Capital Budgeting Analysis of an Ice Cream Store Acquisition for Mr. Specter-A Grocery Store Owner

Introduction

Background of information

Mr. Specter is an experienced grocery store owner based in Vancouver, British Columbia, who has built a successful business over the past 35 years; he has an established brand and loyal customer base across multiple locations in the Metro Vancouver area however, in the recent days, Mr. Specter has come across an opportunity to potentially acquire an ice cream shop in a neighboring town that has been neglected by its current owner and has been put up for sale; as a prudent entrepreneur, Mr. Specter wishes to conduct thorough due diligence on this possible acquisition to determine if purchasing and revitalizing this ice cream shop represents a wise strategic investment that is aligned with his expertise and capabilities.

Acquiring a small business asset such as an independent ice cream shop entails considerable financial, operational, and market risks that must be carefully evaluated before making a final determination since an underperforming asset may continue on a downward trajectory if the root causes of deteriorating performance are not correctly diagnosed and addressed through a well-planned turnaround strategy (Branner, 2009). Additionally, according to Branner (2009), projected customer demand, costs, and future growth potential carry inherent uncertainty that affects risk-adjusted returns; however, an experienced operator like Mr. Specter, with decades of consumer business knowledge, can draw on existing infrastructure and resources to unlock substantial value from a distressed asset through operational improvements, product innovation, and heightened community engagement.

The objective of this report is to provide Mr. Specter with a detailed, data-driven assessment of the financial viability, strategic rationale, and growth opportunities involved with purchasing this ice cream shop; with this in mind, state-of-the-art financial modeling techniques are leveraged to develop 10-year projections of operating performance under current asset conditions and under a revitalization scenario if new equipment investments are made; this projections form the basis of a rigorous investment return analysis consisting of net present value, internal rate of return, payback period, and scenario stress testing. On the other hand, along with financial considerations, the strategic value proposition, risk issues, and mitigation tactics are explored to offer a holistic view of the proposed transaction.

Establishing an appropriate discount rate given current capital market conditions and the inherent risk profile of an independent food retail investment is an integral component when evaluating acquisition economics; this report determines a discount rate derived from fundamental factor models that account for the consumer business space and the risk premium warranted for a distressed, small-scale operation, in addition, expert insights from external databases on industry benchmarks are also gathered to contextualize the projection assumptions; this report aims to equip Mr. Specter with the knowledge required to make a well-informed decision that serves the best interest of his growing business by leveraging financial modeling best practices, sensitivity checks for uncertainty, comparative bound analysis, and strategic scenario planning techniques.

Before outlaying capital and personal brand reputation on this ice cream shop, Mr. Specter has the opportunity to mitigate downside risk while positioning the business for sustainable, long-term prosperity; with this, the output of this engagement will include a clearly explained discount rate backed by sound financial logic, and income statements projections to quantitatively size the opportunity, discounted cash flow analysis driving net present value and internal rate of return calculations, multiple scenarios to stress test key performance assumptions, and ultimately a formal recommendation to Mr. Specter on whether or not to proceed with the proposed ice cream shop acquisition based on the results. If executed judiciously, employing data-driven analytics to evaluate investments and negotiate terms can maximize strategic fit while limiting capital risk—allowing Mr. Specter to take his established grocery empire to the next level; this report aims to give him the decision-making confidence to stretch his proven operational expertise into new realms while exercising financial prudence.

Discount Rate

Determining an appropriate discount rate is a crucial component when evaluating a major business investment decision such as Mr. Specter’s potential acquisition of the neglected ice cream shop. According to Lewellen (1977), the discount rate accounts for both the time value of money and the level of risk inherent in expected future cash flows; it represents the minimum threshold rate of return an investor should achieve from a project to justify moving forward with the investment given capital constraints; for an independent entrepreneur like Mr. Specter deciding whether to allocate significant capital towards purchasing and revamping a retail asset using the cost of equity as the discount rate for valuation modeling is most prudent from a risk perspective. According to Azimi, N. (2021), the cost of equity measures the compensation equity investors – in this case, Mr. Specter himself – required to undertake the inherently risky process of entrepreneurship and business value creation amidst uncertainty. A commonly accepted approach within corporate finance for calculating the cost of equity as the basis for discount rates is the Capital Asset Pricing Model (CAPM). The CAPM framework accounts for the asset’s risk profile within the context of overall capital market dynamics by assessing the risk-free rate, beta, and expected market returns (Sharpe, 1964). The mathematical representation of CAPM is:

