Bookscape is considering investing in an online book ordering and

information service, which will be staffed by two full-time employees. The following estimates relate
to the costs of starting the service and the subsequent revenues from it.
1. The initial investment needed to start the service, including the installation of additional phone
lines and computer equipment, will be $1 million. These investments are expected to have a life
of four years, at which point they will have no salvage value. The investments will be depreciated
straight line over the four-year life.
2. The revenues in the first year are expected to be $1.5 million, growing 20% in year 2, and 10% in
the two years following.
3. The salaries and other benefits for the employees are estimated to be $150,000 in year 1, and
grow 10% a year for the following three years.
4. The cost of the books is assumed to be 60% of the revenues in each of the four years.
5. The non-cash working capital, which includes the inventory of books needed for the service and
the accounts receivable (associated with selling books on credit), is expected to amount to 10%
of the revenues; the investments in working capital have to be made at the beginning of each
year. At the end of year four, the entire working capital is salvaged at book value.
6. The tax rate on income is expected to be 40%, which is also the marginal tax rate for Bookscape.
estimates relate

, and 10% in

service and

Bookscape.
Year
+ Earnings before interest and taxes (1 − t)
+ Depreciation and amortization
− Change in noncash working capital
− (Capital expenditures − Disinvestments)
= Cash flow to firm
Discounted FCFF for undiversified owner
Discounted FCFF for diversified owner

Year
Earnings before interest and taxes (1 − t)
Revenues

Book cost

Labor cost

Depreciation and amortization

Year
Change in noncash working capital aka Investment in noncash working capital
Noncash working capital

Year
Capital expenditures

initial investment
 0 1 2 3 4
0 120,000 183,000 216,300 252,930
0 250,000 250,000 250,000 250,000
-150,000 -30,000 -18,000 -19,800 217,800
-1,000,000 0 0 0 0
-1,150,000 340,000 415,000 446,500 720,730
-1,150,000 279,224 279,896 247,311 327,845 value of these cash flow in the now
-1,150,000 320,036 367,694 372,374 565,783 cas flow and then divide 1+ cost of capital, raised to the power of t

0 1 2 3 4
0 120,000 183,000 216,300 252,930
1,500,000 1,800,000 1,980,000 2,178,000
20% 10% 10%
900,000 1,080,000 1,188,000 1,306,800

150,000 165,000 181,500 199,650

10% 10% 10%
250,000 250,000 250,000 250,000

0 1 2 3 4
150,000 30,000 18,000 19,800 -217,800
150,000 180,000 198,000 217,800 0

0 1 2 3 4
1,000,000

1,150,000
raised to the power of the year
For undiversified owner
Risk-free rate 0.98%
Risk premium 4.72%
Unlevered total beta 4.52
D/E 7.15%
Tax rate 40.00%
Levered total beta 4.71
Cost of equity 23.22%

Default spread (margin) 1.30%

Before-tax (nominal) cost of debt 2.28%
After-tax (effective) cost of debt 1.37%

D/C 6.67%
E/C 93.33%
Cost of capital for the project (Bookscape) 21.77%

For diversified owner

Risk-free rate 0.98%
Risk premium 4.72%
Unlevered beta 1.14
D/E 7.15%
Tax rate 40.00%
Levered beta 1.19
Cost of equity 6.59%

Default spread (margin) 1.30%

Before-tax (nominal) cost of debt 2.28%
After-tax (effective) cost of debt 1.37%

D/C 6.67%
E/C 93.33%
Cost of capital for the project (Bookscape) 6.24%
https://home.treasury.gov/
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/histimpl.html
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/totalbeta.html
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/Betas.html
assumption from the instruction

https://home.treasury.gov/
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/histimpl.html
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/Betas.html
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/Betas.html
reject
accept

first
second
third
fourth
Accounting income-based measures of return
Return on Capital (ROC)

Year
EBIT * (1-T) --> find it in FCFF
BV of capital: beginning
BV of capital: ending
Average BV of capital --> beginning + ending divided by 2 OR use the average formula and then drag it to the right
Return on capital (ROC) --> ebit(1-t) divided by the average BV
Average

Average ROC
Cost of capital for undiversified investors
Cost of capital for diversified investors

Undiversified investors should

Diversified investors should

Cash flow-based measures of return

Payback Period (PP)

Year

0
1
2
3
4

The initial investment of $1.15 million is covered sometime in the

we can cover the -395k from t
Payback Period is:
Payback Period is:

Net Present Value (NPV)

NPV for undiversified investors is:

NPV for diversified investors is:

Undiversified investors should

Diversified investors should

Internal Rate of Return (IRR)

IRR is:

Undiversified investors should

Diversified investors should
 0 1 2 3 4 Average
0 120,000 183,000 216,300 252,930 193,058
0 1,150,000 930,000 698,000 467,800 n.a. bv --> book value
1,150,000 930,000 698,000 467,800 0 n.a. the right and left side of the balance sheet is b
n.a. 1,040,000 814,000 582,900 233,900 667,700
n.a. 11.54% 22.48% 37.11% 108.14% 28.91%
n.a. 44.82% both averages got different scores --> so which one to choo
instead of average we can use median to have not skewed d
28.91%
21.77%
6.24%

the project return is greater than the cost

the project return is greater than the cost

check the full explaination on the ppt

FCFF yearly FCFF

cumulated > add the previous year
-1,150,000 -1,150,000
340,000 -810,000 one and two
415,000 -395,000 two and three
446,500 51,500 three and four
720,730 772,230

year, leading to a payback of between

-395k from the income of the 446k in the coming year somewhere between 2nd and 3rd year we got
2.88 years make sure to add the (-) because of the negative cashflow
2 years and 321 days
convert the 2.88yrs into days

check the full explaination on the ppt present values discounted from the future

-15,724 USD
475,886 USD

the project
the project

check the full explaination on the ppt

21.11% use excel irr formula and just selected all the undiscounted cash flows and ignore the second point

the project
the project
 in the test there will be no tables/forms/headlines so learn every part

and left side of the balance sheet is balanced --> a=l+e --> so we will calculate that --> we can find in fcff so that is non cash working capi

erent scores --> so which one to choose, so we prefer 28.91 because of the statistical outlier, and being conservative is better.
can use median to have not skewed data

one and two

two and three
three and four

years from launching the project.

re between 2nd and 3rd year we got the profit
gnore the second point
at is non cash working capital 150,000 + capital expenditures 1,000,000; and we know our assets are decreasing because of depreciation

vative is better.
asing because of depreciation