Question

This is a managerial accounting question with 'finance' aspects.

Rebel Restaurant Pte Ltd (“RR”) is looking for a new location in shopping malls. RR is
considering purchasing a shop rather than leasing, as it has done in the past. Three retail
shops in a new mall are available. Each shop has its own advantages and disadvantages.
The owner of RR has completed an analysis of each shop that factors in the time value
of money. RR expects to pay a tax rate of 40% for the next four years. The information
is as follows:

At the same time, RR has also received three proposals for a new micro-brewery machine
it intends to install in the shop instead of buying beer from local suppliers. Data on each
machine is as follows:

Required:
(a) The owner does not understand how the shop with the highest internal rate of
return also has the lowest net present value. Explain probable cause(s) of this
contradiction observed by the owner.
(5 marks)
(b) Based on the information available, which shop would you recommend that the
owner of RR choose? Explain your recommendation.
(3 marks)
(c) Compute each machine's payback period. Which machine would you recommend
the owner of RR choose? Why?
(14 marks)

Shop AShop BShop 20% Internal rate of return 13% 17% C0) Net present value $250,000$400,000$200,000 Machine AMachine BMachine C $190,000 10,000 Initial investment in equipment Working capital needed Annual cash saved by operations $180,000 0 $120,000 0 Year l Year 2 Year 3 Year 4 75,000 75,000 75,000 75,000 80,000 68,000 48,000 28,000 80,000 80,000 80,000 80,000

Answer 1

(a)

At times when we are analyzing a single project, both NPV and IRR will provide us the same indicator about whether to accept the project or not. However, when comparing two projects, the NPV and IRR may provide conflicting results. It may be so that one project has higher NPV while the other has a higher IRR. This difference could occur because of the different cash flow patterns in the two projects.

Conflict can be because of

1. Difference in project scale. If two projects have different initial costs, the cross of the NPV method may occur.
2. Difference in cash flows timing. This conflict can happen when most of the cash flows from one project come in earlier years and most of the cash flows from the other project come in later years

(b)

In the above question, I would recommend Shop B because of the highest NPV because of an inherent reinvestment assumption.

The background of such a recommendation is that the reinvestment rate plays the key role. The basic assumption of the NPV method is that future cash flows are reinvested at a discount rate (cost of capital rate), and the IRR method assumes that future cash flows are reinvested at an internal rate of return. The reinvestment rate equal to the cost of capital is a more realistic assumption, especially in the long run.

(c)

	Investment Amount	Additional Cash Flows	Life	Payback Period
	A	B		A/B
Machine A	180000	75000		2.40
Machine B	120000	80000		1.59
Machine C	190000	80000		2.38

We would recommend the owner to choose Machine B because it has the lowest payback period.