Question

Entrepreneurial Decision Making

James Jones is an entrepreneur and founder of Tasty Cakes Bakery. During the last year, Tasty Cakes generated $40,000 in operating cash flows, paid $10,000 in capital expenditures (as it does almost every year), and paid $5,000 in dividends. Jones is interested in significantly expanding this year. To do so, he needs to spend $100,000 on equipment in addition to his normal capital expenditures. He believes that if he buys the equipment, his operating cash flows will surely increase by 25% and possibly could double. He has spoken with the bank, which has offered the following two installment note options: Option 1 is a two-year, 5% $100,000 installment note; and Option 2 is a six-year, 10% $100,000 installment note.

Discuss Tasty Cake's free cash flow. Identify the advantages and disadvantages of each option and recommend which option James should pursue.

Answer 1

Working of all 3 options

Calculation of Increase in Free Cash flows		Option 1	Option 2
Increase in Cash Flow - Note received		1,00,000	1,00,000
Increase in Operating Cash Flow - 25% of 40,000		10000	10000
Sub - Total (A)		1,10,000	1,10,000
Principal Repayment		53763	22957
Interest Cost @ 5% and 10% respectively		5000	10000
Sub - Total (B)		58763	32957
Total Net Cash Flow (A-B)		51,237	77,043

Calculation of Principal Repayment by formula

Present Value of Principal Repayment = [1-1/(1+i)n/i]

As per calculation, Option 2 should be recommended