Brody is considering opening up a second store. Since the current location is do
ID: 2760677 • Letter: B
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
Using the PI model, is the project acceptable?
Explanation / Answer
Calculation of WACC
Particulars
Option 1
Option 2
Equity
4%*0.50
4%*0.50
2%
2%
Debt
5%*0.50
5%*0.50
2.50%
2.50%
Additional risk
5%
4%
WACC
9.50%
8.50%
Profitability index for option 1
Year
Cash flow
Discount rate@9.50%
Present value
1
2500000
0.913242009
2283105.02
2
2500000
0.834010967
2085027.42
3
2500000
0.761653851
1904134.63
4
2500000
0.695574293
1738935.73
5
2500000
0.635227665
1588069.16
Present value inflow(a)
9599271.97
Investment(b)
7000000.00
Profitability index(c) = (a)/(b)
1.37
Profitability index for option 2
Year
Cash flow
Discount rate@8.50%
Present value
1
1500000
0.921658986
1382488.48
2
25,00,000
0.849455287
2123638.22
3
35,00,000
0.782908098
2740178.34
4
45,00,000
0.721574284
3247084.28
5
55,00,000
0.665045423
3657749.83
Present value inflow(a)
13151139.15
Investment(b)
5500000
Profitability index(c) = (a)/(b)
2.39
Answer: Using PI method, option 2 will be selected.
Calculation of WACC
Particulars
Option 1
Option 2
Equity
4%*0.50
4%*0.50
2%
2%
Debt
5%*0.50
5%*0.50
2.50%
2.50%
Additional risk
5%
4%
WACC
9.50%
8.50%
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