Question

Apple is considering whether to build the “Global Store” in Federation Square Melbourne today in 2019. Apple has already purchased the land on the site and wants to make a decision about whether to build on it. Assume the store will have a life of 20 years and will generate revenues of $32 million per year AUD over the 20 years (with the first cash flow at the end of year 1). By building the store Apple will attract negative media attention (see Source 1) causing revenues to fall in its other stores by $400,000 AUD per year for the first five years of the project. By developing the site Apple will also lose existing rental income of $1 million per year. The total annual costs of the store will be 12% of the revenues from the new store and will similarly continue for 20 years with the first cost incurred at the end of year 1. The initial outlay for the project is $300 million AUD for building the store (The land has already been purchased so should not be considered in the analysis). The store will be depreciated straight line over the 20 years to a book value of 0 and Apple projects that the store can be sold at the end of year 20 for $200 million AUD. This sale price is however an optimistic projection and is dependent multiple factors. All values are in AUD. Assume the tax rate is 30% over the 20 years.

a) Why does the analysis not consider the price of the land? Explain with reference to theory.

b) Based on the above information and sources what are the free cash flows generated by Apple’s new store over the 20 years (Refer to your excel spreadsheet)?

c) Calculate the NPV for new Apple store using the below costs of capital and recommend whether they should accept the project for each cost of capital. a. A WACC (cost of capital) of 5.94%? b. A WACC (cost of capital) of 8%?

d) What is the IRR for new Apple store with a cost of capital of 5.94% and 8%? Should they accept the project at a 5.94% cost of capital? Should they accept it at an 8% cost of capital? Why?

e) Based in your analysis in a-d should Apple build the new store if we assume the cost of capital is 5.94%? Consider the NPV and IRR calculation in your answer, but also discuss the validity of some of the assumptions made.

Answer 1

a). land has been exempted from analysis as it has been purchased already irrespective of project being undertaken or not, thus in such cases land cost would go into the sunk cost of project and sunk costs should be excluded from this analysis of capital budgeting. Thus we exclude land costs.

b). sale price of $200mn for store is assumed to be tax deductible and is added to the 20th year cash flows.

c). NPV for 5.94% WACC is $ 11.92 mn and accept the project, while NPV for 8% WACC is $ -41.87 mn, so reject the project.

d). IRR is found to be 6.35% so at WACC of 5.94% it should be accepted while at a WACC of 8% it should be rejected as IRR > WACC for project to be accepted.

e). Yes, if cost of capital is 5.94% then definitely project should be accepted reason being NPV is positive and also IRR > WACC. But this also depends highly on the assumed resale value of project at end of 20 years. As we have assumed book value to be zero and after that its too optimal to assume a resale of 200 mn $ at the end of 20 years. If resale value is less than $ 150 mn then there is no meaning in accepting the project at either of the cost of capitals.