Assignment 4
Question 1
Natasha Brown runs a specialist food store in Portland, Oregon. The store specializes in hard-to-find
food and condiments such as Milifiori Honey from Tuscany, Blue Stilton Cheese from England, and so
on. The store keeps an inventory that, valued at cost, is approximately $1.2 million. The store
generates average sales of $2 million per year, with an operating margin of 8% (after tax). New about
her excellent foods has spread, and Natasha is considering opening an online retail option for the
limited selection of the most popular products. Many of the products are sourced from around the
world and involve long lead times. Natasha would need to order a number of these items in advance
to make sure she has adequate supplies. She estimates that the online channel can generate additional
$400,000 in sales. She would have to spend about $150,000 upfront to build a robust online store
website. (She estimates that the cost of capital for a small business like here is about 15%). Natasha
also expects the operating margins from the business to be the same as her existing business.
Assuming that additional sales from the online channel will be sustained for the foreseeable future (in
perpetuity), is this project worth undertaking?
Question 2
Gluten-Free Baked Goods has created a niche for itself by creating and marketing a line of gluten-free
cakes and desserts. The company has annual sales of $5 million. It has grown slowly but steadily; the
owners have avoided all debt and have relied on internal funds to sustain growth. The firm has no
debt had has generated an after-tax operating income of $400,000. The firm purchased its supplies of
sugar, gluten-free flour, speciality yeasts, and other raw ingredients from a number of suppliers. Even
though the owners were offered 2/10 Net 30 terms by their suppliers, they paid cash on delivery. One
of the owners stated the rationale for this as follows:” We hate to owe anybody anything. Once we
have the supplies and if we like the quality, we like to pay when we get the delivery. After all, our
customers pay us right when they buy our product!” The cost of goods sold were 80% of the sales. The
owners were recently approached by another speciality food manufacturer who wanted to buy the
business for $4 million. The interested firm explained that it had simply taken the perpetuity value of
the most recent after-tax operating income using a cost of capital of 12% to arrive at the value. (The
analysis included a long-term growth potential of 2% per year.) The estimated value was
$400,000/(0.12-0.2). The owners generally agreed with all the assumptions but were still a bit unsure
about the value. They felt that the offer failed to reflect the conservative policies that they have been
following. Do you accept the offer and why?