Reference no: EM132951467
For several years, Arthur King dreamed of owning his own business. One afternoon, he noticed an online ad for the sale of a bookstore in Cannon Beach, Oregon:
Business for Sale - $125,000
Small bookstore in popular summer vacation resort town.
Contact M. Becker, Cannon Beach, Oregon.
To help Arthur decide whether he wanted to purchase the business, he started to create a net present value (NPV) discounted cash flow model to determine what the free cash flows would be and whether the business would be a good purchase.
He knew the business would require him to invest $60,000 of his own money, and borrow $80,000 from a lender. He would immediately pay the $125,000 acquisition price plus $5,000 for closing costs related to the purchase of the land and building. King decided to allocate the $125,000 purchase price as follows: $20,000 for the land, $80,000 for the building, $8,500 for fixtures and equipment, and $16,500 for inventory. The additional $10,000 would be used to fund working capital requirements (cash-on-hand, purchasing inventory, funding accounts receivable).
He would then begin operations and believed the firm would have $90,000 in revenue and $85,000 in costs for each year over the next three years. The costs included $30,000 for salaries, $39,000 for the cost of books, $3,000 for utilities, $5,000 for depreciation of the building, and $8,000 for interest. After three years, he would expand the business with a new storefront dedicated to cookbooks. His construction consultant suggested the expansion would cost $65,000. This expansion would result in an increase in revenues of $45,000, but also increase costs by $37,000. The costs included $14,000 for salaries, $20,000 for the cost of books, $1,000 for utilities, and $2,000 for depreciation of the building. This new level of revenue and expenses would persist indefinitely
Based on his research, he believed he could generate a return of 4% by investing in treasury bonds, or an average return of 12% by investing in what his friend called "the market portfolio", a value-weighted index fund of every marketable security. One of the appealing aspects of treasury bonds is that their return of 4% was guaranteed by the US government, thus was risk-free. The bookstore still had some risk, about half the systematic risk of holding "the market portfolio".
What is the cost of capital for Arthur's bookstore project? (Feel free to use the capital asset, pricing model.)
Complete and submit a net present value analysis for the bookstore. What is the net present value of the bookstore project?
Do you have any concerns about Arthur's cost of capital? Is Arthur violating any assumptions about why the capital asset pricing model (CAPM) is an appropriate method for calculating the cost of capital? (Please respond in no more than five sentences.