1) Perform a Business Sizeup Spike’s Indoor Beach Volleyball and Rock Climbing Inc. caters to a niche market in the Canadian sports industry. As there were no indoor beach volleyball courts in Canada, Spikes faced little competition. The volleyball crazed locality of London, Ontario provided the perfect geographical location for the operations of Spikes. In addition to indoor beach volleyball courts, Spikes had also added an indoor rock climbing wall, a small restaurant with a bar, and had also upgraded the lighting, heating system, computer servers and had added a big-screen television in the lounge area.
Spikes did face some competition in the rock-climbing wall division as there were 2 other competitors in the vicinity who offered similar services at comparable rates. Holistically speaking, the business was doing immensely well and faced little or no environmental threat apart from the fact that the premises was not owned by the business itself. It was leased from another person and was constantly at risk of zoning laws banning the establishment, as it was labeled as a high intensity residential area.
This meant that the lease owner could cancel Spikes lease at any reasonable notice and construct high-rise apartment buildings in its place however Spikes reasoned that since there was no pressure from the neighborhood he would not face too much risk in this regard. As it is, the cost of a potential lease cancellation cannot be quantified and will affect the going concern of the business. Apart from that the business is in a very healthy condition, having around 130 regular teams per season that feed its main operations i. e. olleyball and Spikes has engineered various complementary services to squeeze more revenue out of its main operations which is mainly the restaurant bar and rock-climbing wall. 2) Analyze the expansion qualitatively. The main aim of Misener was to encourage more people to stay after volleyball matches and games via the outdoor patio. Additionally the outdoor patio would be directly over the new outdoor beach volleyball court hence would create an area for the audience to sit, enjoy a match along with some drinks and refreshments which eventually will increase revenues and popularity.
Having a 200 person capacity will provide enough room for spectators to enjoy a match without any congestion. Additionally, Misener has estimated that there will be 95 good weather days out of 120 days per season during which the patio can be open which implies an efficiency of around 80%. Having an extra court meant that four matches can be conducted per day meaning that Spikes can cater to around 8 more teams on a daily basis which will increase their operating revenues.
The downfall of constructing this patio was that Misener was already facing a risk of his lease being cancelled and if the business were to construct an outdoor patio, residential complaints might increase as it will cause noise disturbance as well as littering from the patio. Spikes was in no position to face residential complaints as it could push his lease towards cancellation and he would have to locate another suitable premises to operate from which could essentially destroy his business.
Lastly, the estimates provided by Misener are very optimistic and would require analysis from different projections to ensure that the expansion does remain viable in all possible scenarios. 3) List all the cash flows associated with the expansion, and classify them as relevant (cash, future and different), recurring or one-time costs. Cash Flow| Relevant| Recurring or one time? | Incremental bar revenue| Yes, Future cash flows| Recurring| Incremental food revenue| Yes, Future cash flows| Recurring| Additional league fees| Yes, Future cash flows| Recurring| Beverage COGS| Not relevant| N/A|
Food COGS| Not relevant| N/A| 5 days food inventory| Only applicable as a change in Net Working Capital which is valid for first year only| One Time| 5 days liquor inventory| | One Time| Accounts payable| | One Time| Accounts receivable| No change in AR| N/A| Servers| Yes, Future cash flows| Recurring| Bartender| Yes, Future cash flows| Recurring| Cooks| No Extra cooks are hired| N/A| Maintenance| Yes, Future cash flows| Recurring| Utilities| Yes, Future cash flows| Recurring| Insurance| Yes, Future cash flows| Recurring|
Nets & Balls| All of these cash flows fall under Capital Expenditure made in the first year, hence only relevant for first year. | One Time| Retaining Wall/Fencing| | One Time| Zoning & Permits| | One Time| Stairway| | One Time| Patio Furniture| | One Time| Washroom| | One Time| Amortization| Yes, till end of useful life| Recurring| Bank Loan| Not relevant| N/A| Interest| Yes, for 2 years| Recurring for 2 years| 4) Perform a differential analysis, with sensitivity analysis where necessary. What is the return on investment?
What is the payback period? In the attached file, there are calculations of relevant cash flows and their different impacts on the expansion analysis. The capital expenditure of the first year comes out to be about $43,500 which is financed via a 6% loan with monthly payments. Amortization of $9,300 per year will be charged to depreciate the capital expenditure which yields a tax shield (20% tax) of $1,860 annually. The per month interest payment comes out to be $1,927. 95 and the entire loan will be paid off in two years.
As a result, the annual interest tax shield comes out to be $4,627. 1 for the two years during which the loan is active. The first incremental revenue will come from 8 additional teams playing per day in the new outdoor court. Charging a per season fee of $650 per team, the total increment in revenue from increased teams is calculated to be $15,600 per year. According to Misener, due to the rooftop patio, liquor sales will increase to $6000 a day implying a $3000 revenue increase per day. Assuming 95 days in a season of 120 days during which the patio will be open and active.
As there are 3 seasons in a year the total incremental revenue comes out to be about $427,500 of profit per year. Applying similar calculations to the increase in food sales of $1000 per day yields Spikes additional profit of $99,750 per year. As these are profits before taxes, the company will need to pay taxes which are a cash outflow. Assuming a 20% tax rate, the annual tax payable from incremental revenue comes out to be $108,570. There will be some incremental operating expenses which are a direct consequence of running the patio.
Firstly 2 additional servers will be hired for 8 hours a day at $8. 5 per hour and another bartender will be hired for 8 hours a day at $10 per hour. This comes out to about $61,560 per year after considering the 95 operating days per season assumption. Maintenance and Utilities will be paid at $500 a month and $200 a month which yields $8,400 for the whole year. Insurance will increase by 10% per year which, after considering last year’s insurance of $12,225, comes out to be $1222. 5.
The bar will have to keep inventory of Liquor and food of 5 days and will pay back the suppliers in 10 days which will decrease our net working capital by $10,750 (calculations in excel). Totaling the above will yield us the differential annual cash flows for the expansion. The cost of equity for Spikes, after searching through comparable entities, comes out to be about 15%. The ratio of debt to value of the expansion is calculated to be 10. 26% which yields equity to value ratio of 89. 74%.
The cost of debt is 6% as stated earlier; after plugging these values into the formula for weighted average cost of capital, the WACC comes out to be 14. 08%. Using the above calculated weighted average cost of capital, the terminal value of cash flows for the expansion calculated is $2,592,710. 76. As a result, cash flows for the entire life of the project are calculated and the NPV of the project comes out to be $2,647,878. 40 indicating the expansion will create value of over $2 million. The payback period is less than a year, around 34 days as incremental revenues are vast and the initial outlay is only $43,500.
The return on investment, more commonly known as internal rate of return or IRR, comes out to be 872%. 5) As Earl Misener, would you go ahead with the expansion? Earl Misener should not go only by the numbers which seem too good to be true. In fact, they are too good to be true as one critical factor has not been quantified i. e. the potential risk of losing the lease due to the expansion. If Misener loses the lease then not only will the expansion be redundant, he will have to locate his business elsewhere which for a business like Spikes will spell certain death.
The location is gold as it is situated away from competitors who lower competitive risk and is located near residential areas making it easier for his customers to commute to Spikes. As Earl Misener, he should analyze his fall-back plans and strategies on how to ensure the lease does not get cancelled. If possible, Earl should also try to buy the premises instead of relying on a lease. In my opinion, it is too soon to expand and Earl should solve the lease problem before expanding.