I’m thinking about setting up a wine cellar in my basement. The way I see it, shelf space would be divided into two sections: (1) a “drinking” section where I store bottles for my own consumption and (2) an “investment” section where I store bottles that I intend to sell at a profit after they appreciate in value several years down the line. The idea is to earn enough money with the “investment” section of the cellar in order to subsidize whatever I consume in the “drinking” section over time.
I'm obviously constrained by several things: the amount of money I am able to spend, the amount of wine I can (or want to) drink, the space available for the cellar, and so on.
The case is designed to be presented to the candidate by an interviewer, who plays the role of someone who wants to set up a wine cellar in his basement.
Short Solution (Expand) (Collapse)
The interviewee should perform a back-of-envelope calculation which answers two key questions:
- (1) What will be the size of my cellar (in number of bottles) over time?
- (2) What are the economics of the cellar over time in terms of money earned and money spent?
At this point the interviewee should ask the right questions in order to have all the information needed to answer the initial questions.
1. What does the wine cost?
Interviewer’s answer: $30 per bottle to drink, $100 per bottle to invest
2. How much am I willing / able to spend?
Answer: Initial kick-start $1,500/$12,000, $300/$600 per month thereafter
3. What is my own consumption?
Answer: 2 bottles per week to drink, plus 2 per month to give away as gifts
4. How does the investment wine appreciate?
Answer: 20% p.a.
5. How / when do I sell the investment wine?
Answer: Always after exactly 5 years, no cost of sale, always a buyer, no discounting
6. Are there costs to build / maintain the cellar?
Answer: $200 p.m. (optional)
Key question 1: What will be the size of my cellar (in number of bottles) over time?
To answer this question, first the interviewee should draw a chart of the number of bottles in the cellar over time. Important note: The following diagrams are based on the assumption, that the bottles initially purchased are as old as the bottles being bought in the first year.
Calculation and Conclusion
There should be a kick-start of 170 bottles: 1500/30=50 from the drinking cellar, and 12000/100=120 from the investment cellar.
The monthly consumption of 10 bottles in the drinking cellar (here the interviewee should make the reasonable simplifying assumption, e.g. that a month has ca. 4 weeks) equals my purchases for this cellar (300/30=10), so the drinking section is a steady-state cellar of 50 bottles. In the first five years, given the investment strategy, I sell nothing from the investment cellar and only purchase wine at the rate of (600/100=6*12=72) bottles per year.
Thus at the end of year one, I should have 120+72=192 bottles in the investment section, or 242 bottles in the total cellar. After 5 years (in my time accounting), I sell the kick-start of 192 bottles, and the stock drops significantly. In subsequent years, I always buy the same amount of investment wine as I sell (72 bottles per year), and therefore I always have exactly 5*72=360 bottles of investment wine in my cellar in years 6+: the 72 bottles from each of the last five “vintages” I've purchased. This makes a total long-term steady-state cellar of 360+50=410 bottles.
Key question 2: What are the economics of the cellar over time in terms of money earned and money spent?
Now let’s look at the economics over time. In fact, let’s plot cumulative return (total revenues minus total costs) over at least these 10 years.
Calculation and Conclusion
You have the kick-start of $13,500 and then only costs for the first 5 years. After 5 years, you sell the kick-start of 120 investment bottles and get a big push in revenue of 120*$250=$30,000.
In these first 5 years, you of course also have the cost of 12*$300 for purchase of drinking wine, 12*$600 for investment wine, and 12*$200 for maintenance of the cellar, so 12*$1100=$13,200 per year.
As of year 6, you continue to have the above costs in addition to the revenue of 72*$250=$18,000 from selling 72 bottles. This means that there is a “net return” in these years of $4,800, which is the slope of the above curve in years 6+. You break even after ca. 15 years, and only then does the cellar “pay for itself” and even make a slight return.
III. Concluding observations
So it takes something like 15 years to break even and recoup your initial investments. Nonetheless, we’ve obviously made a lot of simplifying assumptions and painted some rosy scenarios:
- (1) the investment wine always appreciates at 20% p.a.,
- (2) you can fund a cumulative outlay of ca. $80,000 after 5 years out of your own pocket,
- (3) you can always find a buyer for your wine, etc.
Well, yes, it’s extremely aggressive but not completely implausible. It’s certainly not a sustainable return!
What would happen if I had to get external funding (e.g. a bank loan) for this enterprise? What would an unsecured personal loan cost me, and how does this affect the economics of the cellar?
How would you incorporate the time value of money or other opportunity costs?