Question

6. The Johnson’s are considering abandoning their busy lives running a country store. Instead, they may open a daycare in their barn to allow them to spend more time with their son, Timmy. They come to you for advice on what to do since you have already taken part of a finance class. They figure that if they keep working at the store, they would make net cash flows of 150,000 per year for 20 years and then they would retire. They currently have $100,000 saved in the Bank of Podunk. This money and any other money that they receive will be invested to earn 6 percent compounded annually. Thus, this is their ‘discount’ rate. If the Johnson’s decide to open the daycare, they would spend the $100,000 immediately to fund barnyard renovations. At the end of the first two years, the daycare would not generate any net cash. At the end of each of the next three years, the daycare will earn $50,000 per year. At the end of the following five years, it will earn $100,000 per year. They plan to retire at that point (i.e. 10 years from now) and they presume that they can sell their business for $2 million. Ignore any daycare costs that the couple would incur for Timmy if they keep running the store. Also ignore any tax effects. YOU MUST DRAW TIME LINES IN YOUR ANALYSIS a. Calculate the present value of the Johnson’s earnings potential if they keep running the store.

Answer 1

The decision to either run the country store or open a daycare can be taken by comparing the net present value of these decisions and then selecting the one that has a higher net present value.

Running the Country Store:

Tenure = 20 years, Discount Rate = 6 % , Current Savings = $ 100000 and Expected Annual Income = $ 150000

Therefore, Net Present Value = Current Savings + Total Present Value of Annual Incomes = 100000 + 150000 x (1/0.06) x [1-{1/(1.06)^(20)}] = $ 1820488.18

Opening a Day Care:

Initial Investment = $ 100000, Annual Income = $ 50000 at the end of Year 3 to Year 5, $ 100000 at the end of Year 6 to Year 10, Sale Proceeds from Daycare at the end of Year 10 = $ 2000000

Net Present Value = 2000000 / (1.06)^(10) + 100000 x (1/0.06) x [1-{1/(1.06)^(5)}] x [1/(1.06)^(5)] + 50000 x (1/0.06) x [1-{1/(1.06)^(3)}] x [1/(1.06)^(2)] - 100000 = $ 1450510.44

As the NPV of continuing to run the county store is greater than opening a daycare, the couple should continue running the county store.