P26-31A Using payback, ARR, NPV, IRR, and profitability index to make capital in
ID: 2534092 • Letter: P
Question
P26-31A Using payback, ARR, NPV, IRR, and profitability index to make capital investment decisions Hill Company operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of $8,700,000. Expected annual net cash inflows are $1,550,000 for 10 years, with zero residual value at the end of 10 years. Under Plan B, Hill Company would open three larger shops at a cost of $8,340,000. This plan is expected to generate net cash inflows of $990,000 per year for 10 years, the estimated useful life of the properties. Estimated residual value for Plan B is $1,200,000. Hill Company uses straight-line depreciation and requires an annual return of 10%. Requirements 1. Compute the payback, the ARR, the NPV, and the profitability index of these two plans. 2. What are the strengths and 3. Which expansion plan should Hill Company choose? Why? 4. Estimate Plan A's IRR. How does the IRR compare with the company's required rate of return?Explanation / Answer
(1) Payback Period :-
= Cost of investment/Annual net cash flow
Plan A
Plan B
(A) Cost of investment
8700000
8340000
(B) Annual net cash flow
1550000
990000
Payback period (A/B)
5.61 years
8.42 Years
ARR Approach:-
= Avg Accounting profit/Avg Investment
Avg Accounnting profit = Cash flow – Dep Exp
Plan A
Plan B
Annual net cash flow
1550000
990000
(-) Depreciation
870000
714000
(A) Avg accounting profit
680000
276000
(B) Avg investment
8700000
8340000
ARR (A/B)
7.82%
3.31%
NPV:-
Plan A
Plan B
(A) Cost of investment
8700000
8340000
(B)PV of Annual net cash flow (cash flow* PVAF)
(1550000*6.145) = 9524750
(990000*6.145) = 6083550
(C) PV of Scrap/ Residual value
--------
(1200000*0.3855) = 462600
NPV (B+C-A)
824750
(1793850)
(2) Strength & Weakness:-
Payback Approach:-
Strength:-
1. The payback approach may offer advantages in cases where a company has certain time requirements in terms of how long a project will take to pay for itself.
2. The payback approach helps identify which projects offer the quickest payback period.
Weakness:-
1 Projects that require a long payback period may actually generate larger returns than a project with a short payback period.
ARR:
Strength:
1. It considers the total profits or savings over the entire period of economic life of the project.
2. Easy to calculate
3. This method is useful to measure current performance of the firm.
Weakness:
1. A fair rate of return can not be determined on the basis of ARR
2. This method does not consider the external factors which are also affecting the profitability of the project.
NPV:-
Strength:
1.. The calculation of the NPV uses a company's cost of capital as the discount rate. This is the minimum rate of return that shareholders require for their investment in the company.
2. The NPV method also tells us whether an investment will create value for the company or the investor, and by how much in terms of dollars.
Weakness:
1.. The biggest disadvantage to the net present value method is that it requires some guesswork about the firm's cost of capital.
2. NPV method is not useful for comparing two projects of different size.
(3) Company should choose Plan A due to higher & positive NPV, Quicker Payback period, Higher ARR.
(4) Plan A IRR:-
Outflow = Inflow
8700000 = 1550000 * PVAF
PVAF = 5.61
At 12.21%, PVAF =5.61
The IRR is simply the discount rate, which, when applied to a series of cashflows, gives a net present value (NPV) of zero
The Required rate of return is the return a company requires on its projects in order to proceed with them. This is a fairly arbitrary number and differs from company to company. It is not necessarily related to the cost of funds..
Plan A
Plan B
(A) Cost of investment
8700000
8340000
(B) Annual net cash flow
1550000
990000
Payback period (A/B)
5.61 years
8.42 Years
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