(L. OBJ. 2, 4) Using the payback and accounting rate of return methods to make capital investment decisions, and using discounted cash flow models to make capital investment decisions [30—46 min]
Locos 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 $8,410,000. Expected annual net cash inflows are $1,650,000, with zero residual value at the end of nine years. Under Plan B, Locos would open three larger shops at a cost of $8,340,000. This plan is expected to generate net cash inflows of $1,120,000 per year for nine years, the estimated useful life of the properties. Estimated residual value for Plan B is $1,300,000. Locos uses straight-line depreciation and requires an annual return of 8%.
Requirements
1. Compute the payback period, the ARR, and the NPV of these two plans. What are the strengths and weaknesses of these capital budgeting models?
2. Which expansion plan should Locos choose? Why?
3. Estimate Plan A’s IRR. How does the IRR compare with the company's required rate of return?
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