Econ Preparatory Questions

read and answer the Preparatory Questions

STUDY – Upland Restaurant Case Valuing
Mutually Exclusive Capital Projects
Instructions
This case study will ask you to evaluate mutually exclusive investment opportunities by putting yourself in the
shoes of two recent graduates turned restaurant owners and investors. After reading the background scenario
carefully, you will have to answer a series of preparatory questions and write an executive summary. The
questions are meant to guide you to prepare the executive summary. You are free (and encouraged) to work
on additional analyses to make your executive summary stronger.
You will have to upload a single pdf document containing 1) the one-page executive summary, 2) answers to
the preparatory questions, and 3) all the tables and appendices backing up your analysis, including any
additional work you think is helpful.
Note that points will be awarded for presentation. This includes the ease with which one can understand your
work, whether your final document is nicely formatted, whether tables and exhibits are clear and welldocumented, etc. You may want to think of your report as something you would feel comfortable handing in
to your boss if you were a financial analyst.
You may work in groups of up to four students, in which case you only need to submit one report. Please make
sure to include the names and student IDs of all students in the file. Working in groups is highly recommended.
Background
After graduating from UCLA 2 years ago, you and three friends decided to start Upland Restaurant. After
searching for several months for a location in Irvine, you decided to go a different route and buy 5 acres of land
including an old restaurant and a small building, formerly used for offices, at the edge of town. After renovating
the old restaurant, you were able to open and grow sales over the past 2 years. However, lacking the initial
capital, you never did anything with the other smaller building. Now that you have saved up some cash, you
and your friends feel like you can generate some extra income from the existing building. To that end, you
and your team have paid $20,000 to a consulting firm for a forecast of the future revenues and costs
associated with the different options you are considering. The exhibits given below are the outcome of the
consulting firm’s research.
Your first option is to enter a leasing agreement with a former Anteater who runs an event planning company
called Diamond Events. After describing the location and space to her, she is interested in renting it out to
host a variety of events. To make this possible, you will have to renovate the space first, which will take time
and money. Additionally, if Diamond Events were to lease the space, you and your team expect there to be an
increase in repairs, maintenance, and utilities as well as a slight decrease in restaurant sales from an overall
decrease in ambience from the additional event goers (loud partyers, congested parking lot, etc.). Diamond
Events is willing to sign a 4-year lease with an annual rent of $84,000 in the first year, growing at 5% thereafter.
The team’s additional assumptions are given below in Exhibit 1; where the renovation cost is a one-time capital
expenditure and the increase in repairs, maintenance, and utilities, is an annual cost.
Note: All operating income are taxable, therefore operating expenses reduce the taxable income, while capital
expenditures such as renovation costs and equipment costs are not tax deductible.
Exhibit 1: Leasing to Diamond Events Assumptions
Project life
Renovation cost
Tax rate
Cost of capital
Rental growth rate
Increase in repairs, maintenance, and utilities
Decrease in restaurant sales
4 years
90,000 USD
21%
13.00%
5%
15,000 USD
8.0%
Below in Exhibit 2 are the original projections of net restaurant sales for the next 6 years, were you not to
undertake any new project with the small building.
Exhibit 2: Baseline Projection of Restaurant Sales
Year
Net restaurant sales $
1
225,000 $
2
240,000 $
3
260,000 $
4
285,000 $
5
300,000 $
6
310,000
The other option the team is considering is starting a small craft brewery in the space. While the renovations
would be much less expensive, in order to start the brewery, your team would need to buy and install the
required equipment. Additionally, there would be other increases in costs to consider. A major benefit,
however, is that the brewery would serve as a complement to your existing restaurant business. Your team
feels that offering your own unique craft beers will lead to more food sales than would otherwise occur without
them. You project that your craft beverage sales will start at $85,000 in year 1 and grow at 7.5% annually after
that. Additional assumptions are found below in Exhibit 3; where the renovation and equipment costs are onetime capital expenditures and the increase in repairs, maintenance, and utilities, is an annual cost.
Note: The equipment is assumed not to depreciate over time.
Exhibit 3: Building Craft Brewery Assumptions
Project life
Renovation cost
Equipment cost
Tax rate
Cost of capital
Sales growth rate
Brewing ingredient costs
Other operating expense
Increase in repairs, maintenance, and utilities
Increase in restaurant sales
6 years
25,000 USD
150,000 USD
21%
13.00%
7.5%
40% of sales
12% of sales
10,000 USD
15.0%
Lastly, your team needs to consider what you can do with the craft brewery after the project life is over. After
brainstorming, you feel that there are 2 possible outcomes after the 6 years are up. The first outcome, outcome
A, is that the project does not go as planned, in which case you will have no other option than simply ceasing
operations. The second outcome, outcome B, is that the project goes well, you develop a good menu of craft
beverages and a steady customer base. In this case, you believe that you will have two options after Year 6.
The first option, option B.1., is for an outside investor to purchase the craft brewery portion of your business.
The second option, option B.2., is to simply continue operations, which you will value as a perpetuity. The
necessary assumptions are given below in Exhibit 4.
Exhibit 4: Terminal Options
Outcome A – Cease Operations
Project ends after 6th year. No
future cash flows.
Outcome B, Option 1 – Sell to
Investor
Sell craft brewery operations to
an outside investor for an
estimated $600,000 at the end of
the 6th year. Capital gains tax
rate is 15%.
Outcome B, Option 2 – Continue
Operations
Continue operations indefinitely
after the 6th year. Net operating
profits after taxes is expected to
grow 1.5% annually.
For outcome B, your team is unsure about what the best option is and is hoping you can help them determine
which one would add the most value to the business. Additionally, from your time in business school, you are
aware that valuation techniques are very sensitive to the assumptions that are made. While you and your
team worked very hard on projecting sales, growth rates, etc., you understand that these are just expectations
and that actual values can be higher or lower, impacting the attractiveness of the options. Therefore, it will be
important to conduct sensitive analyses on some of the key parameters.
Preparatory Questions
1.Lease option
a. What are the relevant costs and benefits of leasing the additional space to Diamond Events?
b. Are any costs or benefits irrelevant?
c. What is the NPV of leasing the additional space to Diamond Events?
d. What is the IRR?
e. Do the NPV and IRR decision making rules agree?
f. Sensitivity analysis
i. Construct a cost of capital sensitivity table for all valuation types with costs of capital
ranging from 11% to 15% in increments of 0.5%. That is fill in the following chart:
LEASE OPTION COST OF CAPITAL SENSITIVTY
11.0% 11.5% 12.0% 12.5% 13.0% 13.5%
Cost of Capital
NPV
14.0%
14.5%
15.0%
ii. Construct 3×3 NPV and IRR Sensitivity Analyses reflecting the following information
LEASE OPTION NPV SENSITIVITY
Increase in repairs, maintenance, and utilities
Decrease in
restaurant sales
7,500
4%
8%
12%
15,000
22,500