TO: Tennis Club Board of Directors
FROM: Google Answers
SUBJECT: TENNIS PROFESSIONAL OPPORTUNITY
EXECUTIVE SUMMARY
===================
Whether examined by standard financial terms using Net Present Value
(NPV) or ordinary accounting standards, the investment is highly
attractive. Investment of $500,000 at the outset provides an NPV of
almost $237,0000 -- even with the relatively high discount factor of
15%.
We've made the most-conservative of assumptions here, including timing
income at the end of each year. In fact, the additional subscription
income AND membership income will come during the year -- accelerating
cash flows and making this an even more attractive investment
opportunity than the attached model shows:
Tennis Professional Economic Analysis
http://mooneyevents.com/tennis.xls
Several comments on this analysis will also show how the club can make
this investment even MORE attractive.
NET PRESENT VALUE
==================
The NPV analysis discounts each year's cash flow according to timing.
Though the prime rate is near 5%, we've assumed a 15% discount factor
-- which dramatically reduces the impact of significant income in the
"out" years (years 3-5). This is done to reflect the risk of the
Tennis Club investment but a capital rate of 15% is still VERY high
given current economic conditions.
Still, the cash flows are so attractive that the NPV of the project is
$236,785 -- and any positive NPV makes a project a "Go":
Idaho State University School of Business
"Capital Budgeting Techniques" (Krishnan, Fall 2003)
http://cob.isu.edu/santmuku/Files/chapter9.pdf
The fact that subscription and membership income comes in continually
during the year, would make the project more attractive. A
more-precise assumption would be to judge each year's income as
falling at mid-year -- which would only make this project MORE
attractive by lowering the NPV factor calculation.
INTERNAL RATE OF RETURN
========================
The IRR calculation takes the initial outlay and then times the income
for each of the years. It assumes that as capital comes back it can
be reinvested in a project with similar returns -- which is not always
true. In this case, IRR calculations provide a 34.2% return, which is
far above the cost-of-capital.
Again, the true IRR might be a little higher, inasmuch as club
memberships and subscriptions are earned each month of the year and
not at year-end, as this model assumes. However, club revenues
probably will be invested at bank rates, rather than in a project as
attractive as this one -- countering the apparent high IRR.
ACCOUNTING RETURN
====================
Accounting returns are the highest, not taking into account the
cost-of-capital. However, they represent what the club will be liable
for in income taxes, so it's relevant to see what they are.
Accounting returns will be the highest of all -- and they are for this
project at 116%. However, they ignore costs of money.
PROFITABILITY INDEX
===================
The Profitability Index uses the NPV of free cash flows and divides it
by the initial investment of $500,000. Any profitability index higher
than 1 is considered a "Go," as it produces a positive NPV.
The total NPV of Year 1 to Year 5 is $736,785 -- which is 1.474 of the
initial $500,000 investment.
The Profitability Index would be more useful to us if we had multiple
projects to compare and limited capital but it's well above the
minimum of 1.00 here and a strong indication that the project should
be accepted.
PAYBACK PERIOD
================
Payback periods give us an idea how long it will be before yearly
profits from the Tennis Professional program will allow the club to
pay off the initial $500,000 investment. Clearly it uses all of Year
1 and Year 2 income -- leaving about $55,000 to be paid in Year 3.
Inasmuch as Year 3's income is so high it's only slightly more than 2
months in Year 3 before the investment is paid back.
OTHER COMMENTS
=================
We've already noted that the discount rate is extremely high,
considering current interest rates. And we've noted that the attached
financial model is conservative, putting yearly income at the end of a
year rather than accounting for the fact that subscriptions and
memberships will increase every month of the year.
The club can also increase the value of this investment by doing the following:
* making salary contingent on achieving subscription and membership increases
* financing the purchase of the house, thus reducing the initial cash
outlay by the club
Google search strategy:
"profitability index" + NPV
You shouldn't have any problems getting to the Excel spreadsheet used
for these calculations, as most browsers support the Excel file
format. However, if you do please let this researcher know so that we
can post the information in text form here.
Best regards,
Omnivorous-GA |
