Mr. Tiwari a young and upcoming professional decided to open a franchised supermarket after completing his various education. After 30 years of being in operation, he became the owner and CEO of Lowcost Supermarket Inc. (Lowcost), a franchisee of a national food retailer. Lowcost owns a modern 3,500-square-metre superstore that generated more than $20 million in sales in the last fiscal year. Please see Appendix I contains excerpts from Lowcosts financial statements.

Although he is still active and does not plan to retire, Mr. Tiwari has a daughter, Tejal, who is aspiring to follow in her fathers footsteps. Moreover, new competitors are coming into the market, and Mr. Tiwari does not want to be left behind.

Hence, he is currently considering two expansion options that would allow his daughter to prove herself:

1. Expand the existing store to make it a destination outlet that reaches a wider customer base.
2. Buy another store, Other Store Inc. (Other Store), in a neighbouring suburb that would be managed solely by Tejal.

Today is February 2, 2020, and Mr. Tiwari has retained you, CPA, to assess the two options from both a quantitative and qualitative perspective. He has provided you with the critical assumptions underlying the expansion project (Appendix II) and the financial information on Other Store (Appendix III).

He would like you to advise him on which option is the most attractive, in terms of both expected returns and risk levels. He would also like you to calculate and justify an appropriate discount rate that you will use for your quantitative analysis and to assess the appropriateness of the financing alternatives being proposed for each option.

Appendix I
Excerpts from Lowcosts financial statements

Income Statement
12 months ended December 31
(in thousands of dollars)

	2019	2018	2017
Net sales	$20,260	$19,500	$18,750
Cost of goods sold	15,500	14,500	13,750
Gross profit	4,760	5,000	5,000
Operating expenses	3,250	3,100	3,000
EBITDA	1,510	1,900	2,000
Depreciation and amortization	450	500	650
Interest expense	100	100	100
Income before tax	960	1,300	1,250
Income tax	260	400	375
Profit/loss	$700	$900	$875

Cash Flow Statement
12 months ended December 31
(in thousands of dollars)

	2019	2018	2017
Operations:
Cash flow from operations	$1,150	$1,400	$1,525
Changes in non-cash working capital	(75)	(50)	(125)
Total cash from operating activities	1,075	1,350	1,400
Total cash from investing activities	(250)	(300)	(250)
Total cash from financing activities	(100)	(100)	(100)
Dividends	(475)	(850)	(1,400)
Change in cash	250	100	(350)
Cash at beginning of period	100	0	350
Cash at end of period	$350	$100	$0

Appendix II
Critical assumptions underlying the expansion project

The expansion project entails reconfiguring and updating the existing store and adding 2,000 square metres to its floor plan. The project would be complete by the end of 2020, and store operations would continue throughout the construction.

Key estimates supplied by architects (in thousands of dollars) are as follows:

Estimated cost of project (materials, labour, supplies, taxes)

$8,000

Other key estimates provided by consultants (dollar amounts in thousands):

Additional sales revenues in first full year of operations for new store (2021)	$5,000
Annual sales growth rate for the four years following the first full year of expanded and reconfigured operations (2022-2025) applicable to total sales revenue*	10%
Annual sales growth rate without expansion and reconfiguration	4%
EBITDA margin (expected to remain at that level for the foreseeable future)	7.5%
Expansion investment to be depreciated over 16 years on a straight-line basis (also for tax purposes)
Income tax rate	30%
Lowcost's bank has tentatively committed to providing a bridge loan convertible into a 20-year mortgage bearing interest at 6%, for up to $6,000. No repayment is due for the first five years. All the firm's long-term assets will be pledged as collateral to the mortgage, and Mr. Tiwari will personally guarantee the loan. Currently, Lowcost has long-term assets with a book value of $5,000. Lowcost has a line of credit with $1.0 million of remaining borrowing capacity carrying an interest rate of prime plus 200 basis points (current prime rate is 5%). This credit line is unsecured.	$6,000

*Beyond 2025, sales growth is assumed to be approximately 4%.

Future capital expenditures and investment in net working capital will be minimal.

Mr. Tiwari expects his firms return on equity to be 15% (2019 rate) and its long-term target capital structure to be 25% debt and 75% equity as at the end of 2019 (currently debt of $1.5 million and equity of $4.5 million). Mr. Tiwari will inject $1.0 million in the firm (in the form of equity) to get the project going as soon as possible. He believes that the proper time horizon for assessing the project is 16 years because he estimates that the store will need to be refurnished at that time; however, the cost will be much less than the original $8.0 million investment for the full expansion and construction of the new floorplan.

Appendix III

Other Store Inc.
Financial highlights
Fiscal year ended December 31
(in thousands of dollars)

	2019	2018	2017
Sales	$10,000	$10,250	$10,500
Gross margin	2,000	2,100	2,200
Operating expenses	1,300	1,250	1,200
Depreciation	200	250	300
Earnings before income taxes	500	600	700
Income taxes	150	230	260
Net earnings	$350	$370	$440
Cash from operations	$600	$650	$750
Working capital	$200	$250	$300
Long-term assets	$0	$100	$200
Equity	$200	$350	$500

The store occupies a wholly owned building of 2,250 square metres. The firm has no long-term debt. With an aging owner seeking to sell and retire, the firm has underinvested in recent years, paying out a significant portion of its cash flow as dividends. The existing assets are fully depreciated for tax and accounting purposes as at December 31, 2019.

To update the store, bring it to the standards of the franchisor, and expand it to around 3,000 square metres, Mr. Tiwari estimates an investment of $4.0 million will be needed, which would be depreciated over 20 years for both tax and accounting purposes.

Results for 2020 would be affected negatively by the rebranding, construction, and expansion, with sales going down to $9.0 million. However, annual sales growth of 25% is expected for 2021, 2022, and 2023, stabilizing at the long-term rate of economic growth of 3% afterward. Capital expenditures and investment in net working capital are expected to be minimal over the period. Bank financing terms would be similar to those of the store expansion project, with both stores being pledged. The investments time horizon is 20 years, at which point the store will need to be updated but at a much lower cost than the original investment. Mr. Tiwari expects the stores EBITDA margin to be around 7.5% once the renovation and expansion is complete by the start of 2021.

Food retail stores are typically sold for prices that range between five and seven times EBITDA. The owner is willing to sell the company for $3.3 million. Mr. Tiwari wonders if this price is in line with industry norms.

The owner is also willing to finance the purchase, requiring 20% down with the balance due over 10 years in equal instalments. The interest rate would be 12% and would be secured by the underlying store assets and a personal guarantee from Mr. Tiwari.