Question

Cuppa Inc operates a chain of lunch shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of $8,240,000. Expected annual net cash inflows are $ 1,650,000 with zero residual value at the end of ten years. Under Plan​ B, Cuppa would open three larger shops at a cost of $ 8,140,000. This plan is expected to generate net cash inflows of $ 1,500,000 per year for ten ​years, the estimated life of the properties. Estimated residual value is $ 1,000,000. Cuppa uses​ straight-line depreciation and requires an annual return of 8%.

Requirement: Compute the payback​ period, the​ ARR, and the NPV of these two plans. What are the strengths and weaknesses of these capital budgeting​ models?

1. Begin by computing the payback period for both plans. ​

2. Now compute the ARR​ (accounting rate of​ return) for both plans.

3. Next compute the NPV​ (net present​ value) under each plan. Begin with Plan​ A, then compute Plan B. ​(Round your answers to the nearest whole dollar and use parentheses or a minus sign to represent a negative​ NPV.)

4. Which expansion plan should Mugs ​choose? Why? 

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

Answer 1

1. COMPUTATION OF PAYBACK PERIOD

Payback Period = Initial investment / Annual net cash flow

Payback period for :

Plan A = $ 8,240,000 / $ 1650,000 = 4.99 years.

Plan B = $ 8,140,000 / 1500,000 = 5.42 years

2.COMPUTATION OF ARR

ARR = Average Net income / Average Investment

ARR for :

Plan A = 1,650,000 / 8,240,000 = 20.02%

Plan B = 1,500,000 / (8,140,000-1000,000) = 21.01%

3. Computation Of NPV

NPV = Present value of cash inflow - present value of cash outflow

NPV for :

Plan A = ($1,650,000 x PVAF (10years, 8%) - $ 8,240,000 = (1650,000 x 6.71) - 8,240,000 = $ 2,831,500

Plan B =  

Year	Particular	Cash Flow	PVF/PVAF 8%	Present value of cash flow
0	Initial outflow	(8,140,000.00)	1.00	(8,140,000.00)
1 to 10	Annual cash flow	1,500,000.00	6.71	10,065,000.00
10	Salvage	1,000,000.00	0.4632	463,200.00
			NPV	2,388,200.00

3. Which plan should mugs choose.

If the decision is based on payback period or NPV, then Mugs should choose Plan A over Plan B. However if decision is based on ARR Mugs may go for plan B

4. ARR of plan A

NPV (if 15% is the required rate) = ($1,650,000 x PVAF (10years, 15%) - $ 8,240,000 = (1650,000 x 5.0188) - 8,240,000 = $ 41020

NPV (if 17% is the required rate) = ($1,650,000 x PVAF (10years, 17%) - $ 8,240,000 = (1650,000 x 5.0188) - 8,240,000 = $ 553310

Therefore, IRR = 15% + 41020/ (41020+553310) = 15.138%

Estimated IRR of plan A is very much higher than companies required rate of return