Revenue, Tax rate, Discount rate etc. Their graphs are as follows -

Initial Investment Vs NPV RevenueVs NPV

$60,000 $100,000
$40,000 $50,000
$20,000
$0
$0 $500,000 $550,000 $600,000 $650,000
$50,000 $100,000 $150,000 $200,000 ($50,000)
($20,000)
($40,000) ($100,000)

($60,000) ($150,000)
 Variable Costs Fixed Costs
$150,000 $40,000
$30,000
$100,000 $20,000
$10,000
$50,000 $0
$0 ($10,000)
$100,000 $150,000 $200,000 $250,000
($20,000)
$350,000 $400,000 $450,000 $500,000
($50,000) ($30,000)
($40,000)
($100,000) ($50,000)

Tax rate Vs NPV Discount rate Vs NPV

$7,000 $10,000
$6,000
$5,000 $5,000
$4,000
$3,000 $0
$2,000 4% 6% 8% 10% 12% 14% 16%
($5,000)
$1,000
$0 ($10,000)
($1,000)24% 26% 28% 30% 32% 34% 36%
($2,000) ($15,000)

The slope of the graph - Variable Costs vs NPV is highest than other graphs. It shows that NPV

of the project is highly sensitive than other variables. Thus, in terms of sensitivity, Variable costs

are the top followed by Tax rate and Initial Investment. Therefore, company should take more

control over variable cost to keep the project financially feasible till the end of completion.

12

A new designed system needs to be well understood before its practical application so any flaws

can be corrected and further strategies can be built up for its long term functioning. Simulation

model is the digital prototype of the physical model to analyze its performance in real world. A

physical model may be the supply chain system of a production house, intensive care unit system

of a hospital, an interactive teaching system of a school or flight’s data management of takeoff

and landing. Whether such physical set up and system would work efficiently, cost effective and

user friendly, it must be verified through several testing process in real situation. Since, a real

world testing would incur high cost and risk of lives and assets; simulation is effective then.

The variables that may be taken for simulation are –

 Initial Investment

 Selling price

 Sales volume

 Variable cost per unit

 Discount rate

Selling price and Sales volume are normally distributed because with the increase of their values,

the profit/Net cash flow would also increase but after a certain limit, the profit/Net cash flow

would decrease. Their mean and variance can be determined through statistical formula and

methods. Initial Investments, Discount rate and Variable cost per unit are uniformly distributed

as they have constant probability of affecting NPV. With rise in their values, the NPV will

decrease and vice versa. Their Means and variances would be constant due to their constant

probabilities.

Conclusion

The project of starting a new restaurant exclusive for Pizza food item is innovative idea, although

the Industry is highly competitive. If project is solely financed by equity, the cost of project

comes to 8.66% and the capital budgeting tools like NPV, IRR and Payback period suggest that

project should be accepted. If project is financed by 25% debt and 75% equity, the WACC

comes to 7.55% and again project is accepted through NPV, IRR and Payback period analysis. In
the “Best Case” scenario, project is accepted as NPV is positive but in the “Worst Case”

scenario, project is rejected as NPV turns to be negative. The sensitivity analysis suggests that

“Variable cost” is most sensitive to the project followed by “Tax rate” and “Initial Investment”.

Therefore, Variable costs need to be controlled more attentively for the success of project. The

Breakeven points like Discounted Payback period, MIRR and ARR also suggest that project is

profitable. Therefore, it is concluded that project should be accepted and one should start the

business of opening Pizza restaurant.

References:

How to open a pizza shop (2018). Information retrieved from:

https://www.webstaurantstore.com/article/42/how-to-start-a-pizzeria.html

Estimation of Pizza shop equipments (2019). Information retrieved from:

http://www.amazon.com

Electricity, water and Heater usage charges (2019). Information retrieved from:
https://www.npr.org/sections/money/2011/10/27/141766341/the-price-of-electricity-in-your-state

Beta of Domino’s stock (2018). Information retrieved from:

https://www.infrontanalytics.com/fe-EN/35779NU/Domino-s-Pizza-Inc-/Beta

Yield on 10 years Treasury Bond (2019). Information retrieved from:

https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?
data=yieldYear&year=2019

Market return (2019). Information retrieved from: https://www.macrotrends.net/2526/sp-500-

historical-annual-returns