Bob suggested Brody consider using the “discounted payback period approach” and the “Profitability Index Model (PI)”. Bob asked Brody, what is you cost of capital? Brody said, I can raise half from stock (about a 4% cost) and the remaining half from bonds (about a 5% cost). Brody estimated the initial cash outlay for option 1 was $7,000,000 and for option 2, $5,500,000. Bob said first figure out you cost of capital and use that as your discount rate. He then said to take into consideration the added risk, Bob said an additional 5% to option 1, and 4% to option 2. Brody estimated the annual cash flow for the two options.
Cash Flow Year Option 1 = 2,500,000 per year for 5 years
Option 2 = year 1 $1,500,000 year 2 $2,500,000 year 3 $3,500,000 year 4 $4,500,000 year 5 $5,500,000
Answer the following questions for Brody
Which option is the most acceptable using the discounted payback period? Why or why not.
Using the PI model, is the project acceptable? Why or why not? Because option 2 is a higher risk then option1, Bob suggest that Brody use a higher discount rate for option 2 (use a 6% discount rate) but for option 1 use the same rate used as for the discounted payback period calculation.
Does either of the two approaches change your decision about opening a new sports retail store? What would you suggest to Brody.