The Copper Loaf: a second site and a bank covenant
The Copper Loaf is a single café with revenue of £520,000 and a net profit margin of 6%. The owner wants a second site. The project requires £140,000: £95,000 for fit-out and equipment, and £45,000 of working capital, which would be recovered at the end of year 5. Forecast net cash inflows are £38,000, £46,000, £52,000, £44,000 and £30,000 for years 1–5, with the £45,000 working capital returning in year 5. The owner has £60,000 of savings and can borrow £80,000 at 7.5% over five years, but the bank requires payback within three years. Discount factors at 9% are: year 1 0.917, year 2 0.842, year 3 0.772, year 4 0.708, year 5 0.650. A national chain has just announced a branch 400 metres from the proposed site, opening in eight months. The owner currently works 55 hours a week and has no trained site manager.
1. Calculate the payback period and the net present value (NPV) of the second site. Interpret both results.
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Payback: cumulative cash flows are Y1 £38,000; Y2 £84,000; Y3 £136,000; Y4 £180,000. After Y3, £4,000 is still needed. Y4 inflow is £44,000, so 4/44 = 0.09. Payback = 3.09 years. This fails the bank's three-year condition by about one month.
NPV:
- Y1: 38 × 0.917 = 34.85
- Y2: 46 × 0.842 = 38.73
- Y3: 52 × 0.772 = 40.14
- Y4: 44 × 0.708 = 31.15
- Y5: (30 + 45) × 0.650 = 48.75
Total PV = £193.62k; less £140k outlay = +£53.62k.
Interpretation: the project creates value at a 9% discount rate, but the result is sensitive. Without recovery of the £45k working capital, PV is £144.87k and NPV only +£4.87k. The positive NPV therefore depends heavily on a successful exit and on the year-5 assumption, not just on trading profit.
2. Evaluate whether the positive NPV is enough to justify proceeding with the second site. Recommend a course of action.
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A positive NPV is not sufficient. The bank requires payback within three years, but 3.09 years breaches the covenant, so the owner would need to renegotiate or cut the fit-out. NPV is fragile: if the £45k working capital is not fully recovered, NPV falls to about +£4.9k. The national chain opening 400 metres away in eight months makes the £52k year-3 inflow optimistic; a 10% shortfall across years 1–3 would reduce NPV by roughly £11k. The owner also works 55 hours a week and has no site manager, so management capacity is a real constraint. Loan interest is £80,000 × 7.5% = £6,000 a year, which year-1 cash flow covers, but £60,000 of personal savings is at risk.
Recommendation: do not proceed on the current plan. Conditions: reduce fit-out to about £80,000 or negotiate a 3.5-year payback test; appoint a site manager before opening; and phase the launch so the chain's impact can be observed. If those conditions are met, the project's positive NPV and diversification benefit justify proceeding.