In: Accounting
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 Phillip has enough wealth to cover the initial cost of 500k. Assume that he can’t borrow money.
In this situation, would he want to open the electronic store? What is the value of his equity of the electronic store (at t=0) if he opens it?
If he opens the restaurant at t=0 and sell 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 initial investment at t=0?
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%