minicase 3 real options

FNCE 4209 Mini-Case 3 – Real Options

Your team works for a large supermarket chain in the south west of the USA. Your company has developed a new retail concept. The evaluation of this concept is the purpose of this mini-case.

The new retail stores are smaller than the current footprint, more like an “extended-Cumberland Farms” than the traditional supermarket the company currently runs. The facts about each store is set out below:

· Each store would be 30,000 square feet

· The life of a store is 10 years

· Construction costs are expected to amount to $350 per square foot

· Construction costs are depreciable straight-line to zero salvage value over a 7-year life

· Revenue per square foot per year is estimated to be $650

· Gross profit is forecast at 28% of sales, and operating costs 17%

· Taxes are expected to be paid at 20% of pre-tax income

· Net working capital which is primarily inventory is estimated to be 15% of sales (as an example, if sales are forecast to be $10M a year, hypothetically, then year-end NWC is forecast at 15% x $10M = $1.5M)

· Opening NWC requires an investment of $2.3M at t=0

· At the end of the tenth year of operations, NWC will reduce to zero

· The appropriate risk adjusted discount rate to evaluate this project is 10%

Question 1

For the single store project above, evaluate the NPV and IRR of this project. (Hint: I have constructed the assumptions above to make this project realistic – meaning that the NPV should be a small negative amount compared to the initial investment.)

Question 2

The company intends to launch 5 stores as a pilot today, and after observing and studying operations, will make a decision in two years whether to launch 100 of these new stores. There is no obligation to open these potential new stores as no leases have been signed – the company can base the decision to open these new 100 stores based on whether the decision makes sense at that time, given what has been learned from the five pilot stores.

If an appropriate risk-free rate is 1.5%, and an appropriate annual volatility for this type of business opportunity is 50%, is it worth launching the five pilot stores to gain the opportunity to open the 100 stores in two years?

Question 3

Your team has taken your answer from Question 2 to your team leader. Although she agrees with your analysis, she is a bit concerned with the volatility value used of 50% - it feels somewhat arbitrary even if based on some anecdotal evidence. After digging through her materials, she has found some support for the original assumptions used to estimate cash flows.

Most of the assumptions given earlier are fairly certain (as an example, the stores will be 30,000 square feet almost exactly). The three that took the greatest work from the original analyst team were sales per square foot, the gross profit margin, and the operating cost percentage. The team broke the future into likely economic outlooks, and likely strategies from the company’s biggest competitor Aldi. The team had created the following scenarios:

Using this data, estimate volatility directly. Is the opening of the five pilot stores still a good strategy?

Teams

2

Spring 2021

Sales per FootYesNo

Prob40%60%

Expansion25%700720

Normal55%650680

Recession20%500540

Aldi Competes

Gross Profit MarginYesNo

Prob40%60%

Expansion25%29%34%

Normal55%26%30%

Recession20%20%23%

Aldi Competes

Operating CostsYesNo

Prob40%60%

Expansion25%19%17%

Normal55%18%16%

Recession20%17%16%

Aldi Competes

Team 1Team 2Team 3

JiaRunsiGoldJoshuaMorgantiMatthew

WeiYuSilarovaVeraBurnsKate

KellyErinLinJiazhiSchrammCaitlin

ChenFangyiAlexisChristianCookeGordon

VenegasKatherynSalyardsLoganFicaroJames

Team 4Team 5Team 6

LiYangPiccorelliKatherineDuddyPhilip

WangJeannePatelAnujaCossetteJames

CatalinaJustinWangYitingMorrisroePatrick

LazarzCoreySavakisNicholasMunzerChristopher

MichaelsKaylaFlynnBrendanPelletierAlec

Team 7Team 8Team 9

CoulterJohnLiangYigeFrancisKavitha

SalmNathanLiSiweiBarnitzAnthony

EscobarKimberlyQuYingruPatelOhm

KnauerhaseRachelLiuJiachenGogginKallie

Team 10Team 11Team 12

SunXiaochunRosalesDonatoCancillaTrevor

ZhangHanSarandreaJohnBradleyJohn

WangXiranCappellucciRyanDrewryPatrick

WangTongyaoSainiShamikaSolomonOmari