Shannon Kampa is in talks with Resul Ozbayrak Leaseco, a leasing company, to rent store space for new stores that Shannon is considering adding to her high-end natural foods chain. Leaseco would build the stores and lease them to Shannon. For a typical store, Shannon will need to invest $1million of equity funds, all of which goes to finance working capital needs. She estimates that she will earn on average an operating profit of $200,000 per year, before rent payments, but recognizes that the actual operating profits could be higher or lower than that depending on environmental factors she cannot control. Leaseco estimates that they will also have a very long term investment of about $1million in building each store and offers Shannon the following two options: 1) pay a fixed rent of $90,000 per year or 2) pay a variable rent equal to half the operating profits.
Answer the following questions:
(a) Calculate Shannon's pre-tax ROI (return on investment, measured as pre-tax operating profits, after deducting rents, divided by her investment of $1 million) under the two rental options for each of the following 3 scenarios that might occur in the first year of operation:
i) Good news: Operating profits are $300,000 per year,
ii) Medium news: Operating profits are $200,000 per year.
iii) Bad news: Operating profits are $100,000 per year.
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good
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medium
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bad
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op. profit before rent
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300
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200
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100
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Shannon's investment
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1000
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1000
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1000
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a) fixed rent case
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op. profit after rent
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ROI
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b) variable rent case
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op. profit after rent
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ROI
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Is Shannon's investment more or less risky under the fixed rent option, relative to the variable rent option? What is the basis for your conclusion?
(b) Calculate Leaseco's ROI under the two rental options. Is Leaseco's investment more or less risky under the fixed rent option? What is the basis for your conclusion?
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good
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medium
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bad
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op. profit before rent
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300
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200
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100
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Leaseco's investment
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1000
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1000
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1000
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a) fixed rent case
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rental income
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ROI
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b) variable rent case
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rental income
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ROI
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(c) Does the risk of the combined investment that Shannon and Leaseco make in the store depend on which rental option she selects?
(d) Do you see a parallel between this discussion and the impact of increased leverage (from debt financing) on the risk of equity? If so, what is the link?