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Master's level Capital Budgeting

I need assitance in identifying the formulas needed to resolve my problem.

(See attached file for full problem description)

Jane Burns and Carl Foster started a computer store several years ago. The first couple of years were excellent, but then they began to fell the pressure of increasing competition; volume and profit margins plummeted. After paying themselves $20,000 salaries each, they were just breaking even.
Burns and Foster noticed, though that the computer repair business was not nearly as competitive. Most retailers wanted to sell computers, and considered repair an annoyance. Burns and Foster considered leaving the retail business, and starting a repair business. They would handle the management and marketing, hiring technicians to do the repairing primarily on sight. There were several technical schools offering training in computer repair, so they did not anticipate difficulty in finding technicians.

Burns and Foster hired a consultant to help them prepare forecasts and a feasibility study. The consultant charged $3,000 for a study that provided most the numbers they would need for their final decision.

The test equipment and inventory for each technician would cost approximately $15,000 and $7,000, respectively. The technicians would be required to own their own vehicles. An office and small repair shop space could be rented in an industrial area for $1,000 a month, including rent and utilities. Special inventory and special test equipment at that location would cost $20,000 and $15,000 respectively. This special inventory and test equipment would have a 5 year tax life and could support up to two dozen technicians. Technicians could be hired for $2,000 a month, including fringe benefits, and social security tax. The company could bill $50 per hour for a technician's time and could probably bill 30 hours per week per technician. Parts sales would be $20 per hour of billed time and the cost of parts sold would average 60 percent of sale price. Average collection period on revenues would be fifty-five days. Prepaid expenses would be 5 percent of revenue. Inventory would be purchased for cash. Accounts payable and accrued expenses would be 4 percent of revenue. Cash balances would be $10,000.
Burns and Foster expected to hire four technicians immediately, four more at the end of the first full year of operation, eight at the end of the second year, and four more at the end of the third year. They did not expect demand to grow beyond those twenty technicians.

The lease on the store ended December 31, so they could use that at their closing date, starting the new business on January 1. This would give them the next several months to start contacting businesses to sell the repair service, and to start hiring technicians. They could runs the repair business out of the retail store until the end of the year, and be fully operational by January 1. Repair revenue during the transition period would probably cover marginal costs for the period.

One area of concern was the loss they would suffer in closing the old store. Inventory valued at $135,000 would be sold at a going out of business sale for no more that $100,000. Fixtures in the store has a remaining book value of $20,000 for accounting purposes and $12,000 for tax purposes. These fixtures would be worthless and would be written off. In addition closing the old store would force them to repay their only debt - a $50,000 bank loan secured by the inventory.
Burns and Foster wanted to use a 15 percent required return and a 10-year time horizon with no salvage value for fixed assets to evaluate the investment. They did not want to assume a perpetual life in such a volatile field. The business would be set up as a subchapter S corporation. Burns and Foster were both in 28 percent tax brackets due to other family income.

Case Questions:
1. What is the significance of the loss on closing the old store?
2. Identify all relevant cash flows.
3. Compute net present value.
4. What are some of the things that could go wrong in this business?
5. Should Burns and Foster switch from retail sales to computer repair?

(See attached file for full problem description)


Solution Summary

The posting has a capital budgeting case solution