Question

Lapos operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open 8 smaller shops at a cost of $8,400,000. Expected annual net cash inflows are $1,550,000 with 0 residual value at the end of 10 years. Under plan B, Lapos would open 3 shops at a cost of $ 8,250,000. This plan is expected to generate net cash inflows of $1,080,000 per year for 10 years, the estimated useful life of the properties. Estimated residual value for Plan B is $980,000.Lapos uses straight-line depreciation and requires an annual return of 8%.

1) Compute the ROR, the NPV, and the profitability index of these two plans. What are the strengths and weaknesses of these capital budgeting models?

2) Which expansion plan should lapos choose? Why?

3) Estimate Plan A's IRR. How does the IRR compare with the company's required rate of return?

Answer 1

Answer:- Page 1 * According to data- o computation of NPV, ROR and Proofitability Index: Here, we use 'Rate table for the present value of an ordinary Annuity of. I and dook for 8% under 10 years, option A. year cash flow Discount factor @ 81. Discounted cashfleis 1-10 1550000 | 6.701 10,400, 655 Iso, present value 10,400,655 of inflows Less; initial capital 8,400,000 outlay So, NPV 2,000,655

Page 2 ROR = (present value of Inflows - Initial outlay) Initial outlay x 100 nie., Ror (10400655 - 8400000) .8400000 X 100 RoR = 23.82% . 6 .: Poofitability Index = - PV of inflows Initial outlay Die., profitability index = 10400655 8400000 :: Profitability index = 1:24)

Page 3 option. B year cash flow / Discount factor @ 8% Discounted cashflows 7246908 1-10 1080000 . 6. 7101 980000 0.4632 453936 10 Residual value) 7700844 | PV of cash inflows less: initial capital outlay NPV 8250000 -549156 Be (7700844-8250000) 8250000 X 100 | ROR = 26.654 (ie., Negative) .: profitability Index - 7700844 8250000 poofitability Index = 0.93 Strengths of using these capital budgeting models is that,

Page-4 - we can realise if the outcome of the pooject yields positive results i.e., using NPV. - Secondly, impact of present values of inflows over that of outlay can help in decision making based on profitability inder. → facilities Comparison between different sete of alternatives The weakness of this type of model is that decision is made on future set of numbers which may be influenced by several factors and hence a mere estimate and not accurate, 2) Hence, since plan A having NPV, higher profitabili thy index and ROR should be chosen against Plan B. 1.

Page 5 3) IRR of Pland: Given NPV is at 8% Hence we chose 18% so that we get negative NPU in order to compute the value of IRR: year 1-10 cash flow | Discount factor@ 15% Discounted cash flows 1550000 5.0188 7779140 Less: Initial capital 8400000 - outlay NPV -620860 lower discount Rate + (NPV@ lower rates (NPV at laver - Nevat higher rate) x(higher rate- B dower rate). IRR >> IRR - 8% +(2000655) (2000655-6620860))*(15-8 IRR = 13.04% The IRR is higher than the company's required rate of return.

page-6 Hence this yields positive NPV and profitability Source. IRR works like a level above which a the NPV goes negative with profitability index falling below 1. - Hence IRR works as a cushion below which rates falling under yield positive NPV and profits for the given amount of data.