Please help with Case Questions

Case Questions:

1. Compute a net income break-even point for the smaller and larger facilities.

2. Find the sales level (after the first year) that will result in a net present value of $0. Remember that sales the first year will be half of those after the first year.

3. Prepare a decision tree analysis of the alternatives.

4. Prepare a graphical sensitivity analysis showing the relationship between sales level and net present value for each size alternative.

5. Should they lease space of 10,000 or 15,000 square feet? Why?

Weak competition CASE PROBLEM Scandinavian Styles s away. The rent was low, and the Peter Nielsen a the United St for a Danish Nielsen had the Sielsen and Jens Andersen moved to blocks away. The rent was low, nited States as sales representatives space was adequate for their display Danish furniture manufacturer. They thought they could generato ritory and tomer traffic through advertising more ef- rsen had the midwest territory, but fectively than by counting on an expensi net several times a year and talked location. quently on the phone to coordinate The major decisions of Nielsen and An- inments. After several years of selling to dersen proved to be right. Despite a few etail stores that carried numerous styles, mistakes and rocky periods, the business the two decided to start their own store own store thrived. Within 2 years, business was suf- specializing in Scandinavian furniture. fering from severe space limitations. To Nielsen and Andersen continued in control shipping costs, it was necessary to their jobs for another year while they or place large orders. Most of the furniture ganized the business. They knew the de- came "knocked down" and required final mographic characteristics of Scandinavian assembly. Thus, both storage and work furniture buyers from company studies space were needed. They handled the and their own experience. Upper middle space needs temporarily by renting a income and under 45 best described the small warehouse. This, however, was un- group. Thus, they chose to locate in an satisfactory as many customers wanted to upper-middle-income section of Spring- take their purchases with them. A sepa- field. Knowing that furniture was hardly a rate warehouse also created control prob- convenience good, and knowing they lems. By the time they had been in busi- needed adequate display space, Nielsen ness 5 years, the partners decided to build and Andersen leased a 10,000-square-foot a new store, giving them adequate display, area in a small strip shopping center that storage, and assembly space at one loca- had fallen on hard times due to the open- tion. Again, the decision proved to be ing of a large shopping center several profitable. e alternatives 412 Part Four Risk and Investment Choice 1 year if the store was unsuccessful, Bou Looking toward further growth. Nielsen partners agreed to study the alternati d Andersen decided they would have to expand outside of the Springfield area. some more over the weekend and to mal a decision on Monday. They decided on Oak Hill, a suburb in An- From their past experience and obser dersen's old sales territory. The primary vations, Nielsen and Andersen believed appeal of this location was that Andersen vations, the big risks in opening a store of this knew the area and market better than any type occurred in the first year. They pro other. Andersen would run the new store jected sales in the second year to be don. while Nielsen would stay in the old store. ble those in the first year and predicted They decided to evaluate the expansion opportunity using a 10-year horizon; style little growth beyond that. For purposes of changes or balance of payments problems analysis, the partners decided to concen- could end their business. trate on two cases with regard to first-year A developer was in the process of build- sales: weak and successful. Weak sales ing some store space that would be within would be $250,000 the first year, and suc- the right rent range for a furniture store. cessful sales would be $600,000. The prob- Space could be had for $10 per square abilities were estimated to be .7 for suc- foot per year, and a 10-year lease was re- cess and .3 for weak sales. quired. Nielsen and Andersen could can- The primary up-front costs were promo- cel the lease at any time, but there would tion and miscellaneous expenses of be a penalty of 20 percent of the remain- $30,000 without the warehouse/assembly ing lease payments. The location looked space and $50,000 with