Question

David and Jennifer are looking to buy an existing business that’s for sale. They found two stores that intrigue them. Let's call them Store A and Store B. Both stores are for sale at the same price, $1.5 million. The uncertainty David and Jennifer are facing is the health of the economy. They researched the economic forecasts and believe that there is a 65% chance the economy will remain strong and a 35% chance that the economy may slip into a recession. If the economy does go into a recession, their expected sales will decrease. They must pay $1.5 million now (Year 0) to purchase either store. Their cost of capital is 15.0%.

Store A

If the economy remains strong, Store A will generate net cash flows of $250,000 in Years 1 and 2; $350,000 in Years 3 and 4; and $400,000 in Year 5. They then expect to sell the store in Year 6 for $1.55 million.

If the economy slips into a recession, then all of the cash flows, including the sale price of the store at the end of Year 6, will only be 75% of what they would have been had the economy remained strong.

Calculate the net present value (NPV) of their investment if they purchase Store A and the economy remains strong.

Calculate the NPV of their investment if they purchase Store A and the economy slips into recession.

As stated, there is a 65% chance the economy remains strong and a 35% chance the economy slides into recession. Calculate the expected NPV of their investment if they purchase Store A.

Store B

If the economy remains strong, Store B will generate net cash flows of $150,000 in Year 1; $250,000 in Year 2; $350,000 in Year 3; $450,000 in Year 4; and $550,000 in Year 5. They can sell the store at the end of Year 6 for $1.8 million. If the economy goes into a recession, the cash flows and the selling price of the store at the end of Year 6 are only 55% of what the cash flows would have been had the economy remained strong.

Calculate the NPV of their investment if they purchase Store B and the economy remains strong.

Calculate the NPV of their investment if they purchase Store B and the economy slips into recession.

As stated, there is a 65% chance the economy remains strong and a 35% chance the economy slides into recession. Calculate the expected NPV of their investment if they purchase Store B.

Which store should they purchase, based on expected NPV?

If David and Jennifer are extremely risk-averse, they might decide to purchase the store with the lower NPV. Why?

Waiting for a Year

David and Jennifer have the option to wait a year. They could still buy Store A a year from now. By that time, they will know for sure whether or not the economy remained strong or slid into a recession. However, because they waited a year, a new competitor entered the market, and the cash flows are 25% less, including the sale price at the end of Year 7. Also, because of the new competitor, they can purchase Store A one year from now for only $1.2 million. In this case, the purchase is made at the end of Year 1, and the cash flows occur at the end of Years 2 through 6, and the sale of the store occurs at the end of Year 7. Because they waited a year, do not forget to "discount" the purchase price (i.e., the purchase is not happening in the present, but one year in the future).

If waiting a year, they know with 100% certainty that the economy will remain strong. Calculate the NPV of their investment.

If they are only considering whether to buy Store A now (without knowing for sure the health of the economy) or to wait a year and then buy Store A (knowing for sure the economy will remain strong), which should they choose? Why?

Answer 1

As per rules I will answer the first 4 sub parts of the question. However for completeing the logical flow, I have done the first 6 sub parts

1:Store A

NPV if the economy is strong = 205650.01

2: NPV if the economy is in recession = -220762.50

3: Expected NPV= 56405.63

4:Store B

NPV if the economy is strong = 358527.22

5: NPV if the economy is in recession = -477810.03

6: Expected NPV = 65809.18

	Store A					Store B
Year	Capital cost	Strong economy	Recession	Expected Cash flows		Capital cost	Strong economy	Recession	Expected Cash flows
0	-1500000			-1500000		-1500000			-1500000
1		250000	187500	228125			150000	82500	126375
2		250000	187500	228125			250000	137500	210625
3		350000	262500	319375			350000	192500	294875
4		350000	262500	319375			450000	247500	379125
5		400000	300000	365000			550000	302500	463375
6		1550000	1162500	1414375			1800000	990000	1516500
	NPV	205650.01	-220762.50	56405.63		NPV	358527.22	-477810.03	65809.18

WORKINGS