After graduating from Hofstra University 2 years ago, you and three friends decided to start Upland Restaurant.  After searching for several months for a location downtown, you decided to go a different route and buy 5 acres of land including an old restaurant and 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 Hofstra alumnus 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.  In order 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

 

 

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. Below in Exhibit 2 are the original projections of net restaurant sales for the next 6 years.  This will be helpful when calculating both the decrease in sales from the lease option and the increase in sales from the craft brewery option.

 

Exhibit 2: Baseline Projection of Restaurant Sales

 

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 one-time capital expenditures and the increase in repairs, maintenance, and utilities, is an annual cost.

 

Exhibit 3: Building Craft Brewery Assumptions

 

 

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 3 possible outcomes after the 6 years are up. First, while the expected beverage sales are positive, there is the chance that the business does not go as expected and that your team can just cease operations after the project life. Second, you feel that if things go right, there is the possibility that you develop a good menu of craft beverages and an outside investor would want to purchase the craft brewery portion of your business.  Lastly, there is the possibility that you simply continue operations, which you will value as a perpetuity when analyzing which option is best.  The necessary assumptions are given below in Exhibit 4.

Exhibit 4: Terminal Options

Option A - Cease Operations	Option B - Sell to Investor	Option C - Continue Operations
Project ends after 6th year.  No future cash flows.	Sell craft brewery operations to an outside investor for an estimated $600,000 at the end of the 6th year.  Capital gains rate is 15%.	Continue operations indefinitely after the 6th year.  Net operating profits after taxes is expected to grow 1.5% annually.

 

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 is important to conduct sensitive analyses on some of the key parameters.

 

Executive summary

executive summary that lays out major assumptions you used and what decision you have arrived at. 

 

1. Lease option
   1. What are the relevant costs and benefits of leasing the additional space to Diamond Events?
   2. Are any costs or benefits irrelevant?
   3. What is the NPV of leasing the additional space to Diamond Events?
   4. What is the IRR?
   5. Do the NPV and IRR decision making rules agree?
   6. Sensitivity analysis
      1. 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
Cost of Capital	11.0%	11.5%	12.0%	12.5%	13.0%	13.5%	14.0%	14.5%	15.0%
NPV

 

1. Construct 3x3 NPV and IRR Sensitivity Analyses reflecting the following information

LEASE OPTION NPV SENSITIVITY
		Increase in repairs, maintenance, and utilities
		7,500	15,000	22,500
Decrease in restaurant sales	4%
	8%
	12%

 

 

1. Build option - Terminal A:  Cease operations
   1. What are the relevant costs and benefits of starting the brewery?
   2. Are any costs or benefits irrelevant?
   3. What is the NPV of starting the brewery?
   4. What is the IRR?
   5. Do the NPV and IRR decision making rules agree?
   6. Sensitivity analysis
      1. 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:

 

Build OPTION COST OF CAPITAL SENSITIVTY
Cost of Capital	11.0%	11.5%	12.0%	12.5%	13.0%	13.5%	14.0%	14.5%	15.0%
NPV

 

1. Construct 3x3 NPV and IRR Sensitivity Analyses reflecting the following information

BUILD OPTION (A) NPV SENSITIVITY
		Brewing ingredient costs
		30%	40%	50%
Increase in restaurant sales	0%
	15%
	30%

 

1. Which option should Upland choose? Why?
2. Assume Upland decides to start the brewery and that it will not cease operations of the brewery after 6 years. Which other terminal option (B or C), offers Upland the most value?