Second-Location Expansion at Hardwick Street Bakery
Marisol owns Hardwick Street Bakery, a single-location shop with annual sales of $840,000, variable costs at 62% of sales, and fixed costs of $290,000. A landlord has offered a second storefront in a nearby neighborhood: projected first-year sales of $520,000 at the same variable cost ratio, incremental fixed costs of $180,000 (rent, utilities, one manager), plus $60,000 of buildout and $35,000 of equipment. Marisol has $50,000 in cash and can borrow $150,000 at 9% over five years, with level monthly payments of about $3,114. Her accountant warns that the existing store's operating income is thin and that the new lease requires a personal guarantee. The landlord's offer expires in three weeks. Marisol asks whether to sign, and if not, what alternative use of her cash and borrowing capacity would strengthen the business.
1. Calculate the contribution margin ratio, the second location's break-even sales including annual debt service, and the projected first-year result. Based only on this analysis, should Marisol sign the lease? Show your work.
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Contribution margin ratio: 1 − 0.62 = 0.38, or 38%.
Annual debt service: the monthly payment is about $3,114, so 12 × $3,114 = $37,368.
Break-even sales for the new store: fixed costs plus debt service divided by the CM ratio: ($180,000 + $37,368) ÷ 0.38 = $217,368 ÷ 0.38 ≈ $572,021.
At the projected $520,000, contribution is $197,600. After $180,000 of incremental fixed costs, the store earns $17,600 before financing, and after $37,368 of debt service it loses about $19,768. It misses break-even by roughly $52,000 of sales, or about 10%. She would also spend $95,000 of capital while holding only $50,000 cash, leaving no reserve for buildout overruns or early losses. On the numbers alone, signing is not justified unless sales can be shown to exceed roughly $572,000 with a cushion.
2. The bank requires a debt service coverage ratio (DSCR) of at least 1.25 on a combined basis. Compute the ratio and explain why meeting it may still mislead Marisol.
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Combined EBITDA proxy: existing store operating income = ($840,000 × 0.38) − $290,000 = $319,200 − $290,000 = $29,200. New store before debt = $17,600. Combined = $46,800.
DSCR = $46,800 ÷ $37,368 ≈ 1.25.
The project literally meets a 1.25 covenant, but that is misleading. The ratio sits exactly at the threshold with zero margin for error, and it relies on the existing store's thin profit to service debt incurred for the new one. A 5% sales shortfall at the new store removes $9,880 of contribution (0.05 × $520,000 × 0.38) and drops DSCR to about 0.99-a default. The calculation also assumes no cannibalization and no unplanned capital spending. A banker would likely view this as a stressed credit, not a comfortable pass. Marisol should treat covenant compliance as a constraint to negotiate, not a green light.
3. Marisol learns that about 12% of the new store's sales would likely come from existing customers. Recalculate the effect and recommend a concrete next step that limits downside.
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At 12% cannibalization, $62,400 of the new store's sales are not incremental. Lost contribution at the existing store = $62,400 × 0.38 = $23,712. New store net contribution = $197,600 − $23,712 = $173,888; after $180,000 fixed costs it is −$6,112 before debt, and −$43,480 after debt service. That turns a marginal project into a clear loser.
Better alternatives: negotiate a rent-free buildout period or percentage-rent lease that lowers fixed costs; test the neighborhood with a lower-capital catering or wholesale account, or a six-month kiosk; or hire and train a store manager before committing, since Marisol cannot run two sites alone. If she proceeds, set a pre-lease test: signed catering contracts or a deposit-supported forecast above $572,000, a six-month cash reserve, and lease language allowing assignment or early exit. Otherwise preserve cash and improve the existing store's margin.