Question

Sainsbury's is the second largest chain of supermarkets in the United Kingdom. The have expanded internationally and have recently also opened stores in Egypt. However, Sainsbury has since experienced a variety of issues with the Egyptian market. As business development analyst you only see the three follow- ing options for Sainsbury’s business in Egypt:

Today is December 31, 2000. Suppose you have the following information about the financial implications of Sainsbury’s three strategic options.

Option 1: Scale down operations
Sainsbury’s immediately starts to scale down its operations and plans to eventually leave the Egyptian market effective as of Jan. 01, 2006 (i.e. after 5 more years). At the end of 2001, Sainsbury’s operations in Egypt are projected to generate a loss of £6 million. However, due to the effects of scaling down operations and a number of efficiency increases, Sains- bury’s estimates a profit of £7,2 million at the end of 2002, which is then expected to decrease by 3% on a yearly basis until Dec. 31, 2005. All fore- casts for this option are based on assumptions and considered as risky.

Option 2: New local partners
The NPV of acquiring new local partners has already been calculated for you: £12 million

Option 3: Sell business entirely
Sainsbury’s immediately sells its Egyptian operations to a local investor. The local investor is willing to pay a total £15 million, in three parts of £10 million (today) and £4 million (on Dec. 31, 2001) and £1 million (on Dec. 31, 2002). Since the local investor has also presented a bank guarantee for the whole acquisition price (issued by a well-known British bank), op- tion 3 is considered to be risk-free.

The risk-free interest rate is 1% EAR. Sainsbury’s continuing operations in Egypt are seen as risky and the appropriate risk premium is 8%.

1. Calculate the net present values (NPVs) of options 1 and 3 indicated above. (4 pts)

2. Clearlyindicatewhichoption(Option1,Option2orOption3)shouldbe chosen by Sainsbury’s management, and explain the reasons for your choice in two or three sentences – use technical terminology as needed. (1 pts)

Answer 1

	Sainsbury
	Option 1
	NPV Calculation
	As the estimates of operations are risky , using required rate of return =risk free rate +risk premium
	So Required rate of return =1%+8%=9%
	All information in Pounds
	Details			Year 2003	Year 2004	Year 2005	Remarks
a	Net Income /(loss)	(6,000,000)	7,200,000	6,984,000	6,774,480	6,571,246	3% YOY reduction from 2003
b	Discount rate @9%=1/1.09^n=	0.917	0.842	0.772	0.708	0.650
c	PV of Net cash flows =a*b=	(5,504,587)	6,060,096	5,392,929	4,799,212	4,270,859
d	NPV =Sum of PV of cash flows	15,018,509
	Option 3.
	Here the cash flows are backed by bank guarantee , so using risk free rate 1% for discounting.
	Details	Year 2000	Year 2001	Year 2002
a	Cash flow	10,000,000	4,000,000	1,000,000
b	Discount factor @1% =1/1.01^n=	1	0.990	0.980
c	PV of Net cash flows =a*b=	10,000,000	3,960,396	980,296
d	NPV =Sum of PV of cash flows	14,940,692
	If we go by NPV , then the best option is option 1 as it has the highest NPV.
	However, if we consider payback period along with NPV as the decididng factor
	then the option 3 is the best as it has the lowest payback with lowest risk
	and NPV is also quite good.