Question

You own a wholesale plumbing supply store. The store has generated revenues of $1M this year. Next year, revenues will either decrease by 10% or increase by 5%, with equal probability, and then stay at that level as long as you operate the store. You own the store outright. Other costs run $0.9M per year. The cost of capital is 10%.
a) What is the value of the store next year if the revenues decrease? Include next year’s profits in the store value.
b)What is the value of the store next year if the revenues increase? Include next year’s profits in the store value
c)What is the business worth today? (Hint: Since this year’s profit is already generated, it is not included in the store value today.
d )Suppose you have the option in year 1, after learning what future revenues will be, to sell the store for $0.5M. What is the business worth today with this abandonment option?

Answer 1

Net cash inflow from Business;

Revenue - Cost of operation = 1,000,000 - 9,00,000 = 1,00,000

Current year Net cash inflow = 1,00,000

Cost of capital = 10%

Answer 1) In case of decrease

Net cash inflow = 100000 * (1-10%) = 90,000

Value of company =

= 90,000 / 0.10 = $ 9,00,000 = 0.9 Million

Answer 2)

In case of increase

Net cash inflow = 100000 * (1+5%) = 105,000

Value of company =

= 105,000 / 0.10 = $ 1,050,000 = 1.05 Million

Answer 3)

In case of today's valuation ,

net change in cash inflow next year =

= 0.5*10% + 0.50*-5% =  2.5% increase

Net cash inflow = 100000 * (1+ 2.5%) = 1025 000

Value of company =

= 1025000 / 0.10 = 1.025 Million

Answer 4) IN case of abandonment option , cash inflow for one time only ,

Value of company =

Value of company = 0.5 / 1.1 = 0.46 Million.