Tuesday, December 15, 2015

Chris Cycles Up Another Gear

If you recall from the first post in our "The Always Small Business" series we introduced Chris who owned a bicycle shop, "Chris's Bikes & Spokes". Chris is an avid cyclist and lover of many finer things in life.  Chris lives in a good neighborhood with a nicely updated home along with higher end furnishings. He also makes sure to buy a new car every 3-5 years as he doesn't want to be seen in anything older, nor does he like being bothered with repairs generally associated with older vehicles. His family eats out quite a bit at nice restaurants, and love to have new clothes and electronics.


Chris runs his bike shop along with the help of one part-time entry level employee to help explain bicycle options, and occasionally ring up customers. Chris has seen brisk business the last few years as more people turn to biking for recreational and transportation purposes. He has considered expanding to meet the increased demand. However he is somewhat cautious as he doesn't feel he would be able to handle the expansion for a few reasons. For one he doesn't feel he can afford hiring a manager. This stems from the fact Chris utilizes all the profits for his personal lifestyle.  Chris is also uneasy not knowing the amount of losses the new location could possibly incur since he lacks a sufficient cash cushion to absorb losses.


Let's take a look at some financials for Chris's Bikes & Spokes.


Revenue - $615,000
Net Income - $73,800
Net Income Profit % = 12%


Balance Sheet Items:
Cash on hand - $7,000
Loans outstanding - $22,000
Total Assets - 55,000
Total liabilities - 44,000


Chris takes the company profit of $73,800 as his take home pay.  The loan is from when he started the business to fund the initial inventory and equipment purchases. Chris borrowed $50,000 from his parents and has been timely with paying the money back.


Let's tackle his business issues first. Chris wants to open his next store in an up and coming urban neighborhood.  He believes a large amount of the newer residents will want to bike based upon other transportation options.  He wants a space slightly larger than his current one to make room for an expanded repair area.  He also wants to hire an additional person to help handle repairs. This would alleviate him from becoming overwhelmed handling repair work at both stores.  Here are some basic costs that will be associated with the new location.


Rent - $1,500/mth
Manager - $3,416/mth
Renovation costs - 20,000
Equipment/Fixtures - 25,000
Inventory - 30,000
Total = $79,916


Since Chris has substantial cash outlays as part of his start up costs he will have to borrow the funds, or sell equity as he lacks the personal savings for start up costs.  Chris entertained some equity proposals, but didn’t like the idea of others having ownership interests. He has received a senior secured loan proposal for the renovations, equipment, and inventory of $75,000 for 5 years at 8.5% annual interest. We now need to calculate Chris's weighted cost of capital to determine a discount rate.  This will help us determine the expansion feasibility. We begin by making adjustments to Chris's return on equity which currently sits at an unsustainable 670% to a more reasonable 15.5%. This gives us a discount rate of 4.69%.


Here is a 5 year chart of what we can expect the new location to generate in revenue and expenses based off the original location.
Period
Revenue
Expense
Cash Flow
Taxes
Net Cash Flow
Year 1
$250,000
$227,500
$22,500
$6,750
$15,750
Year 2
$275,000
$250,250
$24,750
$7,425
$17,325
Year 3
$300,000
$273,000
$27,000
$8,100
$18,900
Year 4
$350,000
$318,500
$31,500
$9,450
$22,050
Year 5
$400,000
$364,000
$36,000
$10,800
$25,200





$99,225


Now if we discount the future cash flows we get a present value of $85,719.  We can calculate the NPV by subtracting the present value of cash flows minus the expected cash outlays.

NPV= $85,719-$79,916 = $5,803


The new location currently looks economically feasible. But before Chris decides to go ahead with the project we should look at the financial feasibility. We need to convert the loan payments to an after tax basis which will reflect the deductible interest.




Loan



Period
Net Cash Flow
Principal
Interest
Payment
Amount
Tax Savings
After Tax
Payment
Payment
Amount
Year 1
$15,750
$12,657
$6,375
$19,032
$1,913
$17,120
-$1,370
Year 2
$17,325
$13,733
$5,299
$19,032
$1,590
$17,443
-$118
Year 3
$18,900
$14,901
$4,132
$19,032
$1,240
$17,793
$1,107
Year 4
$22,050
$16,167
$2,865
$19,032
$860
$18,173
$3,877
Year 5
$25,200
$17,541
$1,491
$19,032
$447
$18,585
$6,615


Here we see that over the next five years the expansion will be feasible overall despite incurring cash deficits the first two years. Chris  can now decide if he should go forward with his expansion knowing what the likelihood of his losses will be the first few years.

Stay tuned for more on Chris's personal finances and his expansion.

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