Harvard Business School Case Study 1:

Ginny’s Restaurant: An Introduction to Capital Investment Valuation

Lee Hathaway
MMS 185: Managerial Finance
Professor Veraldi
September 13, 2007
1. The net present value of Virginia’s assets is approximately $4.83 million dollars. This value

was obtained from summing the $2 million Virginia receives today plus the present value of

the $3 million she will receive exactly one year from now. These calculations are depicted in

Table A. Thus, Virginia has approximately $4.83 million dollars at her disposal to spend and

consume today if she pleases. This figure takes into account how much she could borrow

today in order to have exactly $3 million to pay back one year from now, plus the original $2

million she receives today. Of course, if she consumes nothing today, she will have a greater

amount to spend in exactly one year. If Virginia invests her holdings at the 6% interest rate,

the future value of her original assets will be $2.12 million under annual compounding, and

at best will be approximately $2.124 million under daily compounding if she consumes

nothing today and decides to let her money grow for a year. Considering the fact that she will

receive an additional $3 million one year from today, the maximum amount of money

Virginia would be able to spend and consume one year from today would be between $5.12

and $5.124 million depending on the compounding rate of an investment which yields an

interest rate of 6%. Table B displays these calculations in detail.

2. My analysis shows that investing $3 million in Ginny’s restaurant today is the optimal
investment decision for Virginia. The calculations included in Table C demonstrate that
Virginia achieves her highest net present value of approximately $5.15 million when she
invests $3 million and saves $1 million. This investment choice is supported by a high future
cash flow, and will provide a substantial amount of up-front capital and labor for the Ginny’s
Restaurant. Thus, by making the investment Virginia increases her current wealth and the
present value of her assets by $1,150,939, approximately a 28.78% increase, from a net
present value of $4 million (if she did nothing) to around $5.15 million. Virginia should only
deviate from this investment option if her indifference curves or preferences are such that she
favors consumption now over future consumption. In this instance, the investment option she
selects will depend on the strength of her preferences for consumption now. Question three
examines this situation in greater detail.
3. Despite Virginia’s strong preference for current versus future consumption forcing her to
consume at least $3.8 million immediately, the planned investment in Ginny’s Restaurant is
still plausible and in fact profitable. Based on the analysis performed in question two, ideally
she should invest $3 million into Ginny’s Restaurant. Calculations illustrated in Table C
demonstrate that Ginny should consume the $3.8 million now, borrow $2.8 million, and
combine that amount with the remaining $0.2 million of her endowment. Despite the fact that
her current wealth decreases from approximately $4.15 million (not including the $1 million
she didn’t invest) when she wasn’t governed by strong current consumption preferences to
$1,350,943.40, she remains profitable. In fact she has little difficulty repaying all of the
principal and additional interest at the 6% rate since future cash flows are known with
certainty in her world. Even if the interest rate were higher, for example 10%, and Virginia
follows the same borrowing and consumption behavior, her current wealth is $1.2 million.
Although lending at these rates is a viable option, my analysis encourages Ginny to explore
other lending options besides bank loans and possibly seek out borrowing money from family
members or other supporters who would charge little or no interest. Even if they were to ask
for a cut of Ginny’s Restaurant’s guaranteed future cash flow, Ginny would be able to avoid
paying interest on the principal and could raise her current wealth closer to the original
present value of her assets before she felt compelled to spend $3.8 million today.
4. In this situation, the fact that Virginia lacks the start-up $4 million endowment shouldn’t
deter her from achieving her entrepreneurial goal. Assuming that the “necessary skills” which
Ginny possesses to operate the restaurant include perseverance, passion for the restaurant
business, self-confidence, an intense work ethic, risk-tolerance, and strong organizational
skills, she should seriously consider embarking on this exhausting, sometimes frustrating, and
tricky business endeavor. Prior to consulting the bank regarding financing loans, Virginia
must formulate a comprehensive business plan to evaluate the profitability and feasibility of
investing her time, money, and capital into the restaurant. If her business plan proves that it
will be a profitable, fun, unique, and realistic investment option, then it is time to take finance
the operation. Although she lacks the sizeable $4 million endowment that she had the
pleasure of managing in questions two and three, my calculations in Table E demonstrate that
Virginia will be able to achieve the target $3 million investment by using a bank loan as a
financing option. Deviating from the $3 million investment option will not be profitable
seeing as her current wealth remains highest by borrowing $3 million compared to the $1, $2,
or $4 million options. Not only will she be able to develop and operate her own restaurant,
she will also be profitable such that her current wealth works out to be $1,150,943.40
assuming that all future cash flows are known with certainty and that the interest rate is 6%.
Even if the bank will only let her borrow against her future earnings, because all future cash
flows are certain, the $3 million loan in this “perfect” capital market situation will be less
than the present value of $4.4 million which is approximately $4.15 million.
5. Despite the fact that Virginia now shares her ownership interests in the Virginia Corporation
with a widely-diffuse group of investors, savers, and spenders, the owners should not deviate
from the optimal $3 million investment in the restaurant based on numerical evidence. Since
spenders have a high preference for current consumption, they seek the optimal net present
value and since savers favor future consumption, they prefer investments with higher future
values. Therefore, in this situation spenders view the $3 million investment option which
yields the highest net present value of $5,150,943.40 as their optimal choice. Similarly,
savers view the $3 million investment option as optimal because it yields the highest future
value of $5.4 million, calculated by summing the $4.4 million dollar future cash flow after
year one plus the $1 million not invested paid out as a dividend to investors. Although, some
sides may argue for more or less money to be saved or spent on principle alone, this analysis
demonstrates that a rational, acceptable compromise can and should be reached by the both
types of individuals.