Capital Budgeting Analysis of an Ice Cream Store Acquisition for Mr.

Specter-a

Grocery Store Owner

Name

The name of the institution

Registration number

Supervisor’s name

Submission date
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

Sales
Year Revenue
The growth rate is an 11% increase per year

1 200,000 ice creams * $6.50 per ice cream $1,300,000

2 200,000*1.11 = 222,000 * $6.70 per ice cream $1,490,000

$1,704,785
3 222,000*1.11 = 246,420 * $6.91 per ice cream

$1,956,635
4 246,420*1.11 = 273,486.2 * $7.14 per ice cream

273,486.2*1.11 = 304,355 * $7.38 per ice cream $2,240,877

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

Present
Discounted Cash
Year Annual Cash Flows Value (PV)
Flows
Factor

0 -$1,000,000 1.000 -$1,000,000

$1,300,000 - (0.41*$1,300,000) - (35*minimum

1 0.926 $246,274
wage/hr*52* (1 + 0.03)) - $10,000

$1,490,000 - (0.41*$1,490,000) - (35*minimum

2 0.857 $370,078
wage/hr*52* (1 + 0.03)^2) - $10,000

$1,704,785 - (0.41*$1,704,785) - (35*minimum

3 0.794 $511,388
wage/hr*52* (1 + 0.03)^3) - $10,000

$1,956,635 - (0.41*$1,956,635) - (35*minimum

4 0.735 $672,410
wage/hr*52* (1 + 0.03)^4) - $10,000

5 $2,240,877 - (0.41*$2,240,877) - (35*minimum 0.681 $855,326

 Present
Discounted Cash
Year Annual Cash Flows Value (PV)
Flows
Factor

wage/hr*52* (1 + 0.03)^5) - $10,000

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 the Analysis

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

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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

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