Question

You are considering starting a small coffee shop in Auckland. After some market research and analysis, you have come up with two potential locations, one in the Central City (to be named as City Café) and the other one in Ellerslie (to be called Ellerslie Café). The setup costs are estimated to be $50,000 for City Café and $45,000 for Ellerslie Café. Given your budget constraint, you can only choose one of these options.

You have learned that small businesses would generally struggle during the first few years of operations. You took an optimistic forecasting approach and estimated that the first year after-tax net cash flows would be $8,000 and $6,800 for City Café and Ellerslie Café, respectively. The annual growth in net cash flows is estimated to be 3% for City Café and 2% for Ellerslie Café for the first 5 years (years 2 to 5) and then based on the end of year 5 cash flows, the growth in cash flows will increase to 6% for City Café and 5% for Ellerslie Café from years 6 to 10 as you improve your customer service and gain more loyal customers.

You are optimistic that you will be running the business for at least 10 years. At the end of the 10^th year, if you were to end the business, you estimated the salvage values (after depreciation) to be $10,000 for City Café and $7000 for Ellerslie Café. Your estimated cost of capital is 9.5%.

Answer 1