Question

You are valuing a bed-and-breakfast in Vermont with the following informa-

tion:

■

The business had pretax operating income of $100,000 in the most recent

year. This income has grown 5% a year for the past three years, and is ex-

pected to continue growing at that rate for the foreseeable future.

■

About 40% of this operating income can be attributed to the fact that

the owner is a master chef. He does not plan to stay on if the business is

sold.

■

The business is financed equally with debt and equity. The pretax cost of bor-

rowing is 8%. The beta for publicly traded firms in the hospitality business is

1.10. The Treasury bond rate is 7%, the market risk premium is 5.5%, and

the tax rate is 40%.

■

The capital maintenance expenditure, net of depreciation, was $10,000 in

the most recent year, and it is expected to grow at the same rate as operat-

ing income.

■

The business is expected to have an operating life of 10 years, after which the

building will be sold for $500,000, net of capital gains taxes.

a. Value the business for sale.

b. How much would the value change if the owner offered to stay on for the

next three years?

Answer 1