Question

Ginny’s Restaurant Problem

Ginny is endowed with $8 million and is deciding whether to invest in a restaurant. Assume perfect capital markets with an interest rate of 6%.

Investment Option	Investment (millions)	End of Year 1 CFs (millions)	End of Year 2 CFs (millions)
1	2	1.8	1.8
2	3	4.3	1.0
3	4	5.4	1.4
4	5	5.2	1.6

1. List 4 perfect capital market assumptions.
2. Which investment option should Ginny choose?
3. Which investment option can be eliminated from consideration? Why?

Ginny is actively pursuing another business venture as a ticket scalper. She estimates that for a $2 million investment in inventory she can resell her tickets for $6 million over the next two years (cash flows realized in exactly two years). Assume the same 6% interest rate.

1. What is the NPV of the Ticket Brokering venture?
2. What is the new value of Ginny’s Corporation?
3. Suppose Ginny does not have the $2 million to start the new venture. Instead, she wants to raise equity capital by issuing 100,000 shares. What price will new investors be willing to pay?

Answer 1

The Solution to Question 1 part i)

The Perfect Capital Market Assumptions are as follows:

1. There is No transaction cost or flotation cost
2. Investors are perfectly rational
3. The Securities are infinitely divisible
4. Tax-free world

The Solution to Question 1 part ii)

In order to decide which investment option to choose, we will calculate the Net Present Value of all the options:

Investment Option 1:

Year	Cash Flows in millions	PV factor @ 6%	Total PV in millions	Cumulative Cash flows
0	(2.00)	1.0	(2.00)	(2.00)
1	1.80	0.9434	1.70	(0.20)
2	1.80	0.8900	1.60	1.60
NPV			$ 1.30

Pay Back Period = 2 + 0.20/1.80 = 2.11 years

Profitability Index = PV of Cash Inflows / PV of Cash Outflows = 3.30 / 2 = 1.65

Investment Option 2:

Year	Cash Flows in millions	PV factor @ 6%	Total PV in millions	Cumulative Cash flows
0	(3.00)	1.0	(3.00)	(3.00)
1	4.30	0.9434	4.06	1.30
2	1.80	0.8900	0.89	3.10
NPV			$ 1.95

Pay Back Period = 1 + 3/4.30 = 1.70 years

Profitability Index = PV of Cash Inflows / PV of Cash Outflows = 4.95 / 3 = 1.65

Investment Option 3:

Year	Cash Flows in millions	PV factor @ 6%	Total PV in millions	Cumulative Cash flows
0	(4.00)	1.0	(4.00)	(4.00)
1	5.40	0.9434	5.09	1.40
2	1.40	0.8900	1.25	2.80
NPV			$ 2.34

Pay Back Period = 1 + 4/5.40 = 1.74 years

Profitability Index = PV of Cash Inflows / PV of Cash Outflows = 6.34 / 4 = 1.59

Investment Option 4:

Year	Cash Flows in millions	PV factor @ 6%	Total PV in millions	Cumulative Cash Flow
0	(5.00)	1.0	(5.00)	(5.00)
1	5.20	0.9434	4.91	0.20
2	1.60	0.8900	1.42	1.80
NPV			$ 1.33

Pay Back Period = 1 + 0.20/5.20 = 1.04 years

Profitability Index = PV of Cash Inflows / PV of Cash Outflows = 6.33 / 5 = 1.27

Based on the Net Present Value, Ginny should choose Investment option 2 as its profitability index is the highest and has low payback period

The Solution to Question 1 part iii)

Ginny should eliminate investment option 3 as its payback period is high for similar profitability index return options.