You have been hired as a consultant by Trader Joes, a private American chain of grocery stores headquartered ten miles north of Whittier. The CEO is currently considering a project that would see Trader Joes add in-store bakeries in its California locations. He has asked you to provide him with a thorough analysis so that he can make the right investment decision. The management team has also been approached by a potential buyer. Your second task is to value the firm.

Here are some facts:

Over the last few years, Trader Joes California stores have sold ten million bakery products annually. All analysis points to this volume remaining steady in the future.

If the company were to have an in-house bakery, you estimate that the average cost per product would be $1.10. Trader Joes will mark up these products by 15%.

To add a bakery, Trader Joes would have to shift things around in the store and to purchase bakery equipment for $15,080,000 which will last for a very long time but it would be depreciated to zero for tax purposes using a 10-year straight-line depreciation schedule.

This project would be financed solely by equity.

Trader Joes currently pays tax at a rate of 32%.

You have collected some information about capital market returns (see Exhibit 1).

Part 1: Investment Decision

a. What is the cost of capital that Trader Joes should use for this project?

b. Should Trader Joes undertake this project?

Exhibit 1 Capital Market Return Data (Historical and Current) Prevailing Yields on U.S. Government Securities (December 2020) Annualized Yield to Maturity 3-Month T-Bills 1-Year Bonds 5-Year Bonds 10-Year Bonds 20-Year Bonds 30-Year Bonds 1.20% 1.40% 1.80% 2.30% 2.50% 2.90% Historic Average Total Annual Returns on U.S. Government Securities and Common Stocks (1950-2020) Standard Average Annual Return Deviation T-Bills Intermediate Bonds Long-term Bonds Large Company Stocks Small Company Stocks 5.2% 6.4% 6.0% 14.0% 17.8% 3.0% 6.6% 10.8% 16.8% 25.6% Historic Average Total Annual Returns on U.S. Government Securities and Common Stocks (1929-2020) Standard Average Annual Return Deviation T-Bills Intermediate Bonds Long-term Bonds Large Company Stocks Small Company Stocksd 3.8% 5.4% 5.5% 12.7% 17.7% 3.3% 5.8% 9.2% 20.3% 34.1% Portfolio of U.S. Government bonds with maturity near 5 years. Portfolio of U.S. Government bonds with maturity near 20 years. Standard & Poor's 500 Stock Price Index. Exhibit 1 Capital Market Return Data (Historical and Current) Prevailing Yields on U.S. Government Securities (December 2020) Annualized Yield to Maturity 3-Month T-Bills 1-Year Bonds 5-Year Bonds 10-Year Bonds 20-Year Bonds 30-Year Bonds 1.20% 1.40% 1.80% 2.30% 2.50% 2.90% Historic Average Total Annual Returns on U.S. Government Securities and Common Stocks (1950-2020) Standard Average Annual Return Deviation T-Bills Intermediate Bonds Long-term Bonds Large Company Stocks Small Company Stocks 5.2% 6.4% 6.0% 14.0% 17.8% 3.0% 6.6% 10.8% 16.8% 25.6% Historic Average Total Annual Returns on U.S. Government Securities and Common Stocks (1929-2020) Standard Average Annual Return Deviation T-Bills Intermediate Bonds Long-term Bonds Large Company Stocks Small Company Stocksd 3.8% 5.4% 5.5% 12.7% 17.7% 3.3% 5.8% 9.2% 20.3% 34.1% Portfolio of U.S. Government bonds with maturity near 5 years. Portfolio of U.S. Government bonds with maturity near 20 years. Standard & Poor's 500 Stock Price Index