A restaurant company is considering further investment in order to increase its seating
capacity. The company prepares its accounts to 31 December each year and, if accepted, the
proposed investment would be made on 1 January 2017 and will become operational
immediately.
Based on the actual results for the year to date, the latest forecast income statement for the
company for the year to 31 December 2016 is as follows:
£’000 £’000
Food sales 180
Drink sales 150
330
Food costs 125
Drink costs 70
Staff costs 55
Other costs* 45
295
Profit 35
*These other costs include rent, light and heat, power and administration overheads. 30% of
these costs vary in proportion to the value of sales and the remainder are fixed costs.
The proposed investment
At present the restaurant is not able to exploit the growing demand from customers because
it does not have sufficient seating capacity. The restaurant is considering the investment of
£40,000 on 1 January 2017. It is expected that this will increase the seating capacity of the
restaurant by 30% compared to the present level. The lease of the current business premises
ends at the end of 2020. At that time the £40,000 investment will have no residual value. Of
this total investment, £30,000 will qualify for 100% tax depreciation in 2017 and the remainder
will qualify for 20% tax depreciation per year, commencing in 2017, calculated on a reducing
balance basis. Any balancing tax charge will be made or allowance will be available at the end
of 2020.
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Sales
It is expected that the additional sales of food and drink will be proportional to the seating
capacity increase and that the mix of food sales and drink sales will not change.
Costs
It is expected that apart from the effects of inflation (see below):
Food costs and drink costs will continue to be the same percentage of food sales and
drink sales as they are in the forecast income statement shown above.
Staff costs are step costs and are expected to increase by 20% from their forecast
value for 2016 if there is any capacity increase.
The variable element of other costs is expected to increase in proportion to the capacity
increase; the fixed cost element is expected to increase by £10,000 if there is any
capacity increase.
Inflation
Cost inflation is predicted to be 4% per annum for each of the years 2017 to 2020 whereas
selling prices are only expected to increase by 3% per annum during the same period.
Taxation
The company pays tax on its profits at 20%. This is payable one year after the profit is earned.
Cost of capital
The company’s post tax money cost of capital for evaluating this investment is 8% per annum.
Required:
(a) Prepare calculations to show whether the investment is worthwhile
assuming that the 30% increase in seating capacity is fully utilised and
recommend whether the investment should proceed.
(17 marks)
(b) Calculate and interpret the Internal Rate of Return (IRR) of the proposed
investment.
(8 marks)
(c) Explain briefly the advantages and disadvantages of discounted cash flow
methods over other traditional methods of capital investment appraisal.
(5 marks)
(Total 30 marks)