the warehouse good, but the question was how much assembly space. These expenses would re- space to rent. sult in an immediate 28 percent tax say- Nielsen and Andersen agreed that ings. Inventory would cost $200,000 with 10,000 square feet was the optimal sales the warehouse/assembly area and space. Andersen was in favor of taking $100,000 without. It was estimated that the 15,000 square feet of space so they would inventory could be liquidated at cost if or have 5,000 square feet for a storage and as when the store was closed. There would be sembly area on site. Nielsen wanted to take no accounts receivable because most cus- a more conservative approach, using weeklytomers used credit cards, and arrange- drop-shipments from the Springfield loca- ments would be made with a finance com- tion to deliver inventory to Oak Hill. The pany for those needing credit. Other distance was over 500 miles, and this would current assets and current liabilities would add approximately 15 percent to the cost of also be negligible. Depreciation and non- the furniture, but risk would be reduced cash expenses would be minimal, so in- substantially, and the need for 5,000 square come and cash flow would be the same. feet of space could be eliminated. As a general guideline, Nielsen and An- Andersen pointed out that if the store was successful, they would quite likely find dersen estimated a cost of goods sold with themselves facing the necessity of buying on-site assembly at 60 percent of sales. their way out of the lease within 2 years to Other variable costs would be 10 percent of get warehouse and assembly space. An 8- sales. They estimated fixed costs other than year lease on 15,000 square feet would rent of $4 a year for every square foot of probably cost $12 a square foot by then. assembly space. The partners faced 28 per space in either sales space or warehouse/ Nielsen was more concerned about buying out of a 15,000-square-foot lease after cent tax rates and used a 10 percent le quired return in their analysis. Chapter 12 Single Investment Risk Analysis 413 Case Questions 1. Compute a net income break-even point for the smaller and larger facilities. 3. Prepare a decision tree analysis of the alternatives. 4. Prepare a graphical sensitivity analysis showing the relationship between sales level and net present value for each size alternative. 5. Should they lease space of 10,000 or 15,000 square feet? Why? 2. Find the sales level (after the first year) that will result in a net present value of $0. Remember that sales the first year will be half of those after the first year. SELECTED REFERENCES Aggarwal, Raj, and Luc A. Soenen. "Project Exit Value as a Measure of Flexibility and Risk Exposure." Engineering Economist 34 (Fall 1989): 39-54. Arnold, Tom, and Richard L. Shockley, Jr. "Value Creation at Anheuser-Busch: A Real Options Example." Journal of Applied Corporate Finance 14 (Summer 2002): 52-61. Bjerksund, Petter, and Steiner Ekern. Managing Investment Opportunities under Price Uncertainty: From 'Last Chance' to 'Wait and See' Strategies." Financial Management 19 (Autumn 1990): 65-83. Chiu, Chui-Yi, and Chan S. Park. "Fuzzy Cash Flow Analysis Using Present Worth Criterion." Engineering Economist 39 (Winter 1994): 113-138. Eschenbach, Ted G., and Robert J. Gimpel. "Stochastic Sensitivity Analysis." En- gineering Economist 35 (Summer 1990): 305-322. Eschbenbach, Ted G., and Lisa S. McKeague. "Exposition on Using Graphs for Sensitivity Analysis." Engineering Economist 34 (Summer 1989): 315-333. Gerchak, Yigal, and Thomas Astebro. "Calculating the Expectation and Variance of the Present Value for a Random Profit Stream of Uncertain Duration." The Engineering Economist 45 #4 (2000): 339-349. Hertz, David B. "Investment Policies That Pay Off." Harvard Business Review (January-February 1968): 96-108. - Risk Analysis in Capital Investment." Harvard Business Review (January-February 1964): 95-106. Hurley, W.J. "On the Use of Martingales in Monte-Carlo Approaches to Multi- period Parameter Uncertainty in Capital Investment Risk Analysis." The En- gineering Economist 43 #2 (Winter 1998): 169182. Hurley, W.L., and L. D. Johnson. "Capital Investment under Uncertainty: Calcu- lating the Present Value of the Depreciation Tax Shield When the Tax Rate Is Stochastic." Engineering Economist 41 (Spring 1996): 243-251. Jones, P. C., W. J. Hopp, and J. L. Zydiak. "Capital Asset Valuation and Deprecia- tion for Stochastically Deteriorating Equipment." Engineering Economist 38 (Fall 1992): 1930. Joy, O. Maurice, and