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Calculation Of Pre-tax Operating Profits

Question

Shannon Kampa is in talks with Resul Ozbayrak Leaseco, a leasing company, to rent store space for new stores that Shannon is considering adding to her high-end natural foods chain. Leaseco would build the stores and lease them to Shannon. For a typical store, Shannon will need to invest $1 million of equity funds, all of which goes to finance working capital needs. She estimates that she will earn on average an operating profit of $200,000 per year, before rent payments, but recognizes that the actual operating profits could be higher or lower than that depending on environmental factors she cannot control. Leaseco estimates that they will also have a very long term investment of about $1 million in building each store and offers Shannon the following two options: 1) pay a fixed rent of $90,000 per year or 2) pay a variable rent equal to half the operating profits.

Answer the following questions:

(a) Calculate Shannon’s pre-tax ROI (return on investment, measured as pre-tax operating profits, after deducting rents, divided by her investment of $1 million) under the two rental options for each of the following 3 scenarios that might occur in the first year of operation:

i) Good news: Operating profits are $300,000 per year,

ii) Medium news: Operating profits are $200,000 per year.

iii) Bad news: Operating profits are $100,000 per year.

 

good

medium

bad

op. profit before rent

300

200

100

Shannon's investment

1000

1000

1000

a) fixed rent case

 

 

 

op. profit after rent

 

 

 

ROI

 

 

 

b) variable rent case

 

 

 

op. profit after rent

 

 

 

ROI

 

 

 

Is Shannon’s investment more or less risky under the fixed rent option, relative to the variable rent option? What is the basis for your conclusion?

(b) Calculate Leaseco’s ROI under the two rental options. Is Leaseco’s investment more or less risky under the fixed rent option? What is the basis for your conclusion?

 

good

medium

bad

op. profit before rent

300

200

100

Leaseco's investment

1000

1000

1000

a) fixed rent case

 

 

 

rental income

 

 

 

ROI

 

 

 

b) variable rent case

 

 

 

rental income

 

 

 

ROI

 

 

 

(c) Does the risk of the combined investment that Shannon and Leaseco make in the store depend on which rental option she selects?

(d) Do you see a parallel between this discussion and the impact of increased leverage (from debt financing) on the risk of equity? If so, what is the link?

 

Summary

The question belongs to Finance and it discusses about calculation of pre-tax operating profit for a new business. Estimated pre-tax profits for the business also need to be calculated along with the risk taken.

Total Word Count 576

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Comments

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