Question 15.8: Alive & Kicking Ltd (AAK) owns a disused warehouse in wh...
Alive & Kicking Ltd (AAK) owns a disused warehouse in which a promoter runs regular small gigs.
There are currently no facilities to provide drinks. The owners of AAK intend to provide such facilities and can obtain funding to cover capital costs. This would have to be repaid over five years at an annual interest rate of 10%.
The capital costs are estimated at £120,000 for equipment that will have a life of five years and no residual value. To provide drinks, the running costs of staff , etc., will be £40,000 in the first year, increasing by £4,000 in each subsequent year. AAK proposes to charge £10,000 per annum for lighting, heating and other property expenses, and wants a nominal £5,000 per annum to cover any unforeseen contingencies. Apart from this, AAK is not looking for any profit as such from the provision of these facilities, because it believes that there may be additional future benefits from increased use of the facility. It is proposed that costs will be recovered by setting drinks prices at double the direct costs.
It is not expected that the full sales level will be reached until year three. The proportions of that level estimated to be reached in years one and two are 40% and 70% respectively.
You are required to:
(i) calculate the sales that need to be achieved in each of the five years to meet the proposed targets
(ii) comment briefly on four aspects of the proposals that you consider merit further investigation.
You may ignore the possible effects of taxation and inflation.
(i)
| Equipment | Running costs | Lighting, heating, etc. | Total outflow | 10% discount | Present value | |
| Year | £000 | £000 | £000 | £000 | rate | £ |
| 0 | 120 | 120 | 1.00 | 120,000 | ||
| 1 | 40 | 15 | 55 | 0.91 | 50,050 | |
| 2 | 44 | 15 | 59 | 0.83 | 48,970 | |
| 3 | 48 | 15 | 63 | 0.75 | 47,250 | |
| 4 | 52 | 15 | 67 | 0.68 | 45,560 | |
| 5 | 56 | 15 | 71 | 0.62 | \underline{44,020} | |
| Present value | \underline{355,850} |
We can assume that the annual sales revenue at the full level is S . We first need to calculate the present value of each year’s expected sales.
| Year | Sales revenue | 10% discount rate | Present value |
| 1 | 0.4 S | 0.91 | 0.364 S |
| 2 | 0.7 S | 0.83 | 0.581 S |
| 3 | 1.0 S | 0.75 | 0.750 S |
| 4 | 1.0 S | 0.68 | 0.680 S |
| 5 | 1.0 S | 0.62 | \underline{0.620 S} |
| Present value | \underline{2.995 S} |
Contribution = sales – variable costs
Because the prices of drinks are to be set at double their direct (variable) costs then half of the total present value of sales 2.995S must represent direct costs and the other half must represent contribution.
Therefore contribution = \frac{ 2.995S}{2}
= 1.4975S which is the present value of
the contribution from the drinks
To break even at an annual interest rate of 10% the present value of the contribution from drinks must equal the present value of the total outgoings, which is £355,850.
1.4975S = £355,850
S = £237,629
Therefore the required sales revenue of drinks in each year are:
| Year | £ | |
| 1 | £237,629 × 40% | 95,052 |
| 2 | £237,629 × 70% | 166,341 |
| 3 | 237,629 | |
| 4 | 237,629 | |
| 5 | 237,629 |
(ii)
Aspects of the proposals that require further investigation:
■ Can the facilities be used outside normal opening hours for alternative uses in order to increase the
contribution?
■ Has market research been carried out to support the belief that there will be additional future benefits?
■ Will the proposed cost plus drinks pricing methods result in competitive prices?
■ Perhaps there is a better way for this project to utilise the space and the capital, and perhaps food may
be an option.