Cost of Equity = Risk-Free Rate + (Beta x (Expected Market Return – Risk-Free Rate)

In our calculations for this case, the Risk-Free Rate is the current yield on 5-year Canadian government bonds, which represents the risk-free rate as it encapsulates the time value of money concept with virtually no default risk; this rate stands at 3.5% based on the Bank of Canada benchmarks. Furthermore, the beta measures the volatility of a security or asset relative to broader market movements; while comparable public companies are unavailable to evaluate, an unlevered beta of 1.5 for a retail ice cream shop smaller than average industry peers would appropriately capture business risk since as per Damodaran, (2021) its empirical research suggest an average unlevered betas for food retail to be around 0.845 reflecting stability, in addition, aggregating equity risk premium data, long-term annual total returns for Canadian public equities fall between 8-10% historically thus, we used 9% to serve as the expected market return for our input therefore:

Cost of Equity = 3.5% + (1.5 x (9% – 3.5%))

= 3.5% + (1.5 x 5.5%)

= 3.5% + 8.25%

= 11.75%

From our analysis, the cost of equity estimate for discounting Mr. Specter’s ice cream shop investment cash flows is approximately 12% based on prevailing risk-free rates, rational beta assessments, and long-run market return expectations; this adjusts for the relatively higher business risk associated within the same business niche; therefore, the 12% cost of equity will serve as the central discount rate for net present value and internal rate of return analysis when evaluating this acquisition opportunity for Mr. Specter.

Calculation and Analysis of NPV, IRR, and Payback Period

A robust financial analysis was conducted to evaluate the acquisition opportunity of the ice cream shop for Mr. Specter, projecting performance over a multi-year investment horizon enabled strategic decisions regarding valuation, resource allocation, and growth planning: quantitatively sizing the total addressable market, constructing income statement and cash flow models, and risk-adjusting returns facilitate effective diligence, the analysis focused on modeling key revenue and cost drivers to derive net present value, internal rate of return, and payback period.

Annual sales were projected starting from a baseline of 200,000 ice cream units in Year 1 based on premises capacity constraints; an 11% compounded annual growth rate reflected remodeling investments to serve more customers and marketing to drive referrals; in addition, Initial pricing was set at $6.50 per ice cream before 3% annual inflationary increases in this phase, top-line assumptions were conservatively underwritten given the high traffic and lack of direct competition.

Gross margins depended on variable costs of raw material inputs for in-house ice cream production. Retail averages suggest that 41% of revenue is attributable to variable costs (Marques, 2022); one new full-time employee was modeled at 35 hours per week earning minimum wage to operate the shop. The minimum wage also inflated by 3% annually per Canadian labor regulations, and a $10,000 upfront investment in refreshed brand messaging and digital channels was projected, again with 3% annual cost inflation. Straight-line depreciation distributed the $1 million equipment capital expenditure evenly over 5 years; given Mr. Specter’s other operations, conservative tax assumptions excluded income tax obligations.

Revenue Drivers

The primary revenue drivers consist of annual ice cream sales volumes and price increases from inflationary effects; baseline first-year sales post-acquisition start at 200,000 units based on historical store throughput. Volume growth of 11% year-over-year reflects expectations for expanding the customer base through enhanced community marketing and word-of-mouth referrals; prices begin at $6.50 per ice cream in the first year then rising 3% annually, representing broader consumer price inflation, with this the annual cash flows from the ice cream store can be calculated as follows:

Table 1

Cash flows from the ice cream store

Cost Drivers

Major costs variables include raw material inputs for ice cream production, hiring a dedicated store employee, revamped digital marketing efforts, equipment depreciation, and income taxes; variable product costs equate to 41% of sales revenue based on average gross margin ratios for retail ice cream a full-time store employee earning minimum wage at 35 hours per week handles day-to-day operations on the other hand, marketing requires $10,000 per year upfront to reconnect with the consumers moreover, straight-line depreciation distributes the $1 million equipment investment evenly over 5 years in addition ,income taxes are conservatively excluded from the analysis, all monetary figures inflate by 3% annually mirroring broader inflation with this we were able to calculate the profitability of the business taking into account the cash inflows and outflows; the cash outflows in Year 0 represented the equipment purchase and remodelling capex however the subsequent annual cash flows involves the deduction of variable production costs, employee wages, digital marketing program expenses, and depreciation from gross sales; the table below displays projected annual profitability:

Table 2

Annual Profitability

Financial Returns

Net Present Value (NPV)

We calculated the NPV was calculated following the guidelines from Dai et al. (2022) by discounting the projected future cash flows to the present value using the discount rate assuming the 12% rate and then deducting the initial investment.

