Question

Question 2

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:

	Shop A	Shop B	Shop C
Internal rate of return	13%	17%	20%
Net present value	$250,000	$400,000	$200,000

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:

	Machine A	Machine B	Machine C
Initial investment in equipment	$180,000	$120,000	$190,000
Working capital needed	0	0	10,000
Annual cash saved by operations:
Year 1	75,000	80,000	80,000
Year 2	75,000	68,000	80,000
Year 3	75,000	48,000	80,000
Year 4	75,000	28,000	80,000

Required:

1. 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.

2. Based on the information available, which shop would you recommend that the owner of RR choose? Explain your recommendation.

3. Compute each machine's payback period. Which machine would you recommend the owner of RR choose? Why?

Answer 1

a/ The internal rate of return also has the lowest NPV due to the following reasons.

The project size may be smaller and the amount of investment may be low in the project which offers the highest Internal rate of return.

B/ Based on the above information it is better to choose shop B as it has the highest Net present value.

C/Each Machine payback period is given below.

Machine details	Machine A	Machine A	Machine B	Machine B	Machine C	Machine C
Initial investment in equipment	180000		120000		190000
Working capital needed	0		0		10000
Annual cash saved by operations:
Calculation of payback period
	Machine A	Machine A	Machine B	Machine B	Machine C	Machine C
	Yearly cashflows	Cumulative cashflow	Yearly cashflows	Cumulative cashflow	Yearly cashflows	Cumulative cashflow
Year 1	75000	75000	80000	80000	80000	80000
Year 2	75000	150000	68000	148000	80000	160000
Year 3	75000	225000	48000	196000	80000	240000
Year 4	75000	300000	28000	224000	80000	320000
Payback period	2	30000/75000	1	40000/68000	2	30000/80000
Payback period	2	0.4	1	0.588235294	2	0.375
Payback period	2	4.8	1	7.058823529	2	4.5
Payback period
Machine A	2 years and 5 Months
Machine B	1 year and 7 Months
Machine C	2 year and 5 Months
Machine B has the lowest payback period so I would recommend choosing Machine B to the owner of RR