Larry, owner/manager of a small restaurant, is contemplating buying a larger restaurant from its owner, who is retiring. Larry would finance the purchase by selling his existing small restaurant; taking a second mortgage on his house; selling the stocks and bonds that he owns; and, if necessary, taking out a bank loan. Because Larry would have almost all of his wealth in the restaurant, he wants a careful analysis of how much he should be willing to pay for the business. The present owner of the larger restaurant has supplied the following information from the past five years:

As with many small businesses, the larger restaurant is structured as a sole proprietorship, so no corporate taxes are deducted. The preceding figures have not been adjusted for changes in the price level. There is general agreement that the average profits for the past five years are representative of what can be expected in the future, after adjusting for inflation.

Larry is of the opinion that he could earn at least $5,000 in current dollars per month as a hired manager. Larry feels he should subtract this amount from profits when analyzing the venture. Furthermore, he is aware of statistics showing that for restaurants of this size; approximately 6.5 percent go out of business each year.

Larry has done some preliminary work to value the business. His analysis is as follows:

The average net profits for the past five years, expressed in current dollars with a small subjective adjustment, are $28,000. Using this average profit figure, Larry produced the following figures in current dollars:

Based on these calculations, Larry has calculated that the value of the restaurant is $510,000.

a. Do you agree with Larry€™s assessment of the restaurant? In your answer, consider his treatment of inflation and his deduction of the managerial wage of $45,000 per year.

b. What PV would you place on the revenue stream? In other words, how much would you advise Larry to be willing to pay for the restaurant?

Transcribed Image Text:

Year Gross revenue Profit S 930,000 945,000 917,000 985,000 1,104,000 $ 75,000 37,000 11,000 103,000 106,000 -4 -3 Last Profits (current ollars Profits 75,000 37,000 11,000 103,000 106,000 Price-level factor 1.28 1.18 1.09 1.04 1.00 Imputed managerial wage $45,000 45,000 45,000 45,000 45,000 Net profits 51,000 -13,400 -33.010 62,210 61.000 Year 5 $ 96,000 43,660 11,990 107,120 106,000 2 2 Last Expected profits Real discount factor 2% 0.980 0.961 0.942 0.924 Present value $27,440 25,294 23,316 21,500 Year $28,000 26,320 24,752 23,268 Next +3 +4