<p>Locos company is considering 2 possible expansion plans. Plan A: open 8 small

Question

<p>Locos company is considering 2 possible expansion plans. Plan A: open 8 smaller shops, cost $8,410,000, expected annual net cash inflows $1,650,000, no residual value at the end of 9 years. Plan B: open 3 larger shops, cost $8,340,000, net cash inflows $1,120,000 per year for 9 years, estimated residual value $1,300,000. Locos use straight line depreciation, requires annual return 8%.</p>
<p>1. compute the payback period, ARR, &amp; NPV of the 2 plans.</p>
<p>2. estimate plan A's IRR. how does the IRR compare with the company's required rate of return?</p>

Explanation / Answer

Plan A: cost 8,410,000, annual cash inflows 1,650,000, no residual value at end of 9 years. Depreciation = 8,410,000/9 = 934,444 per year

Plan B: cost 8,340,000, annual cash inflows 1,120,000, 1,300,000 residual value at end of 9 years. Depreciation equals ( 8,340,000-1,300,000)/9 = 782,222

Payback period = cost of investment/annual cash flow.

For A: 8,410,000/1,650,000 = 5.1 years

For B: 8,340,000/1,120,000 = 7.4 years

ARR = average profit/average investment

For A: (1,650,000-934,444)/(8,410,000/2) = 0.0170 or 17.0%

For B: (1,120,000-782,222)/((8,340,000+1,300,000)/2) = 0.070 or 7.0%

NPV is the present value of the cash inflows and outflows.

For A: Present value of an ordinary annuity of 1,650,000 at 8% for 9 periods is 10,307,365. Subtract out the initial payment for A: 10,307,365 – 8,410,000 = 1,897,365 for NPV for A.

For B: Present value of an ordinary annuity of 1,120,000 at 8% for 9 periods is 6,996,514. Subtract out the initial payment of 8,340,000 and then add in the future value of the residual value, which is 650,324 (1,300,000/1.08^9) 6996514 – 8340000 + 650324 = -693,162 for NPV of B.

IRR of A: 13%. A lot better than required.

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