[SHAH99]

The management of JAP Recreation Club is evaluating the option to launch a restaurant that would serve complete meal to its members. Presently, it has a snack bar shop which sells snacks and drinks only.

A management consultant firm was hired at a fee of Rs. 85,000 to prepare the feasibility of the project. JAP’s Accountant has extracted the following information from the consultant’s report:

(I) The restaurant will be launched on the first day of the next year.
(ii) The club membership has been increasing at the rate of 5% per annum. As a result of this facility, it is expected that the rate would increase to 10% per annum.
(iii) The cost of equipment for the restaurant is estimated at Rs. 7,000,000. It would have a residual value of Rs. 510,000 at the end of its estimated useful life of four years.
(iv) It is estimated that during the first year, an average of 100 customers would visit the restaurant, per day. The number would increase in line with the increase in membership. The average revenue from each customer is estimated at Rs. 400 whereas variable costs per customer would be Rs. 260.
(v) Four employees would be appointed in the first year at an average salary of Rs. 200,000 per annum. A fifth employee would be hired from the third year.
(vi) The annual fixed overheads for the current year are estimated at Rs. 4.8 million. 15% of the fixed overheads are allocated to the snack bar. As a result of the establishment of the restaurant the annual expenditure would increase as follows:

Rupees
Electricity and gas 340,000
Advertising 170,000
Repair and maintenance 85,000

After the establishment of restaurant, 20% of the overheads would be allocated to the restaurant whereas allocation to snack bar would reduce to 10%.

(vii) The snack bar is presently serving an average of 250 customers per day and the number is increasing in proportion to the number of members. If the restaurant is launched, the number of customers would reduce by 40% in the first year but would continue to increase in subsequent years in line with the member base. The average contribution margin from snack bar is Rs. 50 per customer.
(viii) JAP’s cost of capital is 6.36% per annum. The rate of inflation is 10%.

Required:
Advise whether JAP should invest in the project. Assume that each year has 360 days
(Hint: Please keep in view the concepts of relevant costing and prepare the cash flows on the basis of the principles of relevant cost.)

[Curlyben]

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