Question

It turns out Campus Coffee (kiosk) is up for sale. The owner wants $ 1 million – its yearly gross revenues are $500,000 per year and their net is about $250,000. You only have $100,000 and you may have to borrow the rest. A credit union is willing to offer you a loan for $500,000 at 10% p.a., and a short-term moneylender is willing to lend you the rest at 20% p.a. There is also the possibility that you could persuade some friends to join you as shareholders. What is your thinking process about this investment from a finance and capital budgeting perspective? Explain your thought process over this business idea.

Answer 1

The campus coffe kiosk is up for the sale for 1 million the profit it generates each year is 0.25 million .

Equity - 0.1 million

Debt - 0.9 million

Interest - 0.5 million at 10% and 0.4 million at 20% amounts to 0.13 million per year

So if one acquires at this condition then net profit after serving the debt will be 0.12 million which gives return on equity of 120% but the gearing ratio will be 9 times which will be very risky if profit does not come as expected.

So to reduce the risk one may approach friend for taking stake in the business

say ,

0.1 million - own

0.4 million- friend

0.5 million - 10% debt

Interest will be - 50k , profit will be 0.2 million

now stake is 20% hence , Return on equity will be 0.2/5 = 40 k on investment of 100k which is 40% , this return is with considerable lower risk as gearing ratio will be equal to 1:1.