Jerry O. Bradley, "A Note on Sensitivity Analysis of Rates of Return." Journal of Finance 28 (December 1973): 1255-1261. Keeley, Robert, and Randolph Westerfield. "A Problem in Probability Distribu- tion Techniques for Capital Budgeting." Journal of Finance 27 (June 1972): 703-709. Weak competition CASE PROBLEM Scandinavian Styles s away. The rent was low, and the Peter Nielsen a the United St for a Danish Nielsen had the Sielsen and Jens Andersen moved to blocks away. The rent was low, nited States as sales representatives space was adequate for their display Danish furniture manufacturer. They thought they could generato ritory and tomer traffic through advertising more ef- rsen had the midwest territory, but fectively than by counting on an expensi net several times a year and talked location. quently on the phone to coordinate The major decisions of Nielsen and An- inments. After several years of selling to dersen proved to be right. Despite a few etail stores that carried numerous styles, mistakes and rocky periods, the business the two decided to start their own store own store thrived. Within 2 years, business was suf- specializing in Scandinavian furniture. fering from severe space limitations. To Nielsen and Andersen continued in control shipping costs, it was necessary to their jobs for another year while they or place large orders. Most of the furniture ganized the business. They knew the de- came "knocked down" and required final mographic characteristics of Scandinavian assembly. Thus, both storage and work furniture buyers from company studies space were needed. They handled the and their own experience. Upper middle space needs temporarily by renting a income and under 45 best described the small warehouse. This, however, was un- group. Thus, they chose to locate in an satisfactory as many customers wanted to upper-middle-income section of Spring- take their purchases with them. A sepa- field. Knowing that furniture was hardly a rate warehouse also created control prob- convenience good, and knowing they lems. By the time they had been in busi- needed adequate display space, Nielsen ness 5 years, the partners decided to build and Andersen leased a 10,000-square-foot a new store, giving them adequate display, area in a small strip shopping center that storage, and assembly space at one loca- had fallen on hard times due to the open- tion. Again, the decision proved to be ing of a large shopping center several profitable. e alternatives 412 Part Four Risk and Investment Choice 1 year if the store was unsuccessful, Bou Looking toward further growth. Nielsen partners agreed to study the alternati d Andersen decided they would have to expand outside of the Springfield area. some more over the weekend and to mal a decision on Monday. They decided on Oak Hill, a suburb in An- From their past experience and obser dersen's old sales territory. The primary vations, Nielsen and Andersen believed appeal of this location was that Andersen vations, the big risks in opening a store of this knew the area and market better than any type occurred in the first year. They pro other. Andersen would run the new store jected sales in the second year to be don. while Nielsen would stay in the old store. ble those in the first year and predicted They decided to evaluate the expansion opportunity using a 10-year horizon; style little growth beyond that. For purposes of changes or balance of payments problems analysis, the partners decided to concen- could end their business. trate on two cases with regard to first-year A developer was in the process of build- sales: weak and successful. Weak sales ing some store space that would be within would be $250,000 the first year, and suc- the right rent range for a furniture store. cessful sales would be $600,000. The prob- Space could be had for $10 per square abilities were estimated to be .7 for suc- foot per year, and a 10-year lease was re- cess and .3 for weak sales. quired. Nielsen and Andersen could can- The primary up-front costs were promo- cel the lease at any time, but there would tion and miscellaneous expenses of be a penalty of 20 percent of the remain- $30,000 without the warehouse/assembly ing lease payments. The location looked space and $50,000 with the warehouse good, but the question was how much assembly space. These expenses would re- space to rent. sult in an immediate 28 percent tax say- Nielsen and Andersen agreed that ings. Inventory would cost $200,000 with 10,000 square feet was the optimal sales the warehouse/assembly