ECON 134A

CASE STUDY 2 - Upland Restaurant Case

Valuing Mutually Exclusive Capital Projects

Instructions

This case study will ask you to evaluate mutually exclusive investment opportunities by putting yourself in the shoes of two recent graduates turned restaurant owners and investors. After reading the background scenario carefully, you will have to answer a series of preparatory questions and write an executive summary. The questions are meant to guide you to prepare the executive summary. You are free (and encouraged) to work on additional analyses to make your executive summary stronger.

You will have to upload a single pdf document containing 1) the one-page executive summary, 2) answers to the  preparatory  questions,  and  3)  all  the  tables  and  appendices  backing  up  your  analysis,  including  any additional work you think is helpful.

Note that points will be awarded for presentation. This includes the ease with which one can understand your work, whether your final  document  is  nicely  formatted,  whether  tables  and  exhibits  are  clear  and  well- documented, etc. You may want to think of your report as something you would feel comfortable handing in to your boss if you were a financial analyst.

You may work in groups of up to four students, in which case you only needto submit one report. Please make sure to include the names and student IDs of all students in the file. Working in groups is highly recommended.

Background

After graduating from  UCI  2 years ago, you and three friends decided to start  Upland  Restaurant.   After searching for several months for a location in Irvine, you decided togo a different route and buy 5 acres of land including an old restaurant and a small building, formerly used for offices, at the edge of town. After renovating the old restaurant, you were able to open and grow sales over the past 2 years.  However, lacking the initial capital, you never did anything with the other smaller building.   Now that you have saved up some cash, you and your friends feel like you can generate some extra income from the existing building.  To that end, you and your team  have  paid $20,000 to a consulting firm for a forecast of the future  revenues and costs associated with the different options you are considering. The exhibits given below are the outcome of the consulting firm’sresearch.

Your first option is to enter a leasing agreement with a former Anteater who runs an event planning company called Diamond Events.  After describing the location and space to her, she is interested in renting it out to host a variety of events. To make this possible, you will have to renovate the space first, which will take time and money. Additionally, if Diamond Events were to lease the space, you and your team expect there to bean increase in repairs, maintenance, and utilities as well as a slight decrease in restaurant sales from an overall decrease in ambience from the additional event goers (loud partyers, congested parking lot, etc.).   Diamond Events is willing to sign a 4-year lease with an annual rent of $84,000 in the first year, growing at 5% thereafter. The team’s additional assumptions are given below in Exhibit 1; where the renovation cost is a one-time capital expenditure and the increase in repairs, maintenance, and utilities, is an annual cost.

Note: All operating income are taxable, therefore operating expenses reduce the taxable income, while capital expenditures such as renovation costs and equipment costs are not tax deductible.

Exhibit 1: Leasing to Diamond Events Assumptions

Below in Exhibit 2 are the original projections of net restaurant sales for the next 6 years, were you not to undertake any new project with the small building.

Exhibit 2: Baseline Projection of Restaurant Sales

The other option the team is considering is starting a small craft brewery in the space.  While the renovations would be much less expensive, in order to start the brewery, your team would need to buy and install the required equipment.   Additionally,  there would  be  other  increases  in costs to consider.   A  major  benefit, however, is that the brewery would serve as a complement to your existing restaurant business.  Your team feels that offering your own unique craft beers will lead to more food sales than would otherwise occur without them. You project that your craft beverage sales will start at $85,000 in year 1 and grow at 7.5% annually after that. Additional assumptions are found below in Exhibit 3; where the renovation and equipment costs are one-

time capital expenditures and the increase in repairs, maintenance, and utilities, is an annual cost. Note: The equipment is assumed not to depreciate overtime.

Exhibit 3: Building Craft Brewery Assumptions

Lastly, your team needs to consider what you can do with the craft brewery after the project life is over. After brainstorming, you feel that there are 2 possible outcomes after the 6 years are up. The first outcome, outcome A, is that the project does not go as planned, in which case you will have no other option than simply ceasing operations. The second outcome, outcome B, is that the project goes well, you develop a good menu of craft beverages and a steady customer base. In this case, you believe that you will have two options after Year 6. The first option, option B.1., is for an outside investor to purchase the craft brewery portion of your business.

The second option, option B.2., is to simply continue operations, which you will value as a perpetuity.  The necessary assumptions are given below in Exhibit 4.

Exhibit 4: Terminal Options

For outcome B, your team is unsure about what the best option is and is hoping you can help them determine which one would add the most value to the business.  Additionally, from your time in business school, you are aware that valuation techniques are very sensitive to the assumptions that are made.  While you and your team worked very hard on projecting sales, growth rates, etc., you understand that these are just expectations and that actual values can be higher or lower, impacting the attractiveness of the options.  Therefore, it will be important to conduct sensitive analyses on some of the key parameters.

Preparatory Questions

1)    Lease option

a.    What are the relevant costs and benefits of leasing the additional space to Diamond Events?

b.    Are any costs or benefits irrelevant?

c.    What is the NPV of leasing the additional space to Diamond Events?

d.    What is the IRR?

e.    Do the NPV and IRR decision making rules agree?

f.     Sensitivity analysis

i.    Construct a cost of capital sensitivity table for all valuation types with costs of capital

ranging from 11% to 15% in increments of 0.5%. That is fill in the following chart:

ii.    Construct 3x3 NPV and IRR Sensitivity Analyses reflecting the following information

2)    Build option - Outcome A:  Cease operations

a.    What are the relevant costs and benefits of starting the brewery?

b.    Are any costs or benefits irrelevant?

c.    What is the NPV of starting the brewery?

d.    What is the IRR?

e.    Do the NPV and IRR decision making rules agree?

f.     Sensitivity analysis

i.    Construct a cost of capital sensitivity table for all valuation types with costs of capital

ranging from 11% to 15% in increments of 0.5%. That is fill in the following chart:

i.       Construct 3x3 NPV and IRR Sensitivity Analyses reflecting the following information

3)    Assuming the worst outcome for the craft brewery project (outcome A), which option should Upland choose: do nothing, lease to Diamond event, or open craft brewery? Why?

4)    Assuming a good outcome for the craft brewery (outcome B), which of the two options (B.1. or B.2.) offers most value?

Executive Summary

Prepare a short (less than 1 page) executive summary that lays out major assumptions you used and what decision you have arrived at: should you go ahead with the leasing option, the craft brewery option, or leave the small building idle?