Question

I work for a baseball team. our retail store has an opportunity to renovate part of a storage area to create a second store for game days. The estimated cost of renovation is $150,000. Expectations are that the additional revenue per year will be $40,000. The second store would also increase staffing expenses by $9000 per year. The project life will be 10 years and then the space will need to be redesigned or converted for other uses.
Indicate whether you would accept the project and explain why?

Answer 1

The decision would depend on the cost of capital or opportunity cost of the business. The initial cost of the renovation is given to be $150,000 and the pay offs from the renovation are (40000-9000)= $31000 per year for 10 years. This is equivalent to a total of $310,000 inflow as compared to an outflow of $150,000. However since the cash inflows/ benefits are occuring at a future date, we need to compute its present value to compare it to the cost of the investment. This is possible only when the discount rate is estimated with reasonable accuracy.

Let us assume that the discount rate is 10%. The present value of cash inflows will be $31000* (P/A, 10%,10 years) = 31000* 6.145= $190,495. When compared to the cost, the net present value of this decision is positive and hence the project should be accepted. Hence knowing the discount rate is essential for coming to a conclusion.