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Mrs Glam wants to expand her clothes shop. Mrs Glam has commissioned a market research company at a cost of $3,000 to research her options for her. The company have offered two options:
Option 1:
Remain in her the current premises and undertake an advertising campaign at a cost of $2,000 to increase the profile of the shop in the area. It is estimated that revenue will increase by 10% from its current level of $50,000 per year. The contribution earned on revenue is 30%.Option 2:
Move the shop to a more central location and undertake an advertising campaign to both increase the profile and the move to new premises. This more extensive campaign would cost $4,000 but revenue would be expected to increase by 18% from its current level. The level of contribution earned on revenue is not expected to change.There would be further costs involved in moving location which have been estimated:
Moving costs are estimated to be $1,500. This includes the cost of refitting the shop, and would be payable immediately
New shop fittings will be required costing $2,500. These will be depreciated on a straight line basis.
Rates of $4,000 will be payable yearly in advance. This cost is 15% higher than Mrs Glam currently pays, due to the location.Other information:
Mrs Glam uses a cost of capital of 10%
The expansion is to have a life of 4 years.Question says
Calculate the present value of the INCREMENTAL contribution cash flow that will arise if option 2 is compared to option 1.Answer is 3804. I am not even able to understand the solution. If in option 2 it is saying that contribution will not change so why it is finding incremental contribution.
Secondly, In option 1 he is saying that 30% is contribution of Total Revenue so why is he taking it same condition for option 2.Professor can you please help. Thank you.
Option 2 does not say that the contribution will not change. It says that the level of contribution on revenue will not change – so it will stay at 30%.
The extra contribution from option 1 is 30% x 10% x 50,000 = $1,500.
The extra contribution from option 2 is 30% x 18% x 50,000 = $2,700.
So option 2 gives 1,200 more per year than option 1 for each of 4 years.
Professor Option 1 says that it is 30% per revenue.
So how can we assume that it is same for option 2. Because in option 2 it is saying that it is constant so it can be constant in context of before planning to invest, not after Option 1. It is not saying that Option 2 has constant contribution as option 1.
That is why I was really confused.
Thank you.Neither option is saying that there is constant contribution.
We know that the contribution at the moment is 30% of revenue. Option 1 says that the 30% will not change. Option 2 says that the level of contribution earned on revenue is not going to change (and so will stay at 30% as well). It does not say that the actual contribution is unchanged – it would be ridiculous for the revenue to increase by 18% but the contribution to remain unchanged.
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