Ginny's Restaurant Case Solution

Ginny’s Restaurant Solution Professor A. Spieler Hofstra University

Question 1

Ginny can consumer $4.83M today. Since the $3M cash flow one year from now is known with certainty, Ginny can borrow against the future cash flow. Specifically, Ginny can borrow an amount such that the principal and interest will exactly equal the $3M future endowment.

present

consumption  $2M  $3M

1.06

 $4.83M

Similarly, Ginny can delay consumption of her present endowment of $2M and earn interest @6%. Therefore, future consumption = $5.12M

future

consumption  $2M (1.06)  $3M  $5.12M

Question 2

Ginny should choose Alternative 3. This project generates the highest NPV (at t=0). Analogously, project 3 also generates the highest future cash flows (at t=1).

Investment

Cash

End of Year CF

NPV t=0

Total Wealth t=1

Total Wealth

1 3 1.8 0.70 4.70 4.98

2 2 3.3 1.11 5.11 5.42

3 1 4.4 1.15 5.15 5.46

4 0 5.4 1.09 5.09 5.40

NPV ( project 3)  $3M  $4.4M

1.06

 $1.15M

Since all future cash flows are known with certainty, Ginny’s wealth immediately

increases upon the announcement of her decision to undertake the project. Ginny’s balance sheet after announcement of investment:

Q: What if the perfect capital market assumptions are dropped, i.e. end of year CFs are not known with certainty? What about Ginny’s ability to commit to the project?

NOTE: Same solution results if end of year cash flows are computed.