Analyze a project with cash flow, break even, NPV

Case Study Analysis: Too Hot To Handle!

Capital Budgeting

a. Briefly summarize the case
b. Formulate answers to questions 1, 2, 3, 4, 5, 6, and 7 at the conclusion of the case. Be sure to include your calculations where appropriate.

Capital Budgeting

Too Hot To Handle!

When Patsy opened her full service salon and day spa three years
ago, she knew that she would have to make some difficult choices
regarding the hiring and firing of qualified professionals such as
cosmetologists, estheticians, nail technicians and massage therapists.
However, she was confident that her salon management training at Chic
University coupled with her industry experience as a stylist would serve
her well.

And serve her well they certainly did! Within three years of
starting her own business, and after a few setbacks, she had managed to
assemble a team of 10 salon professionals who were all extremely
motivated, people-oriented, and driven individuals who worked hard at
retaining their clients and drumming up retail sales. Of course, Patsy had
put in place an incentive plan, which the stylists found to be challenging,
yet lucrative. Patsy's salon revenues had grown significantly each year
to their current annual level of $500,000. On average, the salon serviced
about 40 customers per day with an average ticket of $50.
However, over the past year or so a number of new salons and
nail spas had opened up in the city. Competition had become much more
severe and customers were being swayed by numerous discount coupons.
Patsy was well aware that her current sales growth rate of 10% would not
continue for very long.

At the suggestion of some of her regular clients, she decided to
explore the possibility of expanding her service offerings to include
tanning booths. She figured that such an addition would complement her
current salon business by offering customers the opportunity to come in
for about 15-30 minutes and have a worthwhile tanning experience or
better still to enjoy a relaxing tan instead of waiting out in the lounge.
As Patsy began exploring the various costs and investments
required, she realized that she had very little knowledge about the tanning
business. What appealed to her the most was that the revenues from the
tanning business would be all hers to keep unlike the other salon services
where she paid the salon professional a commission of up to 50% of the
revenue generated from the services rendered. What was most confusing
to Patsy was whether she should go in for the tanning dome unit or the
relatively cheaper tanning bed.

"Call up that toll free number that's listed on the Sun-Quest
Catalog", said her ever-resourceful husband, Alan, who worked as a sales
representative for a chemical company. "It always works for me," he
added. After many hours of agonizing over the issue, Patsy finally gave
in and made the call.

The salesman, Mike, who answered the call was extremely
helpful, courteous, and convincing. "Tanning is a great complement to a
Salon and Spa," he said. "We have shipped many units to salons all over
the country, and they seem to be doing pretty well."

"Let's say I do start the tanning service at my salon, Mike,
should I go in for the less expensive tanning bed or the more expensive
tanning dome?" asked Patsy, eager to sort out her dilemma. "Well,"
responded Mike, "Each unit has its own pros and cons. The bed costs
considerably less than the dome, but it takes longer for an equivalent tan
per session. The dome on the other hand, costs more, but it does the job
faster, provides for a complete body and facial tan, and lasts longer."

"Do you have a comparison chart showing the approximate costs,
features, and revenue potential of each option, Mike?" asked Patsy.
"Absolutely," said Mike. "I would be happy to email you a copy right
now, if you like." "That would be great!" said Patsy, "It would certainly
help me make an informed decision. As you can see, Mike, I really want
to figure out which of these two units is Too Hot To Handle!"

Exhibit 1

Some Relevant Information
Salon Hours: Sunday, Monday Closed
Tuesday-Thursday 9 AM - 7 PM
Friday 9 AM - 5 PM
Saturday 9 AM - 2 PM

Advertising Costs $300 per month (Yellow Pages Ad.)
$200 per month (other advertisements)
Patsy's After-tax cost of funds: 11% per year
Depreciation method: Straight line over 5 years
Tax rate: 30%

Exhibit 2

Mike's Email
From: Mike Reynolds <[email protected]
Sent: Thursday, February, 10 200X 11:45 AM
To: [email protected]
Re: Tanning equipment comparison chart

Dear Patsy,

As per our conversation, I am attaching a comparison table showing the
relative costs and features of the dome and bed units. Please call our toll free
number if you need any more information. We look forward to
doing business with you.

Dome Unit Tanning Bed
Cost (including shipping) $7800 $2800
Set up cost $500 $200
Electricity cost per session $0.50 $0.30
Number of sessions/hour 4 3
Number of bulbs needed 48 28
Cost per bulb $22 $22
Bulb life 1300 hours 1300 hours
Unit life 8 years 5 years
Suggested price/visit $3 $3
Space requirement 9 ft X 5ft X 5ft 10 ft X 10 ft room

Other income
Tanning Lotion 1 bottle/10 sessions
Profit per sale $5

Questions:

1. Develop operating cash flow forecasts for the relevant lives of each type of tanning equipment using 100% (Best case), 80% (Most Likely Case), and 50% (Worst Case) occupancy estimates for each tanning option. Assume straight line depreciation and a tax rate of 30%.

2. Calculate and comment upon the accounting, cash, and financial break-even sales for the dome unit and the tanning bed unit respectively.

3. Calculate the net present value, payback period, and the traditional IRR for each tanning option under the various
scenarios. What do the decision rules indicate?

4. Can Patsy evaluate this business project by assuming just a onetime purchase? Why or why not? What other evaluation
methods should Patsy use?

5. If you decide to use the replacement chain method, how do the calculation and decision change?

6. What are some externalities, side effects, and other relevant issues that could affect the decision?

7. Based upon your analysis, which of the two units is "Too Hot to Handle"? Why?