Brody is considering opening up a second store. Since the current location is do

Question

Brody is considering opening up a second store. Since the current location is doing well, a second location either on the other side of town (option 1) or one in another county (option 2) is his two options. Either one would be considered to be more risk to Brody. Since Brody has never ventured into an expansion this size, he felt he needed some help. So he called a friend of his at Bank USA. He asked his friend Bob for some methods to help with analyzing the proposed expansion. Bob suggested Brody consider using the “discounted payback period approach” and the “Profitability Index Model (PI)”. Bob asked Brody, what is you cost of capital? Brody said, I can raise half from stock (about a 4% cost) and the remaining half from bonds (about a 5% cost). Brody estimated the initial cash outlay for option 1 was $7,000,000 and for option 2, $5,500,000. Bob said first figure out you cost of capital and use that as your discount rate. He then said to take into consideration the added risk, Bob said an additional 5% to option 1, and 4% to option 2.

Brody estimated the annual cash flow for the two options.

Cash Flow

Year           Option 1                                    Option 2

1                   $2,500,000                                 $1,500,000

2                $2,500,000                              $2,500,000

3                $2,500,000                              $3,500,000

4               $2,500,000                               $4,500,000

5               $2,500,000                               $5,500,000

Which option is the most acceptable using the discounted payback period? Why or why not.

Explanation / Answer

Option 1:

Total discounted (5%) present value of the future cash flow = $2,500,000 * PVIFA(5%,5) = $2,500,000 * 4.329 = $10822500

Discounted Payback period = 7,000,000 * 5 / 10822500 = 3.23 years

Option 2)

Discounted Payback period = 2 + 1744500 / 3111500 = 2.56 years

Option 2 is the most acceptable using the discounted payback period because the returning period is 2.56 years in comparison to 3.23 years.

year cash flow discount rate 4% present value 1 $1,500,000 0.962 1,443,000 2 $2,500,000 0.925 2,312,500 3 $3,500,000 0.889 3,111,500 4 $4,500,000 0.855 3,847,500 5 $5,500,000 0.822 4521000

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