Question

The owner of Waco Waffle House is considering an expansion of the business. He has identified two alternatives, as follows:

Build a new restaurant near the mall.

Buy and renovate an old building downtown for the new restaurant.

The projected cash flows from these two alternatives are shown below. The owner of the restaurant uses a 12 percent after-tax discount rate.

Investment Proposal	Cash Outflow: Time 0			Net After-Tax Cash Inflows*
				Years 1–10			Years 11–20
Mall restaurant	$	315,000		$	45,000		$	45,000
Downtown restaurant		140,500			28,000			—

* Includes after-tax cash flows from all sources, including incremental revenue, incremental expenses, and depreciation tax shield.

Use Appendix A for your reference. (Use appropriate factor(s) from the tables provided.)

Required:

Compute the net present value of each alternative restaurant site.

Compute the profitability index for each alternative.

How do the two sites rank in terms of NPV and the profitability index?

Answer 1

Compuration of Net Present value (NPV)
Alternative 1 (Mall Restaurant)
Year	Cash out flow	Cash Inflow
Year 0	-315000
year 1-20		45,000
Discount factor/ Annuity factor @ 12% Discount rate		7.46944
	-3,15,000	3,36,125
NPV		21,125
Alternative 2 (Downtown restaurant)
Year	Cash out flow	Cash Inflow
Year 0	-1,40,500
year 1-10		28,000
Discount factor/ Annuity factor @ 12% Discount rate		5.65022
	-1,40,500	1,58,206
NPV		17,706
Computation of Profitability Index
Profitability Index = (NPV + Initial investment) ÷ Initial Investment
Alternative 1 (Mall Restaurant)
=(21,125+315,000)/315,000
=1.067
Alternative 2 (Downtown restaurant)
= (17,706+140,500)+140,500
= 1.126
The two sites rank in terms of NPV and the profitability index
	NPV	Profitability index
Mall Restaurant	RANK-II	RANK-II
Downtown Restaurant	RANK-I	RANK-I