NPV = Sum of Discounted Cash Flows – Initial Investment

= $1,653,476 – $1,000,000

= $653,476.

Internal Rate of Return (IRR)

Following the argument by Dai et al. (2022) in their study, we calculated the IRR as the discount rate at which NPV equals zero; this calculation involved the process of trial-and-error using Excel, and we were able to obtain the IRR at 29.26%,

Payback Period

As argued by Dai et al. (2022), we obtained the payback period following the steps, and the cumulative cash flow outline over five years is as follows:

Year 1: $246,274

Year 2: $616,352 ($246,274 + $370,078)

Year 3: $1,127,740 ($246,274 + $370,078 + $511,388)

Year 4: $1,800,149 ($246,274 + $370,078 + $511,388 + $672,410)

Year 5: $2,655,475 ($246,274 + $370,078 + $511,388 + $672,410 + $855,326)

Since the initial investment is $1,000,000, the cumulative cash flows surpass the initial investment between Year 2 and Year 3; therefore we can see that the payback period occurs in year three (after 2 years and $616,352 of cumulative cash flow), and the remaining cash inflow accumulates more than the initial investment over the remaining years with this, the payback period for this project is approximately 3.43 years (2 years + $383,648 of the cash inflow in year 3

Advice to Mr. Specter based on theAnalysis

Based on the financial analysis, we found that there was a positive net present value of $653,476, a high internal rate of return of 29.26%, and a rapid payback period of 3.43 years. therefore, with these projected figures, we find that the acquisition of the neglected ice cream shop presents a potentially lucrative investment opportunity for Mr. Specter; if he can Leverage his operational expertise within grocery retail and the strategic alignment with his existing brand, investing in this business could catalyze value creation however, it is important for him to exercise prudent judgment by validating assumptions and mitigating downside risks before outlaying his capital.

In addition, the projected growth rates for revenues and costs require scrutiny to ensure achievability since our overly optimistic forecasts could undermine actual returns; with this basis, Mr Specter should assess the total addressable market in the location, foot traffic patterns, and viability of volume throughputs based on production constraints before finalizing targets.

Furthermore, the discounted cash flow analysis utilized a 12% cost of equity as the hurdle rate, which construed moderate risk tolerance, so if Mr. Specter has different risk perceptions or return requirements, adjusting the rate would impact net present value calculations, we would advise him to get more consultations from advisors within this niche and location on discount rates appropriate for small, independent food retail investments rather than depending on the industry-wide averages.

Lastly, While considerable opportunities exist to upgrade equipment, optimize processes, and regain community awareness, executing a successful turnaround strategy still necessitates managing risks around deteriorating performance, budget overruns, quality control, and changing consumer preferences; hence, strong project management and community engagement best practices must be used to complement this financial analysis.

References

Azimi Ashtiani, N. (2021). Evaluation of the Relationship between Audit Firm Choice and Cost of Equity. Iranian Journal of Accounting, Auditing and Finance, 5(2), 25-33.doi: 10.22067/ijaaf.2021.40231

Branner, P. (2009). Risk evaluation within Asset Management: A practical perspective. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.1374609

Dai, H., Li, N., Wang, Y., & Zhao, X. (2022). The analysis of Three Main Investment Criteria: NPV, IRR, and Payback Period. Proceedings of the 2022 7th International Conference on Financial Innovation and Economic Development (ICFIED 2022). https://doi.org/10.2991/aebmr.k.220307.028

Damodaran, A. (2021). Country default spreads and risk premiums. Welcome to Pages at the Stern School of Business, New York University. https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

Lewellen, W. G. (1977). Some observations on risk‐adjusted discount rates. The Journal of Finance, 32(4), 1331–1337. https://doi.org/10.1111/j.1540-6261.1977.tb03331.x