OASIS in The Dessert is a new dessert-only restaurant in Jonesboro, AR. It serve
ID: 1172111 • Letter: O
Question
OASIS in The Dessert is a new dessert-only restaurant in Jonesboro, AR. It serves wine, cheesecake, and brownies. In the most recent year, the company had $462,984 in revenue. The operating expenses for the company were 62% of revenue, and depreciation expense was another $20,000 per year. OASIS is looking at adding crepes to their menu and serve them for breakfast as well. The managers believe that the crepes will add $52,000 to revenue each year. The operating expenses will remain at 62% of revenue. The only new equipment needed is a $75,000 crepe maker, which will be depreciated over 5 years using the straight-line method (assume no salvage value). The managers believe that this restaurant will continue into the foreseeable future.
The company has a bank loan in the amount of $300,000 in which they make semi-annual interest only payments until the loan matures in 7 years. The coupon rate of interest on the loan is 8.5%. If the company were to get a new loan today, they would pay an interest rate of 9.25%. Oasis is not a publicly-traded company, so there is no market for their common stock. The three owners own a total of 275,000 shares of common stock at an estimated value today of $1.45 per share. Based on historical information, the beta for the company has been estimated to be 2.35. The S&P 500 is expected to return 14% next year, the 90 Day T-Bill Rate is 2.5%, and the company’s tax rate is 30%.
Should the company enter into the Crepe market? Why or why not?
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Explanation / Answer
Beta = 2.35
Risk free return = 2.5%
Market return = 14%
So, as per the CAPM model, company should expect a return of ( Rex) = Rfr + Beta * ( Rm - Rfr )
= 2.5% + 2.35 * ( 14% - 2.5% )
= 30%
Now,
As per given data
Before the Macine is installed;
Revenue = 462,984
Operating Ex = 6% * ( 462,984 ) = 287,050
Depreciation Ex = 20,000
Interest expense = 300,000*8.5% = 25,500
Pre Tax Income = Rev - Ope Ex - Dep Ex - Int Exp = 130,434
Post Tax Income = 130,434 * ( 1 -Tax rate ) = 130,434 * 70% = 91,304
After Installing the machine;
Revenue new = 462,984 + 52000 = 514,984
Operating Ex new= 287,050 + 62% ( 52,000 ) = 31,290
Depreciation Ex new= 20,000 + ( 75,000 / 5 ) = 35,000
So, as the profitibility decreases when we install new machines, thus we should not install it !
Interest expense new= 25,500 + ( 75,000 * 9.2 % ) = 32,437.5
Pre Tax Income = Rev new - Ope Ex new - Dep Ex new - Int Exp new = 128,256
Post Tax Income new = 128,256 * ( 1 -Tax rate ) = 128,256 * 70% = 89,779
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