?Detailed Question: Please complete all the three questions. Answer each question by representing good standards in few paragraphs.
Critical thinking is requisite to be illustrated by application of financial principles.
Remember to Show all the calculations in details?.
Brody’s Sports LLC:
Brody is owner of the Brody Sports Company. The company sells sports equipment and cloths to the general public. The company marks up its products by at least 100% which is consistent with other sports retailers. Retail sports business is risky and tends to raise or fall with the country’s economic conditions.
Brody is considering opening up a second store. Since the current location is doing well, a second location either on the other side of town (option 1) or one in another county (option 2) is his two options. Either one would be considered to be more risk to Brody.
Since Brody has never ventured into an expansion this size, he felt he needed some help. So he called a friend of his at Bank USA. He asked his friend Bob for some methods to help with analyzing the proposed expansion.
Bob suggested Brody consider using the “discounted payback period approach” and the “Profitability Index Model (PI)”. Bob asked Brody, what is you cost of capital? Brody said, I can raise half from stock (about a 4% cost) and the remaining half from bonds (about a 5% cost). Brody estimated the initial cash outlay for option 1 was $7,000,000 and for option 2, $5,500,000.
Bob said first figure out you cost of capital and use that as your discount rate. He then said to take into consideration the added risk, Bob said an additional 5% to option 1, and 4% to option 2.
Brody estimated the annual cash flow for the two options.
Cash Flow
Year Option 1 Option 2
1 $2,500,000 $1,500,000
2 $2,500,000 $2,500,000
3 $2,500,000 $3,500,000
4 $2,500,000 $4,500,000
5 $2,500,000 $5,500,000
Answer the following questions for Brody:
1. Which option is the most acceptable using the discounted payback period? Why or why not.
2. Using the PI model, is the project acceptable? Why or why not? Because option 2 is a higher risk then option1, Bob suggest that Brody use a higher discount rate for option 2 (use a 6% discount rate) but for option 1 use the same rate used as for the discounted payback period calculation.
3. Does either of the two approaches change your decision about opening a new sports retail store? What would you suggest to Brody.