Brody is owner of the Brody Sports Company. The company sells sports equipment and cloths to the general public. The company marks up its products by at least 100% which is consistent with other sports retailers. Retail sports business is risky and tends to raise or fall with the country’s economic conditions. Second retail outlet Brody is considering opening up a second store. Since the current location is doing well, a second location on the other side of town would allow him to capture business that’s currently not willing to travel all the way across town to his store. Since Brody has never ventured into an expansion this size, he felt he needed some help. So he called a friend of his at Bank USA. He asked his friend Bob for some methods to help with analyze the proposed expansion. Bob suggested Brody consider using the “risk adjustment discount rate” or RADR, and the “Profitability Index Model (PI)”. Bob asked Brody, “What’s your cost for funding the project?” Brody answered, I’m not sure but the bank usually charges 8.25% APR and I can provide a guess about other funding sources. Bob went on to say, let me send you some numbers, and you should use a risk premium for this project. Bob sent Brody the following information:
Exhibit 1 Year Cash Flow 7% discount 1 $3,900,000 $3,644,860 2 $4,017,000 $3,508,603 3 $4,137,510 $3,377,441 4 $4,261,635 $3,251,181 5 $4,389,484 $3,129,642 6 $4,521,169 $3,012,646 7 $4,656,804 $2,900,023 8 $4,796,508 $2,791,611 9 $4,940,403 $2,687,252 10 $5,088,615 $2,583,765 $30,887,025 Initial Outlay $30,887,025 Bob suggested a risk premium of 5%.
Answer the following questions for Brody
RADR, is the project acceptable? Why or why not.
Using the PI model, is the project acceptable? Why or why not.
Does either of the two approaches change your decision about opening a new sports retail store?
What would you suggest to Brody?