Case 16.39

LO 7

Case studyNPV of opening a small business Jinny Buffett recently retired as a flight attendant and is interested in opening a fitness center and health spa exclusively for women in Grand Cayman, where she resides. After careful study, she is somewhat puzzled as to how to proceed. In her words, I see my business going in one of two directions: Either I open the fitness center and health spa all at once, or I start with the health spa and hold off on the fitness center for a while. Either way, it should be a success because women on this island love to be pampered. My only concern about the fitness center is the initial cost, but if the projections look good enough, I know some investors in Phoenix who can help me get started. In any event, I plan to retire permanently in 10 years.

The following information is available:

Jinny has identified a suitable location for her business in a new shopping center in George Town, capital of the Cayman Islands. The developer has units of 1,000 square feet and 2,500 square feet available and is willing to sell either unit for CI$150 per square foot (CI$1.00 = US$1.25). Alternatively, the space can be leased at a cost of CI$1.80 per square foot per month, on an annual basis.

page 645 Commercial real estate values have more than doubled in Grand Cayman during the past 10 years, with no slowdown in sight. As a result, Jinny is more attracted to the purchase option because she expects the price per square foot to be CI$300 by the time she is ready to sell her unit in 10 years.

Exercise machines and other equipment necessary to open the fitness center would cost US$50,000. In addition, US$35,000 would need to be invested in equipment related to the health spa. The useful life for all such equipment is 10 years, and the expected salvage value is not large enough to be concerned about.

In addition, US$8,000 would need to be invested in an inventory of cosmetics and skin care products necessary to operate the health spa. This level of inventory would need to be maintained throughout the 10-year period and will be given away to loyal customers when Jinny retires permanently.

The health spa can be operated in the 1,000-square-foot unit. Variable operating costs would include CI$0.10 per square foot per month for cleaning and CI$0.40 per square foot per month for utilities. The 2,500-square-foot unit is large enough to operate both the fitness center and health spa, and the CI$0.10 rate per square foot for cleaning would not change. However, if the 2,500-square-foot unit were used, the health spa would be located in an open loft that would need to be air-conditioned at all times. As a result, utility costs are expected to be CI$0.60 per square foot per month under this option.

Jinny is a certified aesthetician and expects to do most of the makeovers, facials, and peels herself, but she needs a qualified assistant for the health spa. She estimates that hiring an appropriate person will cost US$25,000 per year. Likewise, for the fitness center, two full-time aerobics instructors would be hired for US$20,000 each per year, and a physical trainer would be hired for US$30,000 per year.

Additional fixed costs include US$3,000 per year for advertising and US$4,500 per year for maintenance, insurance, and other items. These costs will be incurred without respect to the size of operations.

Annual membership fees to the fitness center will be CI$300, and a preliminary market survey shows a demand of approximately 500 initial members. Although members tend to come and go, the net change in membership from year to year is not expected to be significant. No additional fees will be charged to fitness center members.

Health spa fees are assessed on a user basis, although the steam room facilities are available at no charge to fitness center members. The net cash inflow from cosmetics and skin care products (after deducting the cost of inventory used and sold) is expected to be CI$8,000 per month.

Jinnys cost of capital is 12%, and there are no taxes in the Cayman Islands.

Required:

a.) Calculate the net present value in US$ of an investment in the health spa only, assuming that the 1,000-square-foot unit is purchased and then resold at the end of 10 years. (Hint: Before making your present value calculations, multiply all amounts expressed in CI$ by $1.25 to convert into US$.)

b.) Calculate the net present value in US$ of an investment in the fitness center and health spa, assuming that the 2,500-square-foot unit is purchased and then resold at the end of 10 years.

c.) page 646 Jinny is quite concerned about possible forecasting errors and has asked you to prepare a more conservative estimate. Repeat part b, assuming that the fitness center attracts only 300 members per year (rather than 500); that the net cash inflow per month from cosmetics and skin care products is only CI$6,000 per month (rather than CI$8,000 per month); and that commercial real estate values in Grand Cayman at the end of 10 years are only CI$200 per square foot (rather than CI$300 per square foot).

d.) Explain why it might be in Jinnys best interest to lease (rather than purchase) the 1,000-square-foot unit if she initially decides to open the health spa only. Although no calculations are required, you should consider both quantitative and qualitative factors in your response.

e.) What is your overall recommendation? Include an explanation of any additional factors that you would consider in making your recommendation. Keep in mind that Jinny has not given herself a salary in her projections. Assume that a reasonable salary would be CI$4,000 per month.