Brody is considering opening up a second store. Since the current location is doing well, a second location either on the other side of town (option 1) or one in another county (option 2) is his two options. Either one would be considered to be more risk to Brody. Since Brody has never ventured into an expansion this size, he felt he needed some help. So he called a friend of his at Bank USA. He asked his friend Bob for some methods to help with analyzing the proposed expansion.Bob suggested Brody consider using the discounted payback period approach and the Profitability Index Model (PI). Bob asked Brody, what is you cost of capital? Brody said, I can raise half from stock (about a 4% cost) and the remaining half from bonds (about a 5% cost). Brody estimated the initial cash outlay for option 1 was $7,000,000 and for option 2, $5,500,000. Bob said first figure out you cost of capital and use that as your discount rate. He then said to take into consideration the added risk, Bob said an additional 5% to option 1, and 4% to option 2. Brody estimated the annual cash flow for the two options.

Cash Flow

Year Option 1 Option 2

1 $2,500,000 $1,500,000

2 $2,500,000 $2,500,000

3 $2,500,000 $3,500,000

4 $2,500,000 $4,500,000

5 $2,500,000 $5,500,000

Using the PI model, is the project acceptable?