Question

Pearl Asian Restaurant operates in the Hong Kong International Airport passenger terminal. It is about time for the restaurant to negotiation for a new lease for the coming year. The landlord offers the owner of the restaurant two options. The first option is a fixed lease with a rent of $97,500 per month. The second option is a variable lease with monthly rent to be paid at 18% of the revenue of the restaurant. The restaurant owner expects that the annual revenue would be $8,000,000 for the coming year.

To expand his business, the restaurant owner also considers of acquiring one of the following catering outlets in the airport. One is a bistro and the other is a cafe. The annual revenue of the bistro or the cafe is the same, i.e. $500,000 for the current year. The variable cost of the bistro is 40% of its revenue and its annual fixed cost is $200,000. The cafe has a variable cost of 35% of its revenue and an annual fixed cost of $225,000.

The restaurant owner thinks that if he purchases the bistro, he could reduce its variable cost to 32% of its revenue. If he purchases the cafe, he could save $30,000 a year on its fixed cost. In either case, he thinks he could raise the revenue by 40% in the coming year.

For the proposed new lease for the restaurant, answer the following questions:

(i)Calculate the ‘indifferent revenue level’ of the restaurant for the coming year.

(ii)Explain, with reasons, which lease option that the restaurant owner should take.

Answer 1

	(i)	INDIFFERENT REVENUE LEVEL=X
		Profit=Revenue -Variable Cost -Fixed Cost	40%
		OPTION OF ACQUIRING BRISTO:
		Variable costs =32%*X
		Fixed Costs	$200,000
		Profit=X-0.32X-200000
		Profit=0.68X-200000
		OPTION OF ACQUIRING CAFE:
		Variable costs =35%*X	$0
		Fixed Costs=225000-30000	$195,000
		Profit=X-0.35X-195000
		Profit=0.65X-195000
		For Indifferent Revenue Level:
		0.68X-200000=0.65X-195000
		X(0.68-0.65)=200000-195000=	$5,000
		0.03X=5000
		X=5000/0.03=	$166,667
		Indifferent Revenue Level	$166,667
	(ii)	Annual Cost of Fixed Lease Option	$1,170,000	(97500*12)
		Expected Revenue	$8,000,000
		Annual Cost of Variable Lease	$1,440,000	(18%*8000000)
		Fixed Lease Option will have lower cost
		Restaurant owner should take Fixed Lease option