area and space. Andersen was in favor of taking $100,000 without. It was estimated that the 15,000 square feet of space so they would inventory could be liquidated at cost if or have 5,000 square feet for a storage and as when the store was closed. There would be sembly area on site. Nielsen wanted to take no accounts receivable because most cus- a more conservative approach, using weeklytomers used credit cards, and arrange- drop-shipments from the Springfield loca- ments would be made with a finance com- tion to deliver inventory to Oak Hill. The pany for those needing credit. Other distance was over 500 miles, and this would current assets and current liabilities would add approximately 15 percent to the cost of also be negligible. Depreciation and non- the furniture, but risk would be reduced cash expenses would be minimal, so in- substantially, and the need for 5,000 square come and cash flow would be the same. feet of space could be eliminated. As a general guideline, Nielsen and An- Andersen pointed out that if the store was successful, they would quite likely find dersen estimated a cost of goods sold with themselves facing the necessity of buying on-site assembly at 60 percent of sales. their way out of the lease within 2 years to Other variable costs would be 10 percent of get warehouse and assembly space. An 8- sales. They estimated fixed costs other than year lease on 15,000 square feet would rent of $4 a year for every square foot of probably cost $12 a square foot by then. assembly space. The partners faced 28 per space in either sales space or warehouse/ Nielsen was more concerned about buying out of a 15,000-square-foot lease after cent tax rates and used a 10 percent le quired return in their analysis. Chapter 12 Single Investment Risk Analysis 413 Case Questions 1. Compute a net income break-even point for the smaller and larger facilities. 3. Prepare a decision tree analysis of the alternatives. 4. Prepare a graphical sensitivity analysis showing the relationship between sales level and net present value for each size alternative. 5. Should they lease space of 10,000 or 15,000 square feet? Why? 2. Find the sales level (after the first year) that will result in a net present value of $0. Remember that sales the first year will be half of those after the first year. SELECTED REFERENCES Aggarwal, Raj, and Luc A. Soenen. "Project Exit Value as a Measure of Flexibility and Risk Exposure." Engineering Economist 34 (Fall 1989): 39-54. Arnold, Tom, and Richard L. Shockley, Jr. "Value Creation at Anheuser-Busch: A Real Options Example." Journal of Applied Corporate Finance 14 (Summer 2002): 52-61. Bjerksund, Petter, and Steiner Ekern. Managing Investment Opportunities under Price Uncertainty: From 'Last Chance' to 'Wait and See' Strategies." Financial Management 19 (Autumn 1990): 65-83. Chiu, Chui-Yi, and Chan S. Park. "Fuzzy Cash Flow Analysis Using Present Worth Criterion." Engineering Economist 39 (Winter 1994): 113-138. Eschenbach, Ted G., and Robert J. Gimpel. "Stochastic Sensitivity Analysis." En- gineering Economist 35 (Summer 1990): 305-322. Eschbenbach, Ted G., and Lisa S. McKeague. "Exposition on Using Graphs for Sensitivity Analysis." Engineering Economist 34 (Summer 1989): 315-333. Gerchak, Yigal, and Thomas Astebro. "Calculating the Expectation and Variance of the Present Value for a Random Profit Stream of Uncertain Duration." The Engineering Economist 45 #4 (2000): 339-349. Hertz, David B. "Investment Policies That Pay Off." Harvard Business Review (January-February 1968): 96-108. - Risk Analysis in Capital Investment." Harvard Business Review (January-February 1964): 95-106. Hurley, W.J. "On the Use of Martingales in Monte-Carlo Approaches to Multi- period Parameter Uncertainty in Capital Investment Risk Analysis." The En- gineering Economist 43 #2 (Winter 1998): 169182. Hurley, W.L., and L. D. Johnson. "Capital Investment under Uncertainty: Calcu- lating the Present Value of the Depreciation Tax Shield When the Tax Rate Is Stochastic." Engineering Economist 41 (Spring 1996): 243-251. Jones, P. C., W. J. Hopp, and J. L. Zydiak. "Capital Asset Valuation and Deprecia- tion for Stochastically Deteriorating Equipment." Engineering Economist 38 (Fall 1992): 1930. Joy, O. Maurice, and Jerry O. Bradley, "A Note on Sensitivity Analysis of Rates of Return." Journal of Finance 28 (December 1973): 1255-1261. Keeley, Robert, and Randolph Westerfield. "A Problem in Probability Distribu- tion Techniques for Capital Budgeting." Journal of Finance 27 (June 1972): 703-709