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QUESTION

You have been asked by an investor to value a local restaurant. In the most recent year, the restaurant earned pre-tax operating income of $325,000.

You have been asked by an investor to value a local restaurant. In the most recent year, the restaurant earned pre-tax operating income of $325,000. Operating Income has grown an average of 6 percent annually during the last 6 years, and it is expected to continue growing at that rate into the foreseeable future. By introducing modern management methods, you believe the pre-tax operating income growth rate can be increased to 7 percent beyond the second year and sustained at that rate through the foreseeable future. The investor is willing to pay a premium to reflect the value of control equal to 15 percent.

The beta and debt-to-equity ratio for publicly traded firms in the restaurant industry are 1.8 and 1.5, respectively. The business' target debt-to-equity ratio is 2.0 and its pre-tax cost of borrowing based on its recent borrowing activities is 8 percent. The business specific risk for firms of this size is estimated to be 5 percent. You conclude that the specific risk of this business is less than other firms in this industry due to its sustained profit growth, low leverage, and high return on assets compared to comparable restaurants in this geographic area. Moreover, per capita income in this region is expected to grow more rapidly than elsewhere in the country, adding to the growth prospects of the restaurant business. At an estimated 14 percent, the liquidity risk premium is believed to be relatively low due to the excellent reputation of the restaurant. Since the current chef and the staff are expected to remain if the business is sold, the quality of the restaurant is expected to be maintained.

The 10-year Treasury bond rate is 6 percent, the equity risk premium is 5.5 percent, and the federal, state and local tax rate is 40 percent. The annual change in working capital is $20,000, capital spending for maintenance exceeded depreciation in the prior year by $14,000. Both working capital and the excess of capital spending over depreciation are projected to grow at the same rate as operating income. What is the business worth?    Make sure to show all your work.

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