Problem:
You have the opportunity to purchase a franchise office equipment servicing business for $500,000; you also have the opportunity to start your own, independent, office equipment sales-and-service business, which would also require a start-up investment for $500,000. In either case, you will serve as the owner/manager of the business. You investigate the likely returns to your investment (after properly accounting for all other costs of the businesses, including the value of your time), and your best estimate of the returns are as shown in Table below. You suspect that, further than five years our, any estimate of returns on the investment is too speculative to be worth including.
a. You anticipate that the risk-free return on your $500,000 would be about 3% per year and that you should apply a "risk premium" of 4% to both investment opportunities. Which project has the highest present value of returns to the investment? Is that investment a "good" investment? Why or why not?
b. On consideration, you conclude that the independent operation is likely to be more risky than average, while the franchise operation is likely to be less risky than average. You decide the "correct" risk premiums to apply are 3.5% for the franchise and 4.5% for the independent store. Does this change your assessment of which opportunity is a better investment? If not, why not? If it does, why?
Year Returns to the Franchise Returns to the Independent Business
1 $100,000 $50,000
2 $125,000 $75,000
3 $150,000 $175,000
4 $175,000 $225,000
5 $175,000 $225,000.