You own a small bagel store in a downtown Eugene location. Your tandoori-baked bagels are a big hit, so you are considering opening a second store in a local neighborhood where many Indian expatriates live.
You estimate that leasing and equipping the new store will cost $100,000. (Assume that you can secure this capital somehow.) In the first year the store will produce profits (positive cashflow) of $10,000. In years 2 through 5 you expect it will have no real competition, so profits will grow at a 10% annual rate. But as the novelty wears off and competitors enter your local market, profit growth will slow: to 6% annually in years 6 through 10, and to 2% annually in years 11 through 15. You believe that by year 15 you will wish to exit the business, either because the market will become crowded, or because you are a serial entrepreneur and you will want to chase a different dream.
Use the grid on the last page to record your answers to the following computational questions. Because many questions depend on previous answers, it will be valuable for you to work on this with one or several partners, checking each other's work.
Base case analysis (most likely scenario)
- Without doing any significant calculations, what would you expect the payback period for this investment to be (roughly, within one year)?
- What is the computed payback period (within 0.5 years)?
- What is the return on investment (RoI) over the payback period?
- What is the return on investment (RoI) over the full 15 years?
- Because you are a new and small business, investors expect a high return to compensate them for their risk, so your cost of capital is considerable. What is this investment's NPV over 15 years at a 15% discount rate?
- At a 15% DR, should you go forward with the new store?
- Say you are able to convince your investors that your company isn't so risky, and you get them to drop their discount rate—say to the cost of capital of many large cap stocks. What is the NPV at a 10% DR?
- Should you go forward with the project at a 10% DR?
- Within a 0.1% tolerance, what is the internal rate of return (IRR) of this project?
- The above answers were under your "best guess" assumptions about the store's future profit growth. For this and the next two questions, redo your calculations under "pessimistic" assumptions, assuming that the store's profits do not grow at all (i.e., remain at $10,000 per year for fifteen years.) What is the NPV at a 10% DR now?
- What is the project's IRR?
- How does this IRR compare with the cost of capital for a small business?
- Finally, try a more optimistic assumption. For this and the next two questions, assume that from a year 1 cashflow of $10,000, profits grow each year at 10% throughout the full 15 years. What is the project's NPV at a 15% DR?
- What is its NPV at a 10% DR?
- Within 0.1%, what is its IRR?
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