Question

You own a wholesale plumbing supply store. The store currently generates revenues of $1.02 million per year. Next​ year, revenues will either decrease by 10.2% or increase by 4.6%​, with equal​ probability, and then stay at that level as long as you operate the store. You own the store outright. Other costs run $880,000 per year. There are no costs to shutting​ down; in that case you can always sell the store for $440,000. What is the business worth today if the cost of capital is fixed at 10.5%?  

​(​Hint: Make sure to round all intermediate calculations to at least four decimal places.​)

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Answer 1

Answer –

Following are given in the question:

1. Cost of capital is 10.5%
2. Revenue is $1,020,000 per year with equal probability of increase and decrease by 4.6% and 10.2%
3. Other running cost is $880,000
4. Salvage value of the store is $440,000

Assumptions:

1. Since the store is self-owned therefore no startup or project cost will be there
2. The period of operation is not given in question and will depend on the will of the owner to run the store, but for calculation of business worth today we have to assume a period of operation, let the period of operation be 10 years
3. Tax rates are not given hence we assume that there is no tax on the cash flows

For calculating the present value or worth of business we have to first calculate the annual cash flows

Statement showing annual cash flows

Particulars	Year 1	Year 2	Year 3 to 10
Revenues	$ 1,020,000	$                                     991,440	$    991,440
		[($1,020,000 * 1.046)*0.50 + ($1,020,000 * 0.898)*0.50]
Less : Running cost	$     880,000	$                                     880,000	$    880,000
Cash Flows	$     140,000	$                                     111,440	$    111,440

Statement showing present value of business

Period	Particulars	Amount	Discounted Factor @ 10.50%	Present Value
1	Cash Flows	$ 140,000	0.905	$    126,700
2	Cash Flows	$ 111,440	0.819	$      91,269
3 to 10	Cash Flows	$ 111,440	4.291	$    478,189
10	Salvage Value of Store	$ 440,000	0.368	$    161,920
	Present Value of Business			$    858,078

Hence business worth today is $858,078 while considering the above assumptions.