Question

Phillip is planning on opening an electronics store. He will run it for only 1 year. The initial cost for opening a store is 500K and it will generate an EBIT of 800k at the end of year for sure. Risk-free rate is 5%, tax rate is 35%. Suppose John’s current wealth is 50k. He can borrow money from a bank. Bank knows that his electronic store will generate EBIT of 800k at the end of year for sure.

In this situation, would he want to open the electronic store?

What is the value of his equity of the electronic (at t=0) if he opens it?

If he opens the restaurant at t=0 and sells the entire ownership of the electronic store to Zach at t=0, with what price can Phillip sell the ownership? How much return did Phillip make relative to his investment at t=0?

Answer 1

Given : initial investment required for establishment of electronic store = 500K

Current wealth of Philip = 50K

Amount to be borrowed from the bank = 500K - 50k = 450K

Present Value of the business

EBIT = 800K

less: interest = 22.5K (450K*5%)

EBT = 777.5

less: Tax = 272.125k

EAT = 505.375

Less:Loan repayment = 450k

Cash flows after tax from equity point of view = 55.375

Present Value of the business for John's = 55.375*PVF(5%,1) =55.375*0.952=52.738k

1. Yes, Philip can open the store as his net present value is positive

NPV = present value of inflows - present value of outflows = 52.738-50k = 2.738k

2.Present value of his equity is equal to the present value of his business at equity point of view i.e.= 52.73K

3.He can sell his ownership to Zach @ t=0 at any price on or above 52.73K to make a profit out of sale.

4. return from investment by philip = return / investment = (2.738/50K)*100=5.476%