Question

Mastery Problem: Capital Investment Analysis

HomeGrown Company

HomeGrown Company is a chain of grocery stores that are similar to indoor farmer's markets, providing fresh, local produce, meats, and dairy products to consumers in urban areas. HomeGrown is considering opening several stores in a new city, and has proposals from three contractors (Alpha, Beta, and Gamma companies) who would like to provide buildings for the new stores.

The amount of expected revenue from the stores will depend on the design of the contractor. For example, if HomeGrown decides on a more open floor plan, with less shelf space for products, revenue would be lower overall. However, if HomeGrown decides on a very crowded floor plan, it may lose customers who appreciate a more open feel.

As the project manager for HomeGrown, you are responsible for deciding which if any of the proposals to accept. HomeGrown's minimum acceptable rate of return is 20%. You receive the following data from the three contractors:

Proposal	Type of Floor Plan	Initial Cost if Selected	Residual Value
Alpha	Very open, like an indoor farmer’s market	$1,472,000	$0.00
Beta	Standard grocery shelving and layout, minimal aisle space	5,678,900	0.00
Gamma	Mix of open areas and shelving areas	2,125,560	0.00

You have computed estimates of annual cash flows and average annual income from customers for each of the three contractors' plans. You believe that the annual cash flows will be equal for each of the 10 years for which you are preparing your capital investment analysis. Your conclusions are presented in the following table.

Proposal	Estimated Average Annual Income (after depreciation)	Estimated Average Annual Cash Flow
Alpha	$313,094	$351,145
Beta	272,019	461,411
Gamma	527,245	592,819

Method Comparison

Compare methods of capital investment analysis in the following table to begin your evaluation of the three capital investment proposals Alpha, Beta, and Gamma. You decide to compare four methods: the average rate of return, cash payback period, net present value, and internal rate of return methods.

	Average Rate of Return Method	Cash Payback Method	Net Present Value Method	Internal Rate of Return Method
Considers the time value of money
Does not consider the time value of money
Easy to compute
Not as easy to compute
Directly considers expected cash flows
Directly considers timing of expected cash flows
Assumes cash flows can be reinvested at minimum desired rate of return
Can be used to rank proposals even if project lives are not the same

Average Rate of Return

You begin by trying to eliminate any proposals that are not yielding the company’s minimum required rate of return of 20%. Complete the following table, and decide whether Alpha, Beta, and/or Gamma should be eliminated because the average rate of return of their project is less than the company's minimum required rate of return.

Complete the following table. Enter the average rates of return as percentages rounded to two decimal places.

Proposal	Estimated Average Annual Income	Average Investment	Average Rate of Return	Accept or Reject
Alpha	$	$	%
Beta
Gamma

Cash Payback Method

You’ve decided to confirm your results from the average rate of return by using the cash payback method.

Using the following table, compute the cash payback period of each investment. If required, round the number of years in the cash payback period to a whole number.

Proposal	Initial Cost	Annual Net Cash Inflow	Cash Payback Period in Years
Alpha	$	$
Beta
Gamma

Net Present Value

Even though you’re fairly certain that your evaluation and elimination is correct, you would like to compare the three proposals using the net present value method, and get some data about the internal rate of return of the proposals, each of which are expected to generate their respective annual net cash inflows for a period of 10 years.

Compute the net present value of each proposal. You may need the following partial table of factors for present value of an annuity of $1. Round the present value of annual net cash flows to the nearest dollar. If your answer is zero enter "0". For the net present value, if required, use the minus sign (-) to indicate a negative amount.

Present Value of an Annuity of $1 at Compound Interest (Partial Table)
Year	10%	20%
1	0.909	0.833
5	3.791	2.991
10	6.145	4.192

	Alpha	Beta	Gamma
Annual net cash flow	$	$	$
Present value factor
Present value of annual net cash flows	$	$	$
Amount to be invested
Net present value	$	$	$

Final Questions

After reviewing all your data, answer the following questions (1)-(3).

1. What can you say about each proposal?

Proposal	Internal Rate of Return
Alpha
Beta
Gamma

2. What can you say about these proposals?

a. HomeGrown would be breaking even (i.e., profit = 0) if Alpha’s proposal is chosen.

b. Only Gamma’s proposal is yielding more than HomeGrown’s minimum desired rate of return.

c. Gamma’s proposal is the only proposal that would be acceptable to HomeGrown.

3. Which proposal is the best choice for HomeGrown given the data collected?

Answer 1

Comparison of methods

	ARR	Payback	NPV
Considers the time value of money	No	No	Yes	IRR Yes
Does not consider the time value of money	Yes	Yes	No	No
Easy to compute	Yes	Yes	No	No
Not as easy to compute	No	No	Yes	Yes
Directly considers expected cash flows	No	Yes	Yes	Yes
Directly considers timing of expected cash flows	No	No	Yes	Yes
Assumes cash flows can be reinvested at minimum desired rate of return	No	No	Yes	Yes
Can be used to rank proposals even if project lives are not the same	Yes	Yes	No	Yes

Calculation of ARR

Acceptance or rejection is based on a benchmark return of 20%, as given in the question.

Calculation of Cash Payback Method

Calculation of Net Present Value

Answer 1 - IRR estimation

IRR is the rate at which NPV = 0.

Answer 2

Evaluation of Options:

Option A - When NPV=0, it does not indicate that the project has no value. It represents the fact that the present value of cash inflows over a period of time equals the value of investment to be made today. Hence, it does not imply breakeven; it implies that the earnings of the company matches with the minimum expected return.

Hence, this option is incorrect.

Option B - This is true, since Gamma's return is the only one that exceeds 20%. Hence, this option is correct.

Option C - This is not true, since Alpha and Gamma both pass the minimum creiteria of 20%. Hence, this option seems incorrect.

Answer 3

Based on the data given, Gamma seems the best proposal, due to :

• Highest ARR
• Lowest payback period
• Highest NPV
• Highest IRR

In case of any questions or clarifications on the above workings, please share the same in the comments section.

All the best!