OASIS in The Dessert is a new dessertonly restaurant in Jone

OASIS in The Dessert is a new dessert-only restaurant in Jonesboro, AR. It serves wine, cheesecake, and brownies. In the most recent year, the company had $462,984 in revenue. The operating expenses for the company were 62% of revenue, and depreciation expense was another $20,000 per year. OASIS is looking at adding crepes to their menu and serve them for breakfast as well. The managers believe that the crepes will add $52,000 to revenue each year. The operating expenses will remain at 62% of revenue. The only new equipment needed is a $75,000 crepe maker, which will be depreciated over 5 years using the straight-line method (assume no salvage value). The managers believe that this restaurant will continue into the foreseeable future.

The company has a bank loan in the amount of $300,000 in which they make semi-annual interest only payments until the loan matures in 7 years. The coupon rate of interest on the loan is 8.5%. If the company were to get a new loan today, they would pay an interest rate of 9.25%. Oasis is not a publicly-traded company, so there is no market for their common stock. The three owners own a total of 275,000 shares of common stock at an estimated value today of $1.45 per share. Based on historical information, the beta for the company has been estimated to be 2.35. The S&P 500 is expected to return 14% next year, the 90 Day T-Bill Rate is 2.5%, and the company’s tax rate is 30%.

Should the company enter into the Crepe market? Why or why not?

Solution

The estimated profit of Oasis without the new crepe

The existing yearly revenue of the restaurant Oasis is $462,984 and the operating expense is 62% of the revenue.

Hence,the total operating expense of Oasis=(0.62*$462,984)=$287,050 approximately yearly

The yearly depreciation expense for the restauarant is $20,000.

The restuarant has a bank loan of $300,000 at 8.5% coupon interest rate.Therefore,the yearly interest expense of the company=(0.085*$300,000)=$25,500

Since,here the owners of the company own common stock it will not directly affect the income or profit of the company and hence can be excluded from profit/income calculation.

Therefore total yearly profit of the restaurant=(Total yearly revenue-total operating expenses-total yearly interest payment-yearly depreciation expense)=($462,984-$287,050-$25,500-$20,000)=$1,30,434

Now,the company pays a corporate tax of 30% on its yearly profit.Hence,following tax deduction company\'s yearly earning=$41,30,434-(0.3*$41,30,434)=$1,30,434-$39,130.2=$91,303.8

Estimated profit of Oasis including the new crepe

The existing yearly revenue of the restaurant is expected to increase by $52,000 due to addition of new crepe

Hence,following crepe the total yearly revenue of Oasis=($462,984+$52,000)=$514,984

The operating expense still remains at 62% of total yearly revenue.Thus,the yearly operating expense of the company=(0.62*$514,984)=$319,290 approximately

The new crepe machine will cost $75,000 and depreciate over 5 years at a straight line method.Hence,the yearly depreciation expese after the machine is installed=($75,000/5)=$15,000

Now recall,that before the crepe machine is installed the existing depreciation expense is $20,000 yearly.Thus,the total yearly depreciation after the installation of crepe machine=($20,000+$15,000)=$35,000

The existing yearly interest expense is already $25,500 and if the company takes another loan of $300,000 the interet rate becomes 9.25% making the yearly interest expense=(0.0925*$300,000)=$27,750 making the total yearly interest expense=($25,500+$27,750)=$53,250

Hence,the yearly estimated profit of Oasis following the installation of crepe machine=($514,984-$319,290-$35,000-$53,250)=$107,444

Now,assuming that the corporate tax rate still remains at 30%,the after tax yearly earning of the company=$107,444-(0.3*$107,444)=$75,210.8

Now,if instead of $300,000 if the company takes a new bank loan of $100,000 considering the cost of the new crepe machine($75,000) and with 9.25% of interest rate,the yearly interest payment of the company becomes=(0.0925*$100,000)=$9250 and the total yearly interest payment=($25,500+$9250)=$34,750

The difference bwtween previous yearly interest and the present=($53250-$34750)=$18,500 which can compensate for the reduced after tax yearly earnings by Oasis before and after the crepe machine installation($91,303.8-$75,250)=$16,053.8

Hence,observe that the tax deducted yearly earning of Oasis actually decreases after the installation of the crepe machine (comparing $91,303.8 of yearly earning before the crepe machine to $75,250 following the new crepe machine) considering all other conditions same as mentioned in the problem.Notice that the operating expense,depreciation expense and the interest expense all go up more compared to the increase in revenue previous situation.Hence,just looking at the estimated profit difference and cash flow calculations installation of the new crepe machine might not be a reasonable idea for Oasis.But considering the purchasing cost of the crepe machine or $75,000 the company can reduce the ammount of the new bank loan which could reduce the overall interest expense of the company and then perhaps the company might consider installing the machine with the prospect of higher tax deducted yearly earning.

Additionally,the beta for the company is 2.35 indicating that the security price of the company is essentially 235% more volatile or risky than the normal market rate.Thereofre,it indicates high market volatility for the company as well which also indicates against the installation of the new machine.