Question

Sam wants to start a small commercial bakery to supply gourmet deserts to local restaurants.    He believes that with his product line and his connections in the restaurant business, he can grow the business over the next five years into a profitable niche player in the pre-made food supply business.   Sam projects the following cash flows (after any necessary reinvestment in the business):

Year 1        $350,000
Year 2        $450,000
Year 3        $650,000
Year 4        $1,000,000
Year 5        $1,350,000

Sam thinks the increase in profits will peak in about year six at $1.5 million, and that after that, they will grow at about 6% per year.

Sam is going to put up half the money and an investor associate is putting up the other half. This investor puts money into a lot of early stage companies, and he usually expects to make about 35% return.

Sam figures that once the business matures, he and the investor should only expect to make about 18% on the business, as that is similar to what some small publicly traded commercial bakeries make.  

Using discounted cash flows (including the terminal value), what is the net present value of Sam’s business?

Answer 1

Till the end of year 6, the investor will seek 35% rate of return, and after year 6, as the business gets mature, they will seek 18% rate of return. The initial investment is $1,000,000 as investors usually make 35% return on its investment.

Using DCF, the net present value of John's business

= - Initial investment + Present value of expected cashflows

= (-1,000,000) +

= -1,000,000 + 3,072,862

NPV = $ 2,072,862