Suppose you own a concession stand that sells hot dogs, peanuts, popcorn, and be

Question

Suppose you own a concession stand that sells hot dogs, peanuts, popcorn, and beer at a ball park. You have three years left on the contract with the ball park, and you do not expect it to be renewed. Long lines limit sales and profits. You have developed four different proposals to reduce the lines and increase profits. The first proposal is to renovate by adding another window. The second is to update the equipment at the existing windows. These two renovation projects are not mutually exclusive; you could take both projects. The third and fourth proposals involve abandoning the existing stand. The third proposal is to build a new stand. The fourth proposal is to rent a larger stand in the ball park. This option would involve $1,000 in up-front investment for new signs and equipment installation; the incremental cash flows shown in later years are net of lease payments. You have decided that a 15% discount rate is appropriate for this type of investment. The incremental cash flows associated with each of the proposals are: Using the internal rate of return rule (IRR), which proposal(s) do you recommend? Using the net present value rule (NPV), which proposal(s) do you recommend? How do you explain any differences between the IRR and NPV rankings? Which rule is better?

Explanation / Answer

Calculate NPV and IRR in excel using the formulae as follows

NPV = NPV(15%,C2:E2) - Initial Investment

IRR = IRR(B2:E2)

We get the following table

According to IRR, choose a project which has highest IRR. So project D is selected

According to NPV, choose a project which has highest NPV. So project C is selected

IRR dont consider the trend of cash flows, it only take care of the overall return. There is a thumb rule, when IRR and NPV are giving different outcomes always choose a project with better NPV.

So building a new stand is preferable.

Year 0 Year 1 Year 2 Year 3 IRR NPV A. Add a new window                      (75,000)                      44,000                   44,000                 44,000 35% $25,461.91 B. Update existing                      (50,000)                      23,000                   23,000                 23,000 18% $2,514.18 C. Build a new stand                    (125,000)                      70,000                   70,000                 70,000 31% $34,825.76 D. Rent a larger stand                         (1,000)                      12,000                   13,000                 14,000 1208% $28,469.88 A & B together                    (125,000)                      67,000                   67,000                 67,000 28% $27,976.08

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