Opening a restaurant is risky. Its success or failure depends on whether customers like it. Often,...

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Opening a restaurant is risky. Its success or failure depends onwhether customers like it. Often, success does not occur overnight.It may take several years before a robust clientele of neighborhoodregulars develops, and the restaurant gains recognition andreputation around the city and among tourists. Much of the successand recognition depends on whether other new restaurants openaround the same time. In addition, the current culinary trend playsa significant role. Bottom line is, while average statistics onrestaurant successes and failures in specific areas is available,it is difficult to predict ahead of time whether a particularrestaurant will be successful, and it may take time and patience tofind out. You are assigned with a task to determine whether topursue a project that involves opening a new restaurant in theNorth Shore neighborhood of Milwaukee. You were able to collect thefollowing information.
To start operations, you need to renovate an existing restaurantspace at the cost of $200,000. The space will be rented from a realestate company at the cost of $60,000 per year. In addition, thefixed cost of running the restaurant, regardless of the success ofthe restaurant, is estimated at $150,000 per year. If therestaurant is successful during a certain year, it will producegross earnings (before the fixed cost or rent is subtracted) of$800,000 per year. If the restaurant is not successful, it willproduce gross earnings of $50,000 per year during that year.
You also estimated that the likelihood that the restaurant willbe successful in the first year of operations is 10%. If therestaurant becomes successful during a particular year, it willremain successful forever. The likelihood that the restaurant willbecome successful in the second year of operations is 20%. Thelikelihood that the restaurant will become successful in the thirdyear of operations is 5%. If the restaurant has not becomesuccessful by the end of the third year of operations, it willremain unsuccessful.
Should the company open the restaurant? You assume there is nocorporate tax, and due to the volatile and risky nature of therestaurant business, you require a discount rate of 20%.

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State 1 Restaurant is successful in year 1 Formula Year n 0 Forever Initial investment I 200000 Gross earning G 800000 Rental cost R 60000 Fixed cost F 150000 GRF Net cash flow CF 200000 590000 CFn20 PV of cash flow 200000 2950000 NPV 2750000 State 2 Restaurant is successful See Answer

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Transcribed Image Text

Opening a restaurant is risky. Its success or failure depends onwhether customers like it. Often, success does not occur overnight.It may take several years before a robust clientele of neighborhoodregulars develops, and the restaurant gains recognition andreputation around the city and among tourists. Much of the successand recognition depends on whether other new restaurants openaround the same time. In addition, the current culinary trend playsa significant role. Bottom line is, while average statistics onrestaurant successes and failures in specific areas is available,it is difficult to predict ahead of time whether a particularrestaurant will be successful, and it may take time and patience tofind out. You are assigned with a task to determine whether topursue a project that involves opening a new restaurant in theNorth Shore neighborhood of Milwaukee. You were able to collect thefollowing information.To start operations, you need to renovate an existing restaurantspace at the cost of $200,000. The space will be rented from a realestate company at the cost of $60,000 per year. In addition, thefixed cost of running the restaurant, regardless of the success ofthe restaurant, is estimated at $150,000 per year. If therestaurant is successful during a certain year, it will producegross earnings (before the fixed cost or rent is subtracted) of$800,000 per year. If the restaurant is not successful, it willproduce gross earnings of $50,000 per year during that year.You also estimated that the likelihood that the restaurant willbe successful in the first year of operations is 10%. If therestaurant becomes successful during a particular year, it willremain successful forever. The likelihood that the restaurant willbecome successful in the second year of operations is 20%. Thelikelihood that the restaurant will become successful in the thirdyear of operations is 5%. If the restaurant has not becomesuccessful by the end of the third year of operations, it willremain unsuccessful.Should the company open the restaurant? You assume there is nocorporate tax, and due to the volatile and risky nature of therestaurant business, you require a discount rate of 20%.